Capital Markets and The

Capital Markets and the Evolution of Family Businesses
Author(s): Utpal Bhattacharya and B. Ravikumar

Source: The Journal of Business, Vol. 74, No. 2 (April 2001), pp. 187-219
Published by: University of Chicago Press
Stable URL: http://www.jstor.org/stable/10.1086/209670
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Utpal Bhattacharya
Indiana University
B. Ravikumar
Pennsylvania State University
Capital Markets and the

Evolution of Family Businesses*
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 have benefited from discussions with Franklin Allen,

Suman Banerjee, David Bates, Patrick Bolton, Ralph Chami,
Tom George, John Heaton, Charlie Kahn, Tom Rietz, Jay
Ritter, Paul Weller, and Ben Wilner. Seminar participants at
the 1999 American Economic Association Meetings, the 1998
American Finance Association Meetings, the 1998 French Finance Association Meetings, the 1998 Summer Econometric
Society Meetings, the 1997 Western Finance Association
Meetings, the International Monetary Fund, and at the Universities of Amsterdam, Case Western, Erasmus, Frankfurt, TelAviv, Tilburg, Tulane, and Vienna provided valuable comments. We are also grateful to Xuemin Yan, who provided able
research assistance.
1. It is notoriously difficult to define a family business. For
the purpose of this article, we define a family business as a firm
which is predominantly owned and run, explicitly or tacitly, by
a single household.
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.
(Journal of Business, 2001, vol. 74, no. 2)

2001 by The University of Chicago. All rights reserved.
0021-9398/2001/7402-0001$02.50
187 from 194.117.2.107 on Thu, 25 Feb 2016 10:19:15 UTC
This content downloaded
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Journal of Business
rean industrial conglomerates, called chaebols, began as small family

businesses; their explosive growth occurred after the Korean War
ended (1953). Family businesses began in China during the Ming Dynasty (13681644), but, because of revolutions in the home country
in the twentieth century, they could flourish only in the rim of countries
bordering the mainland.
The second stylized fact about family businesses is that their dominance diminishes as capital markets develop. In economies with welldeveloped capital markets, large family enterprises are an exception
rather than the rule. In the United States, the large family businesses
of the nineteenth centurythose of the Carnegies, the Du Ponts, the
Fords, the Morgans, and the Rockefellershave become publicly held
corporations. In Europe, the House of Rothschild, which began when
Meyer Amschel Rothschild (17441812) opened a coin and antique
dealership in Frankfurt in 1764 and grew to become Europes biggest
private enterprise, is but a shadow of its former self.2
The third stylized fact about family businesses is that, despite their
diminished dominance, they are still very important in all countries. In
developed countries, they account for a significant share of the economy. For example, they account for 40% of the U.S. gross domestic
product (GDP) and 60% of its workforce; 66% of Germanys GDP
and 75% of its workforce; and roughly 50% of Britains workforce. In
developing countries, family firms represent virtually the entire private
economy. In India, for example, family businesses account for 70% of
the total sales and net profits of the biggest 250 private-sector companies.3
Given the important and changing nature of the role played by family
businesses, it is curious to find that no formal model exists in the financial economics literature to analyze their evolution. This article is an
attempt to remedy this deficiency. Considering the richness and complexity of the issues involved in the evolution of family businesses
historical, cultural, and economicthis article, by choice, restricts its
attention to one key economic aspect: capital markets. Specifically,
we construct a dynamic model to analyze how the development of primary capital markets affects the evolution and the sale of family businesses.
Many economic forces influence the decision to sell a family business. Recent literature has concentrated on whether a business should
2. The data in the above two paragraphs come from Okochi and Yasuoka (1983), Rosenblatt et al. (1985), Ward (1987), and Goody (1996). A voluminous empirical literature
consisting of surveys and case studies on family businesses exists. Twenty-eight North
American schools offer programs on family businesses. There is even a special research and
management school devoted to issues concerning family businessesthe Family Business
Network (FBN) in Switzerland.
3. The data in this paragraph come from the Economist, October 5, 1996.
Capital Markets
189
be sold privately or publicly. A few themes have emerged. Ibbotson

and Ritter (1995) hyothesize that firms will offer stock publicly late in
their life cycle, when the diversification benefit outweighs the moral
hazard or adverse selection cost plus the fixed cost of issuance. Zingales
(1995) focuses on the private benefits of control; selling to a dispersed
group of shareholders maximizes proceeds for the cash flow rights, but
selling to a private buyer maximizes proceeds for the control rights.
Chemmanur and Fulghieri (1999) focus on asymmetric information;
although selling to a dispersed group of shareholders is good from a
diversification point of view, these shareholders, in contrast to a private
venture capitalist, are disadvantaged when it comes to information related to firm value. Pagano (1993) argues that a public market for equity
may not arise at all; because an issuer bears all the costs of listing, but
reaps only a part of the increased diversification benefits he provides
to others, he may refuse to issue. Shleifer and Vishny (1997) emphasize
that external financing is best raised in economies where legal protections exist to provide external financiers with confidence that they will
get their money back. Another strand of the financial economics literature has extended the agency conflicts identified by Jensen and Meckling (1976); concentrated ownership leads to better monitoring of management but lower liquidity.4 Pagano, Panetta, and Zingales (1998)
examine the issue empirically.
All of these papers focus on whom to sell a generic business to. Our
article, on the other hand, focuses on when to sell a family business,
be it to a private buyer or to public shareholders. A distinguishing feature of our article is the dynamic nature of our model: this allows us
to characterize the entire evolution of the family business from inception to sale.
We model a family business as a household operating a constant
returns-to-scale production technology in which the households human capital is the fixed factor of production. This factor is a special
business skill that is transferred down through the generations. The
younger generation learns the business skill by working in the family
business and eventually takes over the business from the older generation.5 Though we do not model this implicit contract between the generations, we model its consequences.
Using both internally and externally financed physical capital as well
4. See, e.g., Bhide (1993); Bolton and von Thadden (1998); and Pagano and Roell
(1998).
5. An excerpt from pp. 1920 in Chernow (1990) best illustrates this assumption. We
quote: Early on, Pierpont figured in his fathers business plans. Junius knew that the
Houses of Baring and Rothschild operated largely as family enterprises, grooming sons
to inherit their respective businesses. In fact, the Rothschild insignia of five arrows commemorated five sons dispatched to five European capitals. . . . As a twentieth-century
Hambros Bank chairman put it, Our job is to breed wisely.
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Journal of Business
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.
Capital Markets
191
Sale only occurs if is above a lower bound. Second, contrary to results

in the growth literature, which follow directly from diminishing returns,
the investment rates of family businesses actually increase as they mature. Finally, family businesses tend to be bigger when they cash out,
last longer, and have lower investment rates in economies with lower
than in economies with higher .
Where does , the offer price, come from? We identifity 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. This was the insight of Demsetz
(1968), which this article formalizes. The other three factors are asymmetric information, estate and inheritance taxes, and the lack of competition in the financial intermediaton industry. Though we do not model
these three, we discuss why each of them decreases .
The second part of this article analyzes what happens when external
financing is possible. In this case, the family is not constrained to finance growth only through internally generated funds. The family can
immediately, through external financing, acquire enough physical capital to produce output at the point where the marginal product of total
physical capital equals the borrowing rate of capital. As time progresses, the family increases its own physical capital and decreases the
borrowed capital. If , the offer price, is above a lower bound, a sale
occurs. The higher the offer price, the sooner the sale occurs. Therefore,
though the dynamics in this case are somewhat different, we find the
same result as in the first part of our article: family businesses tend to
be bigger and last longer in economies with lower than in economies
with higher .
We also consider the possibility that the borrowing rate exceeds the
lending rate, and we denote by the gap between the two. We find that,
as the borrowing rate is held constant and the lending rate decreases, the
threshold level of family capital at which the sale is made increases,
and it takes longer to reach the higher threshold. So family businesses
tend to be bigger and last longer in economies with higher .
Where does , the gap between the borrowing rate and the lending
rate, come from? We identify three imperfections in primary capital
markets that affect . These are agency costs, asymmetric information,
and the lack of competition in the financial intermediation industry.
Though we do not model these three, we discuss why each of them
increases .
The article is organized as follows. In the next section, we lay out
the dynamic optimization problem faced by a family business. In Section III, we analyze the case where external financing is not available.
In Section IV, we analyze the case where external financing is availThis content downloaded from 194.117.2.107 on Thu, 25 Feb 2016 10:19:15 UTC
192
Journal of Business
able. Section V concludes with a list of the testable implications of the

model, a discussion on the limitations of the article, and suggestions
for future research.
II. The Model
A. The Family Business

Consider a household-firm using physical capital and human capital to
produce output. Specifically, the production technology in the family
business is given by the following constant returns-to-scale technology:
y t A(k t k rt )h 1
,
t
(1)
where
yt
kt
k rt
ht
the output at period t;

the family physical capital at the beginning of period t;
the rental physical capital at time t;
the family-specific human capital at the beginning of period t;
A the productivity parameter of the family business; and
the output elasticity of physical capital, (0,1).
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,
7. Delegated control and collective ownership is a distinct feature of family businesses.

We quote from the Konoike Family Code (1889) in Japan: Article 12: All the family
assets are made to be managed by the elders of employees, and no family head should
gain control over them.
Capital Markets
193
he has to decide how to split the sales proceeds between consumption

and savings.
If k o is the initial stock of family physical capital, we can formulate
the household problem as choosing c t , k t1 , k rt and w t1 sequences to
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
194
Journal of Business
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.
Capital Markets
195
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.
The solution to (4) satisfies the Euler equations

1
R
c t c t1
(5)
and the transversality condition

TwT
0.
T c T
lim
(6)
196
Journal of Business
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 )
ln(R) ln[w 0(1 )]
(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)
B. Mortality of a Family Business When External Financing

Is Not Available
Before we proceed to determine when the family will cash out, it is
useful to know whether the family will ever cash out. Suppose the
family has k units of physical capital. If the family never wants to sell
its business, then its optimal capital accumulation path is k t1 A
k t , and its maximal lifetime utility is
X(k)
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,
Capital Markets
197
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.
Determining the Time Path of Physical Capital When neither

Borrowing nor Lending Is Allowed
The wealth of the family in the beginning of the post-sale stage consists
only of the proceeds from the sale of private capital at the end of the
presale stage. We know that intermediaries in the primary capital market can provide a price per unit of family capital. Therefore, 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
t0
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Journal of Business
given
(11)
c t k t1 Ak t , t 0, 1, 2, . . . , S 1, k 0 0.
Since Z is strictly concave and the constraint set is compact and

convex, there is a unique solution to (11). We now derive some implications for capital accumulation by fixing S. These implications later help
us characterize the level of capital at which the family business will
be sold. The Euler equations for (11) are
1
Ak 1
t1
, t 0, 1, 2, . . . S 2,
ct
c t1
(12)
,
c S1
(1 )k S
(13)
and
The tradeoff in period S is obviously different from that in other

periods, since the family abandons its current technology and switches
to a new technology in period S. Using the budget constraint, we can
rewrite the above Euler equations as
1
Ak 1
t1
, t 0, 1, 2, . . . . . S 2,
Ak t k t1
Ak t1 k t2
(14)
and
1
Ak
S1
kS
.
(1 )k S
(15)
Solving the above pair recursively, we get

k S Ak S1,
(16)
and
k t1
d t
Ak t , t 0, 1, 2, . . . . . S 2
1 d t
(17)
where d t 1 d t1 , and d S2 1. Define the investment rate

in period t as
t
k t1
d t
Ak t
1 d t
(18)
This gives us our next result.

Theorem 1. Investment rate in the initial period is greater than
. It increases over time, and in the period before sale, it equals .
Capital Markets
199
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.
The Threshold Level of Capital When neither Borrowing

nor Lending Is Allowed
It is tempting to conclude that the threshold level of capital is one in
which the marginal productivity of capital in the family business equals
R, the marginal productivity of wealth in the savings account. The top
half of figure 1 illustrates why this is not necessarily true. If the family
sells the business at k*, there is a drop to k*, the wealth with which
it begins its savings account. The family would do better to delay the
selling in this case, and trade off the lower productivity in the family
business to a lower drop in wealth later on.
One may then be led to believe that the threshold exists at the point
where there is no drop in wealth. Again, except for the special case
where equals R, this is not true. The top half of figure 1 illustrates
why. If the family sells at k**, given the decision rules from the
postsale stage, its consumption sequence from this period on is (1
) [k**], (1 )[R(k**)], and so forth. If the family holds off
selling until the next period, given the result from theorem 1 that the
200
Journal of Business
Fig. 1.Threshold level of capital
Capital Markets
201
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)
Lemma 1. k t k if and only if

Z(k t ) ln[(1 )Ak t ] Z(Ak t ).
(20)
Proof. This proof uses the function Z, described in (8). It is easy

to check that the right-hand side of (20) is greater than the left-hand
side when k t is greater than the k, is equal when k t equals k, and is less
when k t is less than k.
The left-hand side of the inequality (20) gives the sum of discounted
utilities if the sale takes place immediately. The right-hand side of the
inequality (20) gives the sum of discounted utilities if the sale takes
place after one period. Note that in computing this we have used the
result from theorem 1 that the investment rate is always before the
sale period. Lemma 1 thus shows that for the family to sell its business
in period t, the level of capital k t must not be below k. Further, if k t
is greater than k, the family is better off selling the business in period
t than waiting until period t 1.
Lemma 1, however, leaves open the possibility that waiting for more
than one period may be better than selling now. Lemma 2 provides the
sufficient condition whereby waiting for more than one period is not
better.
Define and k as
R 1
1
1,
(21)
and
k Ak .
(22)
See the bottom half of figure 1.

Lemma 2. If , then for all k t k, the family will rather sell
its business in period t than wait any finite number of periods.
Proof. This proof is derived by induction. The lower bound on
has been defined such that if , then k k. Since the investment
rate is always greater than (a result from theorem 1), figure 1 (bottom half ) tells us that the family is expanding in the region to the left
of k. So if k t k, then k tm k for m 1, 2, and so forth, and, therefore,
202
Journal of Business
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. As noted in Section IIIB, we need to verify
that k satisfies inequality (10).
Lemma 3. If selling at time t dominates waiting for a finite number
of periods, then it also dominates never selling.
The formal proof of lemma 3 is in the appendix. The proof shows
that the pair (, k) satisfies the condition Z(k) X(k). Lemmas 1,
2, and 3 give us our threshold level of capital.
Theorem 2. If , then k is the threshold level of capital.
Note that the threshold level of capital in theorem 2 is valid only
when borrowing from, and lending to, an external capital market is
prohibited. Although we relax both assumptions in Section IV, it is
interesting to see how our analysis changes if borrowing is not allowed
but lending from output is allowed.
E. The Threshold Level of Capital When Borrowing Is Not
Allowed but Lending Is Allowed
If the return generated from accumulating capital in the family business
is larger than the return generated from investing in the savings account, the family will not lend any portion of its output as long as the
family business is operating. The next lemma gives us the condition
under which this occurs and so ensures that our results from the previous sections remain unaltered.
Lemma 4. If , where R 1 R/, then k is the threshold
level of capital.
Lemma 4 tells us that as long as is above a critical lower bound,
the threshold level of capital is unaffected. To see why, note that
R
if , then Ak 1 R 1 R 1 R, (23)
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.
Capital Markets
F.
203
Evolution of a Family Business When External Financing Is

Not Available
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
Journal of Business
Fig. 2.Family businesses with different initial capital stocks
204
205
Fig. 3.Investment rates for families with different initial capital stocks
Capital Markets
206
Journal of Business
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.
207
Fig. 4.Family businesses with different elasticities of capital
Capital Markets
Journal of Business
Fig. 5.Family businesses in different capital markets
208
Capital Markets
209
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
We now allow the family to rent physical capital at a rate Q from

outside capital markets (k rt 0) or rent physical capital at a rate R to
outside capital markets (k rt 0). Imperfections in primary capital markets drive a wedge, , between the borrowing and the lending rate,
that is, Q R .
A.
Mortality of a Family Business When External Financing

Is Available
Note that the value of cashing out remains the same, that is, function
Z is the same as in Section III. It turns out now that the family business is immortal if the price in the primary capital market is less
than Q. To see this, let W(k) be the lifetime utility of a family with k
units of capital, assuming it never wants to sell. In the appendix, we
show that
W(k)
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
210
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
As in Section III, we go on to solve the Euler equations recursively

in order to obtain the optimal time path and derive the threshold level
Capital Markets
211
Fig. 6.Family and rental capital under external financing
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.
Evolution of a Family Business When External Financing

Is Available
Notice from (30) that k is a decreasing function of . Therefore, though
the dynamics differ in the two cases, the main result of the last sectionfamily businesses tend to be bigger and last longer in economies
with lower is robust to the possibility of external financing. Some
results are not comparable: for instance, investment rates are difficult
to interpret in an economy with external financing.
What is the effect of , the gap between the borrowing and the lending rate? As is Q R, one way to check the influence of increasing
is to find out what happens as the borrowing rate is held constant and
the lending rate decreases. We state the result in the next proposition.
Proposition 5. In economies with less developed primary capital
markets (higher , same Q, and so lower R), the family business is
bigger at the time of sale and lasts longer than in economies with more
developed capital markets.
212
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
This article models a family business as an infinitely lived household

operating a production technology in which the households human
capital is the fixed factor of production. The household can sell the
business at any point in time through financial intermediaries in primary capital markets. Upon cashing out, the family can earn interest
on the sales proceeds from the family business.
We first consider the possibility 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, the only factor
Capital Markets
213
determining the sale of a family business is the offer price. This is

captured by the parameter in our model. We analyze the effect of
and ask how this is determined. Then we consider the possibility of
external financing. This allows us to look at the effect of another aspect
of primary capital marketsthe spread between the borrowing and the
lending rate, defined at and to ask how this is determined.
Our main results, when there is no external financing, are the following. We show that there is a lower bound on the price offered by primary capital markets that ensures the mortality of a family business.
If the price exceeds this lower bound, we show that, over time, a family
firm grows larger, increases its investment rate, and is eventually sold
off. Family firms that start smaller tend to last longer. We also show
that in economies with less developed primary capital markets (as measured by lower ), family businesses are bigger, last longer, and have
lower investment rates. When there is external financing, our previous
results with respect to are upheld. With respect to , we find that in
economies with less developed primary capital markets (as measured
by higher ), family businesses are bigger and last longer.
Our main results are consistent with the three documented stylized
facts that we laid out in the beginning of this article: family businesses
are crucial in the initial stages of a countrys economic development,
the importance of these family businesses diminishes as capital markets
develop, but their role is still significant in all countries. In a survey
of the 20 largest firms in each of 27 economies, La Porta, Lopez-DeSilanes, and Shleifer (1990) find that, if we define a controlling shareholder as one owning more than 10% of a firm, the family firm is the
most common form of ownership (35% of the sample).
Our results have many testable implications that future researchers
may choose to verify. First, we predict that in the cross section, larger
family firms have higher earnings retention ratios. Second, we predict
that in the time series, the earnings retention ratios of family firms
increase over time. Third, we predict that capital-intensive family firms
last longer and are bigger when they are sold off than are labor-intensive family firms. Fourth, we predict that the size and duration of family
firms is negatively linked with the offer price, (a good measure of
the reciprocal of this variable is the average IPO discount of a country),
and is positively linked with the gap between the borrowing and the
lending rate, (a good measure of this variable is the net interest income as a percentage of total banking assets).
Two critical assumptions drive all our results. The first is our view
that the distinguishing characteristic of a family business is its special
business skill, which is a fixed factor of production. It would be interesting to partially relax this assumption. In a companion paper, Bhattacharya and Ravikumar (2000), we develop a model in which each generation in a family business can continue operating its inherited
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.
Capital Markets
215
Clearly Z* is increasing, strictly concave, and differentiable in w. Using the

above expression for Z*(w), we can derive the decision rules for consumption
and savings to be
c (1 )w,
w Rw.
This is the unique solution since Z* is concave. Q.E.D.
II. Proof of Lemma 3

We need to check whether the inequality (10) holds for k k and . The
minimum value of the left-hand side of (10) occurs when k k. This minimum
value, after substituting for k from (19), and algebraically simplifying, is
1
{(1 )ln ln (1 )[(ln(1 ) ln(1 )]}
(1 )(1 )
(1 ) (1 )(1 )ln (1 ) (1 )(1 ) ln R.

2
The above minimum value is positive if

(1 )ln ln ln R
1
1
[ln(1 ) ln(1 )] .
ln
1
But, from (21), if , it implies that

(1 )ln ln ln R ln .
So, if we can show that
ln
1
1
[ln(1 ) ln(1 )] ,
ln
1
then we are done. Now the above is true if and only if

ln
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.
216
Journal of Business
III. The Determination of W(k)
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 ).
Substituting this in the budget constraint in (3), we obtain

c t k t1 y Qk t
where
y (1 )AK .
The Euler equation is

Q
1
.
c t c t1
Conjecture, as in Hakansson (1970), that optimal consumption is linear in wealth:

c t (k t Y )
where
Y
y
.
Q1
Substituting this in the Euler equation, we obtain the time path of family physical
capital:
k t1 (Q 1)Y Qk t .
Substituting k t1 in the budget constraint of (3) gives us the optimal consumption

path:
c t (1 )Q(k t Y ).
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
Capital Markets
217
where
Q1
/(1)
A
(1 )A
Q
Q1
Q.E.D.
IV. Proof of Theorem 3

The Euler equations for (27) are
A(k t1 k rt1 )1
1
, 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
Solving the above pair recursively, we get

k S y Qk S1,
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.
With this definition, it is easy to show that k t k if and only if

Z(k t ) ln[(1 )(y Qk t )] Z[(y Qk t )].
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)
and k M , the k that solves (26) as an equality, is

kM
(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
where x R 1. From (30), x Q. So we need to show that a b for x

[Q, ).
It is easy to show that a b 1 when x Q take derivatives with respect
to x. The first derivative of a is positive for x [Q, ), and it is 1/[(1 )Q]
at x Q. The first derivative of b is positive for x [Q, ) and at x Q, it is
1/[Q 1]. As Q R 1, the former derivative is greater than the latter
derivative. The second derivative of a is positive for x [Q, ), whereas the
second derivative for b is zero for x [Q, ). This implies that a b for x
[Q, ). Q.E.D.
Capital Markets
219
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Capital Markets and The

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Capital Markets and the Evolution of Family Businesses

Author(s): Utpal Bhattacharya and B. Ravikumar

Capital Markets and the

* We have benefited from discussions with Franklin Allen,

(Journal of Business, 2001, vol. 74, no. 2)

rean industrial conglomerates, called chaebols, began as small family

be sold privately or publicly. A few themes have emerged. Ibbotson

Sale only occurs if is above a lower bound. Second, contrary to results

able. Section V concludes with a list of the testable implications of the

A. The Family Business

the output at period t;

7. Delegated control and collective ownership is a distinct feature of family businesses.

he has to decide how to split the sales proceeds between consumption

The solution to (4) satisfies the Euler equations

and the transversality condition

ln(R) ln[w 0(1 )]

B. Mortality of a Family Business When External Financing

Determining the Time Path of Physical Capital When neither

Since Z is strictly concave and the constraint set is compact and

The tradeoff in period S is obviously different from that in other

Solving the above pair recursively, we get

where d t 1 d t1 , and d S2 1. Define the investment rate

This gives us our next result.

The Threshold Level of Capital When neither Borrowing

Fig. 1.Threshold level of capital

Lemma 1. k t k if and only if

Proof. This proof uses the function Z, described in (8). It is easy

See the bottom half of figure 1.

selling off at period m 1 is better than waiting for m periods. Working

Evolution of a Family Business When External Financing Is

Fig. 2.Family businesses with different initial capital stocks

Fig. 4.Family businesses with different elasticities of capital

Fig. 5.Family businesses in different capital markets

We now allow the family to rent physical capital at a rate Q from

Mortality of a Family Business When External Financing

As in Section III, we go on to solve the Euler equations recursively

Fig. 6.Family and rental capital under external financing

Evolution of a Family Business When External Financing

This article models a family business as an infinitely lived household

determining the sale of a family business is the offer price. This is

Clearly Z* is increasing, strictly concave, and differentiable in w. Using the

This is the unique solution since Z* is concave. Q.E.D.

II. Proof of Lemma 3

(1 ) (1 )(1 )ln (1 ) (1 )(1 ) ln R.

The above minimum value is positive if

But, from (21), if , it implies that

So, if we can show that

then we are done. Now the above is true if and only if

III. The Determination of W(k)

Substituting this in the budget constraint in (3), we obtain

The Euler equation is

Conjecture, as in Hakansson (1970), that optimal consumption is linear in wealth:

Substituting k t1 in the budget constraint of (3) gives us the optimal consumption

IV. Proof of Theorem 3

Solving the above pair recursively, we get

With this definition, it is easy to show that k t k if and only if

and k M , the k that solves (26) as an equality, is

where x R 1. From (30), x Q. So we need to show that a b for x

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