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Too Big to Cheat: Efficiency and Investment in Partnerships

We study the roles private information and capital accumulation play in the structure of partnerships. Partnerships are ventures formed with capital contributions from two members who initially share ownership of a business. Each period, profit is either invested or paid to the partners according to their needs for liquidity. When those needs are private information, the partners have incentives to misreport, and both changes in the ownership structure and investment decisions can be used to provide incentives. Because investment in the business ultimately affects both partners, capital accumulation helps to overcome the incentive to misreport. In fact, if a partner’s ownership share is large enough (“too big to cheat”), the incentive to misreport vanishes. In the long run, either the business becomes a sole proprietorship (immiserization of one partner) or both partners own large, approximately equal shares. The second case is possible only with capital accumulation. Finally, we document several facts about the ownership structure of small businesses and compare them with the model’s predictions. The analysis suggests that private information influences the structure and dynamics of partnerships.

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