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Utpal Bhattacharya
Indiana University
B. Ravikumar
Pennsylvania State University
I. Introduction
An important stylized fact about family businesses is that they are the predominant form of
business organization in the early stages of a
countrys economic development.1 Payne (1983),
in a historical survey of family businesses in Britain, comes to the conclusion that the family firm
is the vehicle whereby the Industrial Revolution
was accomplished. In Japan, family businesses
began as merchant houses during the Edo period
(16031867), and, despite government-prodded
attempts to go public during the Meiji Restoration (1868) and their dismantling by the Allies
after the Second World War (1945), they metamorphosed into the zaibatsus. The large Ko-
We model a family
business as a household operating a production technology in
which the households
human capital is a specific business skill.
Each generation can either bequeath the business and the business
skill to the next generation or sell the business through a financial intermediary and
bequeath the revenue.
Using a dynamic
model, we analyze
how the imperfections
in primary capital markets affect the evolution of family businesses. Whether
recourse to external financing exists or not,
our model predicts that
family businesses are
bigger, last longer, and
have lower investment
rates in economies
with less developed primary capital markets.
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as its fixed human capital, the family business produces output each
period. It then divides the output between current consumption, payments to its external financiers, and future physical capital. It can sell
the business at any point in time through financial intermediaries in
primary capital markets. The household is concerned not only with the
utility it derives from consumption over its lifetime, but also with
the well-being of the next generation. This bequest motive, similar to
motives explored by Barro (1974) and Becker (1974), allows us to
model the household as infinitely lived. Since the familys human capital is fixed, the marginal product of physical capital diminishes as the
household accumulates more physical capital. This increases the temptation to sell off the business and invest the sales proceeds in an interestbearing savings account. We analytically solve the familys dynamic
optimization problem and plot the evolution of family business over
time.
We should stress here that in our model, though a household cares
about the next generation and would, therefore, like to bequeath wealth,
it does not care per se whether this wealth is bequeathed in the form
of an ongoing business or in the form of the proceeds it obtains through
selling the business. It will always bequeath whichever yields the
higher lifetime utility. Therefore, contrary to the popular belief that
households prefer to keep the business forever in the family, we do
not assume that the household has any private benefits of control.6
As one would expect, the evolution of a family business, as well as
the time at which a sale takes place, depends on the development of
primary capital markets in the economy. Two possibilities arise. The
first possibility is that the family business operates in an economy
where primary capital markets are so primitive that external financing
is unavailable and all growth is financed through internally generated
funds. In this case, the only factor determining the sale of a family
business would be the offer price. The offer price is captured by the
parameter in our model. The second possiblity is that the family business operates in an economy where external financing is available. This
introduces another aspect of primary capital marketsthe spread between borrowing and lending ratesthis is defined as in this article.
The first part of this article analyzes the effect of , the offer price,
when there is no external financing possible. Our key results are the
following. First, though returns begin to diminish as the family business
grows, and consequently, the option of cashing out and saving in an
interest-bearing account becomes more and more tempting to the business-owning household, the sale of a family business is not inevitable.
6. Ward (1987) writes, This Business Shall Last Forever. That mottopromoted
by Leon Danco, president of the Center for Family Businessis every family business
owners dream.
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(1)
where
yt
kt
k rt
ht
The head of the household cares about the utility of future generations. We model him as an infinitely lived agent, whose objective in
period 0 is to maximize the discounted sum of utilities for a representative member of his household.7 Assuming utilities to be logarithmic
an assumption that allows tractabilityhis problem is to maximize
ln(c ),
t
(2)
t0
where
c t consumption at period t, and
the discount factor, (0,1)
At the beginning of any period t, the head of the household has to
decide whether to operate his production technology or sell the firm.
If he chooses to operate the technology, he has to decide how much
to consume in the current period, how much capital to rent, and how
much capital to allocate for the future. If he chooses to sell the firm,
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max
ln(c ),
t
(3)
t0
given
c t k t 1 A(k t k rt )h 1
Qk rt if I t 0,
t
w t1
R(k t ct )
if I t 1,
w t1
R(w t c t )
if I t 2,
where
w t the wealth in the savings account at the beginning of period t;
the price per unit of family capital, obtained when the family business is sold;
Q the rental rate for physical capital;
R the gross rate of return in the savings account, R (1/,
); and
I t an indicator function.
The indicator function, I t, is set as follows: if the firm is owned by
the family in period t, then I t 0; if the firm is sold in period t, then
I t 1; and, if the firm has been sold in period s t, then I t 2.
At time period 0, the family is endowed with the technology in equation (1). The first constraint in (3) tells us that, each period, output is
allocated between consumption, rental payments, and future physical
capital. An implicit assumption here is that the physical capital completely depreciates after production. A less radical depreciation rate
could easily be accommodated, but since it complicates the algebra
without buying us any more economic insight, we assume a 100% depreciation rate.
If the family sells off its business through a financial intermediary,
it obtains per unit capital sold. So k units of private capital are converted to k units of wealth, as noted in the second constraint. Once
the family business is sold and the proceeds collected, the household
invests its savings in a risk-free asset that earns a gross return of R per
period. The third and the last constraint tells us that wealth at the beginning of period t 1 is R time savings (wealth minus consumption) at
period t.
As discussed before, we assume that the family-specific human capital is business-specific and is fixed: h t h t. Without any loss of
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generality, let h 1. It should be pointed out here that this is the crucial
assumption driving the results of the article. This assumption gives us
diminishing returns, which implies that, at some point, outside opportunities may become more attractive and cashing out may result.8
If we interpret the fixed stock of human capital in our model as business specific, how does the firm operate once the family divests? To
answer this question, it may be useful to think about who buys the
family firm. We assume that the buyer is another entity who has knowledge of the specific business in which the selling family is engaged.
This buyer would give a value to the factors of production, but not
necessarily the same value the family gives to them. This buyer could
be another family, a nonfamily private firm, a public firm, or a dispersed
group of shareholders who value the assets of the family business and
the management team that comes with the assets (as in an initial public
offering (IPO)). If the buyer is an individual, why cant the family firm
hire such a person to operate its business in the first place? We assume
that there is a severe moral hazard problem with such hires.
The evolution of the family business, starting with a stock of capital
k 0, follows one of three possible time lines: it can either cash out immediately, cash out after a finite number of periods, or never sell.9
B. Primary Capital Markets
Financial intermediaries in our model are risk-neutral. They perform
two functions. First, they own a search-and-match technology that connects the seller of a family business to a pool of prospective buyers.
That is, financial intermediaries help convert k units of the familys
private capital to k units of wealth. As is offer price per unit family
capital, it is a measure of the level of development of primary capital
markets; the higher the , the more developed is the primary capital
market. Second, financial intermediaries facilitate the transfer of funds
from the savers to the borrowers in a society. As R is the lending rate
in the economy and Q is the borrowing rate, the gap Q R (defined
as ) is another measure of the level of development of primary capital
markets; the higher the , the less developed is the primary capital
market.
8. Diminishing returns, however, do not always lead to the death of a family business.
An interesting result in our article is that, whether external financing is allowed or not,
family businesses can be immortal if the offer price is below a critical lower bound. The
intuition is that the family may derive higher utility by settling down at a steady state than
by selling the business at a low price.
9. It would seem that we are forcing the family to either sell the business completely
or not to sell it at all, i.e., we are not allowing it to sell a portion of the business. It would
also seem that we are not allowing the family to buy back its business once it is sold. It
will be apparent as we solve the model that the family would find both these options
suboptimal.
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We now look at two different stages of development of primary capital markets. The first possibility is that the family business operates in
an economy where external financing is unavailable and all growth
is financed through internally generated funds. In this case, financial
intermediaries can only perform their first function, and the only factor
determining the sale of a family business is . The second possibility
is that the family business operates in an economy where external financing is available. In this case, financial intermediaries can perform
both their functions, and both factors and will affect the evolution
of the family business.
III.
No External Financing
The family has to find the optimal period to switch from a nonlinear
technology to a linear technology, a switch that is characterized by a
transaction cost. This is not a standard dynamic optimization problem.
We first determine the familys lifetime utility after cashing out for
arbitrary values of wealth. Then, assuming that the family cashes out
in an arbitrary period S, we determine the familys path of capital accumulation, starting from initial capital k 0 . Given initial k 0, different values of S generate different lifetime utilities for the family, and the
optimal S is the one that yields the highest lifetime utility. In our framework, discovering the optimal S amounts to discovering the threshold
level of capital at which the family cashes out. We begin by characterizing the households problem after it has sold the business.
A. Value of Cashing Out
If the family business is sold now, the households problem is a simple
consumption-savings problem, which could be written as
Z(w 0 ) Max
ln(c ),
t
t0
given
(4)
w t1 R(w t c t ),
w 0 0.
c t c t1
(5)
(6)
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Equation (5) describes the tradeoff between current and future consumption. Giving up a unit of current consumption yields R units of
future consumption. At an optimum, the marginal decrease in utility
of the former should equal the discounted marginal increase in utility
of the latter. Equation (6) is the infinite horizon equivalent of the finite
horizon condition: there is no benefit to saving in the last period.
In the appendix we show that Z(w 0 ) is given by
Z(w 0 )
(1 )2
1
(7)
and that the solution to (4) is unique. The decision rules are linear: c t
(1 )w t , and w t1 Rw t . Note that consumption and wealth
grow at a constant rate of R. We require the condition R 1/ to
hold in order to make the problem nontrivial, because if this condition
does not hold, then wealth and consumption after the sale will not increase, and the family will never sell.
It follows, therefore, that if the family business is sold immediately,
and k units of capital are converted to k of wealth, the present value
of the discounted sum of utilities is, from (7),
Z(k)
1
ln(R)
ln[k(1 )].
2
(1 )
1
(8)
1
ln(1 )
1
1
[ ln() ln A]
(1 )(1 )
ln k.
1
(9)
(This is, essentially, the solution to the Ramsey growth model. See,
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e.g., p. 47 in Sargent 1987.) Clearly, the family will cash out if Z(k)
X(k), that is, if
1
1
ln k
[ln A ln()]
(1 )(1 )
(1 )(1 )
1
[ln ln(1 )
1
ln(1 )
(10)
ln(R)] 0.
1
The inequality (10) says that given , the family will cash out if its
accumulated capital exceeds a lower bound.
A natural question then is, given , cannot the family always accumulate enough capital to satisfy (10)? The answer is no. To see this,
imagine the following feasible path: ct 0, k t1 Ak t . That is, starting
from k0, the family consumes nothing and allocates all output to future
capital. Since (0,1), the highest level of capital it can reach on this
path is k max Ak max . Given , if k max does not satisfy inequality (10),
then the family will never sell, since k max is the highest feasible level
of capital that the family can attain. In other words, despite the diminishing returns to family capital, there is a possibility that for some values of , the family business is immortal. This happens because
the utility the family obtains by selling at a steady state is higher
than the utility it gets by selling at very low offer prices. When we
derive the threshold level of capital at which the family will cash out,
we have to make sure that the threshold satisfies inequality (10).
The next step is to characterize the evolution of family capital. We
initially characterize this evolution under a regime in which neither
borrowing nor lending is allowed. We then analyze how the results
change when borrowing is not allowed but lending is allowed.
C.
max
ln(c ) Z(k ),
t
t0
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given
(11)
c t k t1 Ak t , t 0, 1, 2, . . . , S 1, k 0 0.
, t 0, 1, 2, . . . S 2,
ct
c t1
(12)
,
c S1
(1 )k S
(13)
and
, t 0, 1, 2, . . . . . S 2,
Ak t k t1
Ak t1 k t2
(14)
and
1
Ak
S1
kS
.
(1 )k S
(15)
(16)
and
k t1
d t
Ak t , t 0, 1, 2, . . . . . S 2
1 d t
(17)
k t1
d t
Ak t
1 d t
(18)
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Note from (16) that the investment rate is the period before the
sale, and this is independent of S, the sale period. Note also from the
recursive nature of d t in (17) that, given S, as t decreases, d t decreases.
The decrease in d t implies, from (18), that the investment rate, t , decreases, that is, as we move backwards in time from S, the investment
rate decreases. Finally, as S , d 0 (1 )/(1 ), and 0
. Therefore, for finite S, the investment rate in the initial period exceeds .
The intuition for theorem 1 is as follows. First, relative to the classic
Ramsey model where there is no possibility of sale, capital has another
use (over and above its use as a factor of production): an additional
unit of capital at any point in time in our model has an option value
at the time of sale. Consequently, the investment rate in our model
exceeds that in the Ramsey model at every point in time. (Recall that
the investment rate each period is in the Ramsey model.) Second,
in present value terms, the option value of the family capital is small
in the initial period, and it increases as the family approaches the sale
period. As the option value of the capital increases, the family allocates
more of its income to capital. Hence, the investment rate increases as
the family gets closer to the sale period.
From (16) and (17), if we fix the sale periods capital stock to be
k S , we can work backward in time to solve for k St , t 1, 2, 3, . . . .
Hence, if we can obtain the threshold level of capital at which it is
optimal to sell, we will obtain the entire time path of the familys physical capital. We are now in a position to pinpoint the threshold level of
capital at which the sale takes place.
D.
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investment rate is in the period before the sale, the familys consumption sequence from this period on is (1 )[k**], (1 )[(k**)],
and so forth. The two consumption paths are the same if and only if
equals R, implying thereby that k** is the threshold capital if and
only if equals R.
We now derive the threshold level of capital through the following
three lemmas. Define k as:
R 1 k Ak .
(19)
(20)
1
1,
(21)
and
k Ak .
(22)
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which implies that the marginal product of family capital at the threshold level of capital is greater than R. It is also clear that as R 1/,
and as , theorem 2 holds for . We thus come to the conclusion that, if the above lower-bound restriction on holds, it is suboptimal for the family to sell part of its business. The family only benefits
if it sells the entire business or does not sell any of it.
Notice from (19) that the threshold level of capital depends on the
technology of the family firm (the productivity parameter and the output elasticity of capital), the opportunity cost of not cashing out (the
interest rate in the savings account), and the price offered by the financial intermediary in the primary capital market. We are now in a position to trace the evolution of a family business when external financing
is not available.
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F.
203
Throughout this section, we will assume . We will trace the evolution of a particular family firm indexed by i in this economy. Firm i
is characterized by its fundamental parameters: , A, and .
Proposition 1. Over time, a family firm grows larger until it is
eventually sold off after a finite number of periods.
The mortality of family businesses follows from theorem 2. Notice
in figure 1 (bottom half ) that for active family firms, k t k k. This
implies that capital stock is increasing as we go forward in time, that
is, that the family firm grows over time. Theorem 1 tells us that investment rates increase as family firms mature.
Use (19) to evaluate the threshold capital at which firm i will sell.
Denote this as k(i). Denote the optimal selling period as T. So k T
k(i). Use (16) and (17) to obtain ln(k Tt ), t 1, 2, 3, . . . T 1. Denote
the time series obtained as k t(i). Do the same for family firm j, whose
initial capital is larger.
Proposition 2. Everything else equal, family firm i lasts longer
and has a smaller investment rate than family firm j if firm i starts out
smaller than firm j.
Figure 2 plots the time series for these two firms. Each has the same
fundamental parameters, but different initial capital endowments.
The threshold level of capital for both firms is k; it is independent
of the initial capital stock. Given that the investment rates in the periods
before the sale are the same for the two firmssee equations (16) and
(17)it is apparent that the smaller firm will take longer to reach its
threshold capital than the larger firm. Finally, since we know from theorem 1 that the investment rates increase as we approach the threshold
capital, firm j has a higher investment rate than firm i in each period
because it is closer to the sale period. Figure 3 plots the investment
rates over time for these two firms.
Proposition 3. Everything else equal, family firm i lasts longer
than family firm j if firm i has a higher than firm j.
From (19), we see that the threshold level of capital is increasing in
, the output elasticity of capital. Therefore, firm i has a higher threshold level of capital than firm j. Since they begin at the same level of
capital stock, it takes firm i longer to reach its threshold level than it
takes firm j. Intuitively, diminishing marginal returns to capital set in
more slowly for family businesses with higher output elasticity of capital. Hence, family businesses with higher output elasticities cash out
later and tend to be bigger when they cash out. Alternatively, we can
interpret technologies with higher to be more capital-intensive. Proposition 3 implies that capital-intensive family firms tend to be bigger
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Fig. 3.Investment rates for families with different initial capital stocks
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when they cash out and last longer than labor-intensive family firms.
This is shown in figure 4.
Now consider two economies, A and B, in which Economy A has a
higher . Figure 5 depicts the evolution in these economies of two
family businesses that start off with the same capital stock.
Proposition 4. In economies with less developed primary capital
markets (lower ), the family business is bigger at the time of sale,
lasts longer, and has lower investment rates than in economies with
more developed capital markets.
From (19), the threshold level of capital is bigger for Economy B;
so the family business in this economy is bigger at the time of sale.
Given that the investment rates in the periods before the sale are the
same, it is apparent that it will take the family firm in Economy B
longer to reach the higher threshold capital. Since we know from theorem 1 that the investment rates increase as we approach the threshold
capital, the family firm in Economy A has a higher investment rate
than a similar sized firm in Economy B because it has less time before
the final sale.10
G. Where Does Come From?
Where does , the offer price for the family business, come from? We
identify four imperfections in primary capital markets that affect .
First, given that the efficacy of a sale through a financial intermediary
depends on the search-and-match technology the financial intermediary
employs to find prospective buyers, it seems apparent that would
increase as the matching technology improves. To understand why, notice that as financial intermediaries match the seller to the highest-value
buyer, their quote is the expected maximum value. If outside valuations per unit capital of this family business are assumed to be distributed uniformly over the support [0, v], we get
xn[F(x)]
v
n1
f(x)dx
n
v.
n1
(24)
Economies with well-developed primary capital markets are characterized by financial intermediaries who have access to a large pool of
potential buyers (high values of n); hence, these economies have high
values of .11 Alternatively, well-developed capital markets are charac10. Ward (1987) reports from a U.S. study that fewer than 30% of U.S. family firms
survive two generations and fewer than 15% survive three generations. Payne (1983)
reports similar figures for a British study. Though we could not find such studies for emerging markets, casual observation suggests that family businesses survive longer in these
economies.
11. It should be here that n and are positively correlated for all matching technologies
that connect the seller to one or more of the highest bidders.
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terized by financial intermediaries who seek out a bigger range of valuations (high values of v); hence, these economies have high values of .
Second, because of the lemons problem identified in Akerlof
(1970), sellers have to signal their quality credibly in an economy
where asymmetric information exists. The less the buyer knows about
the firm, the larger the deadweight cost of the signal, and the lower
the net price the seller obtains (lower ). Third, the higher are estate
and inheritance taxes, part of which are borne by the seller, the lower
the net price the seller obtains (lower ). Fourth, the lower the competition in the financial intermediation industry, the larger the commission
for the middlemen, and so the lower the net price the seller gets
(lower ).
IV.
External Financing
1
[ln(k Y ) ln(1 )]
1
1
( ln ln Q),
(1 )2
where
(25)
(1 )A
Y
/1
A
Q
Q1
It is clear that if Z(k) W(k) for all k, then the family will never
want to sell. From (25) and (8), it is easy to show that Z(k) W(k)
if and only if
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Journal of Business
R(k Y )
k
R
.
Q
(26)
The inequality (26) is the condition for the family businesss mortality when external financing is available. Note that (26) will not be satisfied if Q. This tells us that a necessary, though not a sufficient
condition, for a family business to be mortal is that Q. The intuition
for this result is that the family in our model is not forced to sell; it
always has the option to settle down at a steady state where the gross
return to its family capital is Q every period. The utility the family
obstains in this steady state is higher than the utility it obtains if it sells,
because the return is less than Q at the time of sale ( Q) and is
less in every period after the time of sale (R Q).
B. The Threshold Level of Capital When External Financing Is
Available
If S denotes the period in which the family business is sold and k 0 is
the initial capital, the problem in the presale stage is to choose c t and
k t1 to
S1
max
ln(c ) Z(k ),
t
(27)
t0
given
c t k t1 A(k t k rt ) Qk rt ;
t 0, 1, 2, . . . . , S 1; k 0 0.
The optimal amount of rental capital would be chosen such that its
marginal cost equals its marginal benefit. From figure 6, this implies
that the family will immediately supplement its own capital k t with
rental capital k rt such that the marginal product of the total capital, K
k t k rt equals the borrowing rate. So
Q AK 1,
where
(28)
K k t k rt .
Substituting this in the budget constraint in (3), we obtain a reformulated budget constraint:
c t k t1 y Qk t
where
(29)
y (1 )AK
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of capital. The steps are shown in the appendix. Here we just state the
main theorem.
Theorem 3. k is the threshold level of capital, where k is defined as
(R 1 Q)k y.
(30)
C.
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Journal of Business
From (30), the threshold level of family capital and R are negatively
correlated. Note from (28) and figure 6 that K, the total capital employed in the family firm, is unaffected by R. From (29), we conclude
that the consumption path and the family capital path followed by the
family from the initial point k0 does not depend on R either. Hence, as
growth rates are unaffected, it would take the family longer to reach a
higher threshold family capital in the economy with the less developed
capital market.
D. Where Does Come From?
We describe three imperfections in primary capital markets that affect
, the gap between borrowing and lending rates. First, standard agency
conflicts may create a gap between borrowing and lending rates. For
instance, once a family business has borrowed k rt , it could repay Qk rt
or it could run away with the money. This problem, however, can be
prevented if the lender employs a monitoring technology. This monitoring technology is costly; let this cost be ck rt . If R is the riskless lending
rate in this economy, then Q c R. That is, for a competitive lender,
lending to borrowers at the rate Q and incurring a monitoring cost c
would be equivalent to lending at the riskless rate. Thus, one interpretation of is the monitoring cost in the economy. In this view, less
developed primary capital markets are those with higher monitoring
costs. Second, asymmetric information can open up a gap between borrowing and lending rates. Assume that there are two types of family
businesses in the world: good family businesses who return their loans
and bad family businesses who do not return their loans. Lenders lend
to the pool consisting of both, and their screening mechanisms are imperfect. So the borrowing rate in the economy is linked with the average
quality of the pool. Hence, the less effective the screening, the worse
the pool, and the higher the gap between the borrowing and lending
rates (higher ). Third, as competition in the financial intermediation
industry decreases in the economy, the middlemens commissions increase, and so the gap between the borrowing and lending rates rises.
V. Concluding Remarks
Capital Markets
213
214
Journal of Business
production technology or can hire a professional to do the same. Although the professional is more qualified, his interests are not aligned
with the interests of the family. We find that family businesses initially
grow in size by accumulating capital and only later, after reaching a
critical size, professionalize their management. This model does not
solve the cashing-out problem.
Second, our model is deterministic. The introduction of uncertainty
is essential if we want to differentiate between debt and equity. Once
this is done, we can model the evolution of inside equity versus outside
equity and capture the gray area where a business is partially owned
by the family.
Finally, this article is agnostic as to who is the buyer of the family
firm. The buyer could be anyone who values the assets of the family more
than the family does. It could be another family, a nonfamily private
firm, a public firm, or a dispersed group of shareholders who value the
assets of the family business and the management team that comes with
the assets (as in an IPO). If we model both buyers and sellers, we may
discover multiple equilibria because of the participation externality in
the primary capital market. This participation externality arises because
todays seller becomes tomorrows buyer, thus increasing the thickness
of the capital market, and providing a higher to other sellers.12
Appendix
Proofs
I. Proof of the Properties of Z(w0)
We first formulate the dynamic program associated with the problem (4):
Z*(w) max ln c Z*(w), s.t.
w R(w c).
Our first task is to show that there exists a unique Z* that solves the above
functional equation. The usual approach is to verify that the above program forms
a one-to-one mapping from the space of bounded functions into itself and then
verify that the mapping is a contraction. This approach is not applicable since
the return function, ln c, is not bounded. Instead, we appeal to Alvarez and Stokey
(1995), who show that there exists a unique Z*.
Our next task is to show that Z* is the maximum obtained in the problem (4),
that is, that Z* Z. This also follows from Alvarez and Stokey (1995).
We can solve for Z* using the method of undetermined coefficients:
Z*(w)
ln(1 )
ln
ln w
ln R
.
2
1
1
(1 )
(1 )2
12. We thank the referee for pointing out this interesting extension of our model.
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Capital Markets
215
1
1
[ln(1 ) ln(1 )] .
ln
1
ln
1
1
[ln(1 ) ln(1 )] ,
ln
1
1
[ln(1 ) ln(1 )].
Note that the left-hand side of the above inequality equals the right-hand side
when is 1, where they are both equal to 0. If we differentiate both sides with
respect to , we find that as decreases from 1 to 0, the left-hand side increases
at a faster rate than the right-hand side. So the left-hand side is greater than the
right-hand side for all (0, 1). Q.E.D.
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216
Journal of Business
W(k) max
ln(c ),
t
t0
given
c t k t1 A(k t k rt ) Qk rt .
The optimal amount of rental capital would be chosen such that its marginal
cost equals its marginal benefit. This means that (see fig. 6 for an illustration)
Q AK 1
where
K (k t k rt ).
.
c t c t1
y
.
Q1
Substituting this in the Euler equation, we obtain the time path of family physical
capital:
k t1 (Q 1)Y Qk t .
Finally, substituting the above optimal family consumption and physical capital
paths in the expression for W(k), we obtain an infinite series whose finite sum is
W(k)
1
[ln(k Y ) ln(1 )]
1
1
[ ln ln Q]
(1 )2
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Capital Markets
217
where
Q1
/(1)
A
(1 )A
Q
Q1
Q.E.D.
, t 0, 1, 2, . . . . . S 2,
ct
c t1
and
.
c S1
(1 )k S
We can rewrite the above Euler equations by substituting the reformulated budget
contraints in (29) and get
Q
1
, t 0, 1, 2 . . . . S 2,
y Qk t k t1 y Qk t1 k t2
and
.
y Qk S1 k S
(1 )k S
and
k t1 y Qk t g t ,
t 0, 1, 2, . . . . S 3,
where
gt
g S2
1Q
g t1 ,
Q
y(1 )
.
Q
Now define k as
(R 1 Q)k y.
218
Journal of Business
The right-hand side of the above inequality gives the sum of discounted utilities
if the sale takes place after one period. In computing this we have used the reformulated budget constraint (29), which shows that y Qk t is split between ct
and k t1 . In the penultimate period, the proportion allocated to c t is (1 ) and
that allocated to k t1 is .
This implies that if k t k, selling at time t dominates waiting for another
period. But does it also dominate waiting for a finite number of periods? Figure 6
tells us that the family is increasing its equity until the sale point; so if k t k
and the family has not sold its business, then k tm k for m 1, 2, and so forth.
So selling off at period m 1 is better than waiting for m periods. Working
backward, we conclude that selling off now is better than waiting for a finite
number of periods.
But does selling now dominate never selling? Let us show that the answer to
this question is in the affirmative. From (30),
k
Y(Q 1)
,
(R 1 Q)
(R
YQ 1/(1)
.
Q 1/(1) )
/(1)
The interpretation of k M is that it is the level of capital beyond which selling now
dominates never selling. So if we can show that k k M , we are done. From the
above, k k M , if and only if
(R 1 )
Q
1/(1)
(R Q ) 1 1.
So if we can prove that the last inequality always holds, it would imply that
k k M , and we are done.
Define
a
x
Q
1/(1)
and
x1
,
Q1
Capital Markets
219
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