Kin altruism, governance, and inheritance in the family firm

68 Pages·2014·0.52 MB·English

Blood and Money: Kin altruism, governance, and inheritance in
the family firm
ThomasNoe
BalliolCollege/Sa¨ıdBusinessSchool,Oxford
EuropeanCorporateGovernanceInstitute
FirstDraft: 20April,2012,ThisDraft: 15May,2014
Abstract
Thispaperdevelopsatheoryofgovernanceandinheritancewithinfamily-owned/family-managed
firmsbasedonkinaltruism(Hamilton,1964).Familymembersweighthepayoffstorelativesinpro-
portiontorelatedness. Thetheoryshowsthatfamilyownershipandmanagemententailsbothcosts
andbenefits. Kinaltruismmakesrelativessoftmonitors. Thisleadstoa“policingproblem”within
family firms. This policing problem results in both increased managerial diversion and increased
monitoring costs at fixed compensation levels. Relatedness has conflicting effects on managerial
compensation, efficiency, and firm value. On the one hand, owners are more willing to concede
rents to family managers to increase collective family payoffs. On the other hand, because family
managersinternalizethecoststothefamilyfromtheirrejectionofownerdemands,relatednessalso
lowersmanagers’reservationcompensationdemands. Whenincentiveconstraintsbind,increasing
kinship always increases the efficiency of the family firm under family management but, in some
cases,doesnotincreasefirmvalueandmayalsopromotenepotistichiring. Whentheparticipation
constraintbinds, kinshiplowersefficiencybutmayraisefirmvalueanddoesnotinducenepotism.
Regardlessofwhichconstraintbinds,introducingpassiveexternalcapitalintothefamilyfirmlow-
ersthepayoffandutilityofownersandraisesthepayoffandutilityofmanagers. Whenthefamily
firmiscreatedbythebequestofafounder,underveryweakrestrictions,thecalculusofrelatedness
impliesthatthefounderismorealtruistictowarddescendantmanagersthanthedescendantowner.
Thishigherdegreeofaltruismmaycreateincentivesforfounderstodesigncomplexbequests.
Keywords: Corporategovernance,entrepreneurship,kinaltruism,contracttheory
IwouldliketothankseminarparticipantsattheBalliolInterdisciplinaryInstitute,Oxford,theSa¨ıd
Business School, the University of Manchester, University of Rotterdam, Humboldt State University,
the University of Reading, Tel Aviv University, Gothenberg University, the Bank of Finland, NBER
Entrepreneurship Workshop 2013, and the European Summer Symposium on Financial Markets 2013.
Special thanks are extended to Andy Gardner, Andrew Ellul, and Simon Gervais for very helpful and
detailedcommentsonearlierdraftsofthispaper. Theusualdisclaimerapplies.
1 Introduction
The organization of economic activity around family units is globally pervasive. The vast majority of
businesses are controlled by families. As pointed out by Fukuyama (1995), outside the Anglo-sphere,
NorthernEuropeandJapan,thepreponderanceofnon-statefirmsarefamilycontrolled. Asdocumented
by Porta, Lopez-de Silanes, and Shleifer (1999), 45% of publicly listed international firms are family
controlled. Even in the U.S., the majority of firms with revenues less than $500 million are family
controlled,andmanyverylargefirmsaretiedtofamilies,e.g.,Ford,andWalmart. Moreoveranumber
of very large firms are controlled, managed, and wholly or almost wholly owned, by members of a
single family, e.g., Koch Industries and Cargill in the U.S., Esselunga S.p.A and Parmalat Finanziaria
S.p.A. in Italy. In fact, even using the most narrow definition of “family firm,” one that restricts the
scope of family firms to those firms where multiple family members are involved with management
and succession is dynastic, Astrachan and Shanker (2003) estimate that more than 30% of US GNP is
contributedbyfamilyfirms.
Whilebiologicalkinshipisnotadefiningcharacteristicofafamily(giventhepossibilityofadoption)
biologicalkinshipneverthelessisfundamentaltodefiningtheconceptoffamilyandisdescriptiveofthe
vast majority of family units. The aim of this paper is to develop a theory of family firms, firms where
ownership and management are separated but both are in the hands of members of the same family,
basedonthisfundamentalproperty. Thistheoryisfoundedontheconceptofinclusivefitnessdeveloped
byHamilton(1964). Theinclusivefitnessofagivenagentisthatagent’sownfitnesssummedwiththe
weightedfitnesssumofallotheragents,theweightsbeingdeterminedbytheotheragents’coefficientof
relatedness,i.e., theirkinship, tothegivenagent. Thelogicbehindkinaltruismisthatgeneexpression
affectsthenumberofcopiesofageneinthegenepoolboththroughitsdirecteffectonthefitnessofthe
agentexpressingthegeneandthroughitseffectonthefitnessofotheragentssharingthegene. Because
of relatedness, kin have a far higher than average probability of sharing any gene, including genes for
altruisticbehavior,thanunrelatedagents. Thus,ageneforkinaltruismcanincreaseinapopulationeven
if it is harmful to the fitness of the agent having the gene, provided that the costs to the agent are low
relativetothebenefitstokin. Selectionofakinaltruisticgenerequiresthat
rB>C, (1)
whererrepresentsthecoefficientofrelatedness,Bthebenefittotherelative,andCisthecosttothealtru-
isticagent. Ourtheoryofthefamilyfirmidentifiesfitnesswithterminalwealthlessanynon-pecuniary
effort costs and assumes that family members maximize their inclusive fitness. Identifying wealth and
with fitness is admittedly a strong assumption. However, strong positive associations between wealth
andfitnesshavebeendocumentedbothinhistorical(ClarkandHamilton,2006)andcontemporary(Net-
tleandPollet,2008)societies,atleastformales. Thus,theassumptionisnotimplausibleasafirst-order
approximation.1
1Notethatthealtruismselectionequation, (1)requiresanumberofancillaryassumptions. Ingeneral, selectionforkin
altruismrequiresonlygeneticcorrelationbetweenthebenefactorandrecipientofaltruism.Thiscorrelationneednotbebased
ondescent. See,Chapter3ofMcElreathandBoyd(2007)foracompletediscussion. Also,perse,thekinselectionequation,
(1), doesnotdependonHamilton’sinclusivefitnessmodel. Itcanbederivedfromothermodelsofselectionnotbasedon
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Kin altruism in family firms is clearly a hypothesis worthy of consideration. The theoretical foun-
dation of kin altruism is simple, its driving exogenous variable—kinship—is observable, its empirical
predictionshavebevalidatedbynumerousstudiesofhumanbehavior.2
ThekeycharacteristicsofkinaltruismbasedontheHamilton’sconceptofinclusivefitness,arethat
altruism is stable over time, symmetric, limited, and restricted by the calculus of genetic relationship.
Thebondsofrelationarestablebecausethedegreeofkinshipbetweentwoagentsisconstantovertheir
life span. Kin altruism is symmetric because they are derived from a relatedness which is a symmetric
relationindiploidssuchashumans.3 Altruismislimitedbecause,exceptforidenticaltwinsandhighly
inbredfamilies,eventhetightestkinshipbonds,parent/offspringorsibling/sibling,producerelatedness
sufficient to internalize roughly half of the effect of an agents’ actions on a relative. Because altruism
is governed by the calculus of relationship, it is roughly based on the length of the path in the family
tree that connects relatives. Thus, inclusive fitness predicts that ancestors will be more altruistic to
descendantsthanthedescendantslinkedthroughtheancestorwillbetowardeachother.
The key hypothesis underlying this paper is that kin altruism is a distinguishing feature of family
firms. As we discuss in detail in Section 8.3, it is certainly plausible, although not uncontroversial,
to posit non-kinship based altruism bonds that mimic most aspects of kin altruism. The presence or
absenceofotherformsofaltruismisnotcrucialtothevalidityofourpredictionsbecausethecontrasts
we draw between family and non-family firms depend only on the assumption that, because of kin
altruism, on average, relationships between kin exhibit significantly higher overall levels of altruism
than relationships between non kin. The consensus in the psychology and evolutionary psychology
literature supports this assumption. The analysis in this paper should also not be taken as arguing that
altruism should only be incorporated into models of agents who are biologically related.4 Our aim is
simply to study the effect of kin control and management on firm behavior by considering an obvious
differencebetweenkinandnon-kinfirms, geneticrelatedness, andusingthemostwell-establishedand
researched consequence of relatedness for behavior, kin altruism. The question of whether the bonds
betweenagentsinsocialnetworksarebestmodeledbyaltruismorsomeotherparadigm(e.g.,reciprocal
exchange,repeatedgame)isaninterestingquestionbutoutsidethescopeofthispaper.
We introduce kin altruism into a principal/agent model of effort, monitoring, and diversion. The
effort model is quite standard, i.e., managerial effort affects the distribution of project cash flows and
is only observed by the manager. Cash flows are also only observed by the manager unless the owner
incursanon-pecuniarymonitoringcost. Thus,themonitoringmodelcloselyresemblesastandardcostly
inclusivefitness,e.g.,neighbor-modulatedfitness(WestandGardner,2013).
2For example, Madsen, Tunney, Fieldman, Plotkin, Dunbar, Richardson, and McFarland (2007) provides experimental
evidencethatagents’willingnesstobearcoststobenefitotheragentsismonotonicallyincreasinginkinship.DalyandWilson
(1988) find that the intra-family child homicide probability is 11 times higher for step-parents than natural parents. Field
evidence from other researchers shows that kinship relations increase political alliance ability (Dunbar, Clark, and Hurst,
1995),facilitatetheassumptionofgroupleadership(Hughes,1988),andincreasecooperationincatastrophiccircumstances
(Grayson,1993).
3Diploidshavetwohomologouscopiesofeachchromosome,onefromthemotherandonefromthefather. Somesocial
insects(e.g., bees, ants, andwasps)arehaplodiploids—malescarryonehomologouscopyandfemalestwo. Forsuchhap-
lodiploids,thebrother–sistercoefficientofrelationisasymmetric. TheauthorwouldliketothankAndyGardnerforpointing
outthisasymmetry.
4Forexamplesofinterestingmodelsthatdevelopaltruismbasedoninternalizationofother(non-necessarilyrelated)agents
welfare,seeLeeandPersson(2010)andLeeandPersson(2012)
Blood&Money 18th May,2014 2/67
state verification model, for example Townsend (1979). However, in contrast to most state-verification
models,theownercannotcommittomonitoring.
We analyze the model by first considering monitoring and reporting policy at fixed compensation
and effort levels. Next, we endogenize compensation and effort. We ask two sorts of questions. First,
howdoeskinshipaltruismaffecttheinternalworkingsofthefamilyfirm,i.e.,howdoeskinshipaltruism
affect monitoring, effort compensation, value generation, and the division of value between owners
and managers? Second, we ask how kinship altruism affects the interaction between the family firm
and external environment, i.e., the willingness of the firm to hire external managers and raise external
capital. Finally,becauseweaimtomodelfirmswhereownershipandmanagementaredividedbetween
differentagentsinthesamefamily, andbecausethestereotypicaloriginofsuchfirmsisabequestbya
firmfoundertodescendantrelatives,weconsiderhowkinaltruismaffectsbequestdecisions.
A basic insight of this analysis is that, at fixed compensation and effort levels, increasing kinship
alwaysincreasesboththelikelihoodofmonitoringandmonitoringexpense. Becausekinshipreducesthe
incentive of the family owner to monitor the family manager, kinship generates a “policing problem”
This effect increases the threshold level of managerial underreporting required to make the owner’s
monitoring threat credible. Reduced credibility of monitoring leads to more underreporting and thus,
a higher equilibrium probability of monitoring as well as greater monitoring expense. Moreover, The
policing problem is highly convex in the degree of kinship, i.e., the effect of kinship on monitoring
expenseisfairlysmallatlowlevelsofkinshipbuttheadverseeffectofincreasingkinshipisverylarge
at high levels of kinship. Thus, increasing the kinship between the owner and manager from second
tofirstcousinwillhaveonlyanegligibleeffectonmonitoringexpensewhileincreasingkinshipfroma
half-siblingtofullsiblingswillhaveasubstantialeffect. Themodel’spredictionofapositiveassociation
between monitoring expense and kinship is consistent with the observations of Bertrand and Schoar
(2006)thatcooperationbetweenfamilymembersisfrequentlydifficulttoachieve. Theseresultsarealso
consistent with experimental evidence provided in Barr, Dekker, and Fafchamps (2008) which shows
that, although genetic relatedness lowers the cost of group formation, kin altruism does not support
enforcementofrisk-sharingagreements.5
Next,weturntoendogenizingthetermsofemploymentandexaminetheeffectsofkinshiponcom-
pensationandfirmperformance. Thekeyinsightfromouranalysisisthatthewelfareeffectsoffamily
ownership depend on the “frontier” on which managerial compensation is negotiated: the agency fron-
tier, along which compensation is fixed by effort incentive compatibility, or the labor market frontier,
along which compensation is set by the manager’s participation constraint. Along the agency frontier,
increasingkinshipalwaysincreasestotal(managerplusowner)valuegeneratedbythefamilyfirmwhen
kin-managedbutalsodistortsthehiringdecisionbyincreasingnepotism,theowner’swillingnesstohire
lesscompetentkinmanagersovermorecompetentexternalcandidates. Alongthelabormarketfrontier,
increasingkinshipalwaysreducestotalvaluebutdoesnotinducenepotism. Incontrasttotheproduction
ofvalue,thedivisionofvaluebetweenownersandmanagersdependslargelyonthecostofemploying
5Theeffectofkinshiponpolicingopportunismmodeledinthispaperis,inamoregenericandreduced-formframework,
alsoanalyzedbyevolutionarybiologistsstudyingtheproblemofhow“policingstrategies,”canbefavoredbynaturalselection.
Ratnieks(1988)findsevidencetosupportanegativeassociationbetweenrelatednessandpolicinginacomparativestudyof
BumblebeeandHoneybeebehavior.GardnerandWest(2004)andElMouden,West,andGardner(2010)developtheoretical
modelswhichshowthathighlevelsofrelatednessdisfavortheselectionofpolicingstrategies.
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themonitoringtechnology. Whenthecostsofmonitoringarelow,kinshipgainsarecapturedbyowners.
In fact, in the labor market setting, owners may gain from increased kinship even though increasing
kinshiplowerstotalvalue. Incontrast,whenthecostofmonitoringarehigh,kinshipgainsarecaptured
bymanagers.6
Thelogicbehindtheagencyresultsisthattheincreasedpolicingcostsinducedbyfamilyownership
are always dominated by the higher levels of managerial effort induced by kinship altruism. When the
costs of monitoring are low, family ownership may, even at endogenous compensation levels, still lead
to increased policing costs. However, in this case, policing costs are second order relative to the effort
stimulation engendered by the manager’s partial internalization of the gains to firm value produced by
effort. When the cost of monitoring is high, family owners adjust managerial compensation upward to
reducetheunderreportingincentivesofrelatedmanagersandthiscompensationadjustmentreducesboth
theincentiveofthemanagertodivertandtheincentiveoftheownertomonitor. Increasedcompensation
also improves managerial effort incentives and thus increases total value. However increased compen-
sationperselowersfirmvalueand, hence, whenthecostofmonitoringisveryhigh, althoughthetotal
gain from increased kinship is positive, the value of the firm is reduced. Increasing kinship increases
nepotismforthesamereasonsthatitincreasesvalueunderkinmanagement: Whenincentiveconstraints
bind,managersearnagencyrents,ownerspreferkin-rentcapturetooutsider-rentcapture. Thus,family
ownerswilloptforinternalmanagersevenwhenthevaluegainfromexternalhiringisfairlylarge. This
resultisconsistentwithBennedsen,Nielsen,Perez-Gonzalez,andWolfenzon(2007),whichdocuments
anegativeeffectofintra-familymanagerialsuccession.
Thelogicbehindthelabormarketresultsisbasedontwosimpleconsequenceofthekinshipaltruism
paradigm: first, kinship altruism is limited and therefore never sufficient to induce a family owner to
increasethecompensationofthefamilymanagerabovethemanager’sreservationdemandsunlesssuch
increases lead to better firm performance. In the labor market setting, the family manager will earn
his reservation utility regardless of whether he works inside or outside the family firm. Second, the
manager’s reservation compensation demands for accepting employment with the family firm depend
on the effect on firm value of the manager rejecting the owner’s employment offer. The family owner
canthususeanyfirmvaluelossresultingfromthemanager’sspurningoftheowner’semploymentoffer
to “hold up” the family manager, i.e., induce the family manager to accept lower compensation from
the family firm than the manager would accept from an external employer. The force of this loyalty
holdup is proportional to the degree to which the family manager is indispensable to the family firm
and the degree of kinship between owner and manager. When the loyalty holdup is effective, it drives
down the family manager’s compensation. Reduced compensation exacerbates the policing problem
within the family firm but if monitoring costs are small, the reduced compensation effect dominates
and increasing kinship increases firm value even as it lowers total value. The incentive for nepotism is
absent in the labor market setting because managerial agency rents are absent. At the same time, the
6Interestingly,theimportanceofthefrontierinourmodelisanalogoustoresultsonkinselectioninevolutionarybiology.
Ifrelatedanimalscompeteonlywithrelativesforafixedpoolofresources,thenaidingonerelativeonlyharmsotherrelatives:
inthiscase,theforceofselectionwillnotfavoranaltruisticallele. Theintroductionofanagencyproblemintotheanalysis,
permitsthepoolofresources(inourmodeltotalvaluegeneratedbyfirm)tovarywithaltruismandthus“opensupafrontier”
overwhichkinaltruismcanoperate. Evolutionarybiologistsopenthefronterusingothermodelingassumptions(Taylorand
Irwin,2000).
Blood&Money 18th May,2014 4/67
higher the quality of the rival outside manager, the weaker the force of the loyalty holdup. Thus, as
the labor market thickens, and close replacements for the family manager become available, the gains
from the loyalty holdup converge to 0. Because family ownership lowers total value by exacerbating
themonitoringproblem,andbecause,inthelabormarketsetting. thereisnocounterbalancingeffectof
kinshiponeffort,inthelimit,thepreferencesofthefamilyownerbecomeanti-nepotistic. Thatis,when
perfect substitutes for external manager are present, the family owner always prefers to hire external
candidates.
Relating these predictions to the existing empirical literature on performance and managerial com-
pensation is difficult for a number of reasons. First, our analysis is focused on wholly family-owned
firms,whiletheempiricalliteraturefocusesonpublicly-ownedfamilyfirms. Second,theliteratureitself
reaches conflicting conclusions: Anderson and Reeb (2003) report a positive effect of family owner-
shiponfirmperformanceforU.S.firmsandSraerandThesmar(2007)reportsimilarresultsforFrench
firms. However, Miller, Breton-Miller, Lester, and Cannella (2007) and Villalonga and Amit (2006)
find, for U.S. firms, that, after controlling for the effect of a founder owner, family firms do not out-
perform non-family firms.7 Third, the value effects in our analysis include the non-pecuniary costs of
managerialeffortwhich,intheagencysetting,arehigherforfamilyfirmsbecausetheequilibriumlevel
of managerial effort is higher. We show that because of this non-pecuniary effort cost, it may well be
thecasethatincreasingkinshipbothincreasesobservedcompensationandreducesthemanager’svalue.
Fourth,ourmodelshowsthattheeffectofkinshiponperformanceishighlyconditionalwhiletheextant
empiricalliteratureseekstodocumentunconditionaleffectsofkinshiponperformanceandmanagerial
compensation. Our results do, however, suggest a number of testable hypotheses based on the condi-
tional effect we derive. For example, the marginal effect of kinship and both firm performance and
managerialcompensationshouldbepositivelyrelatedtothespecificityofthehumancapitalrequiredto
managethefirm. Asecondpredictionisthatthemarginaleffectofkinshiponcompensationshouldbe
positivelyrelatedtothecostsofthemonitoringtechnology. Thesecostsdependbothontheinstitutional
environment(e.g.,legalandaccountingsystem)andthecashflowgenerationtechnology.
Interestingly, in both the agency and labor market settings, kinship increases marginal cost of pas-
siveexternalcapitaltotheownersofafamilyfirm. Thisresultfollowsbecause,inbothsettings,outside
capitalimprovesthebargainingpositionofmanagersrelativetoowners. Familymembersdonotinter-
nalize the gains and losses to outside investors. Thus, the manager’s incentive to exert increased effort
oracceptreducedcompensationwhenworkingforthefamilyfirmisreducedbyoutsideownership. At
the same time, the owner’s incentive to restrict managerial compensation to protect firm profits is also
diminished. Both these effects increase managerial compensation at the expense of owner profits. Ra-
tionaloutsideinvestorsanticipatetheseeffectswhentheypricesecuritiesissuedbythefamilyfirmand
thismakesexternalfinancecostly. Thisresultimpliesthatfamilyfirmownerswillimposehigherhurdle
ratesonnewinvestmentsrequiringexternalfinancethannon-familyfirmsandthatinvestmentinfamily
firms will be more sensitive to financial slack (which can be measured using financing deficit variable
developed by Frank and Goyal (2003)) than investment by non-family firms. To our knowledge, these
predictions have not been tested. However Anderson and Reeb (2003) show that family ownership is
7See Miller and Le Breton-Miller (2006) for a comprehensive summary of these results and the various definitions of
“familyfirm”usedintheempiricalliterature.
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associated with less corporate diversification. If diversifying investments are typically marginal NPV
projects,thisresultisconsistentwiththemodel’spredictions.
Giventhatseparationofownershipandmanagementiscostlyand,insomecases,morecostlywhen
ownershipandmanagementaredividedbetweenkin,thequestionarisesastowhythesortoffamilyfirm
wemodelwouldeverbecreated. Onepossibleoriginisabequesttodescendantsbyafirmfounder. We
showthatbequestsgeneratingdivisionbetweenownershipandmanagementarerationalinthepresence
of kin altruism. At the same time, founders sometimes prefer to pass over close relatives and bequest
theirfirmtomoredistantbutmorecompetentdescendants. Suchbequestdecisionsarevalueincreasing.
This prediction is consistent with the evidence provided by Ellul, Pagano, and Panunzi (2010) which
showsthat lawsthatrestrict ortaxmore heavilyfounderbequeststo distantrelatives(which areperva-
sive in non-Anglo-Saxon legal systems) adversely affect firm value. More generally, we show that the
calculus of kin relationship implies, under very weak conditions, that founder preferences attach more
weigh to total family value than any of the descendant’s preferences. Thus, in the presence of agency
rents,foundershaveapreferenceforgrantingcompetentdistantrelativeshighercompensationandmore
job-securitythanincompetentdirect-descendantswilloffer. Thus,foundershaveanincentivetodesign
bequeststhatpermitthemtocontrolcompensationandhiringpolicyfrom“beyondthegrave.”
2 Model
2.1 Overview
The world lasts for one period, bracketed by dates 0 and 1. All agents are risk neutral and patient.
There are two agents in the baseline model: a “family owner” and a “family manager.” Sometimes,
when there is no risk of ambiguity, will refer to the family owner/manager pair simply as the “owner”
and the “ manager.” The family owner and family manager are kin. The owner has monopoly access
to a project which we will call a firm. The owner can only operate the project if he secures the efforts
of the manager. Collectively, the family owner and family manager are called “family agents” and
the total value received by the family owner and family manager is called “family value.” We assume
that consanguinity between agents leads them to partially internalize the effects of their actions on the
payoffstootherfamilymembers. Thespecificmechanismgoverningthisinternalization,borrowedfrom
thetheoryofkinselection,ispresentedlater.
In the baseline model, the family owner hires the family manager by making a first-and-final com-
pensationofferthatthefamilymanagercaneitheracceptorreject. Iftheofferisaccepted,themanager
makes an unobservable effort decision that produces a cash flow also only observed by the manager.
In order to induce the manager to exert effort and accept employment the owner offers the manager an
employmentcontractthatsatisfieslimitedliability. Botheffortandrealizedcashflowareobservedonly
by the manager. Thus, neither effort nor the realized cash flow are verifiable or contractible. However,
After observing the cash flow, the manager makes a verifiable report of cash flows to the owner. The
manager and owner then divide reported cash flow based on the employment contract. After receiving
themanager’sreport,theownerhastheoptionofmonitoring. Monitoringimposesanon-pecuniarycost
ontheowner. Monitoringisperfectlyeffectiveinthatitalwaysdetectsandreturnstotheownerallcash
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flowsinexcessofreportedcashflow.
3 Specifics
3.1 Preferences
Thekinaltruismpreferencesoffamilyagentsarereflectedintheirutilityfunction,u:
uSelf=vSelf+hvRelative, 0≤h≤1/2. (2)
0≤h≤1/2. (3)
where vSelf represents the agent’s own value and vRelative represents the relative’s value. Value includes
boththemonetarypayoffsandthenon-pecuniarycostsofeffort, inthecaseofthemanager, andmoni-
toring,inthecaseoftheowner. Thescalarhrepresentskinship,thestrengthoftherelation,orfamilytie,
betweenthefamilyagents. Condition3ismotivatedbythefactthatthe1/2isthehighestdegreeofrelat-
ednessproducedbytypicalmatingpatterns.8 Anexemplarofthescenariowehaveinmindisafounder
who has bequeathed her firm to her son. The son, who, lacks managerial ability, hires another family
membertomanagethefirm,sayanephewwhohasworkedwiththefounderandissteepedinthefirm’s
culture and tacit knowledge base. Later, we will discuss how founder kin altruism can rationalize such
bequests and hiring decisions. For now, we take the manager–owner dyad as given. Note that agents
arenotaltruisticinthesenseofpreferringrelatives’gainstotheirown. Ifaskedhowtheywouldsplita
fixedamountofmoneywitharelative,eachrelative’spreferredchoiceistotakeeverythingforherself.
However, relatives might abstain from such transfers when the transfers are highly dissipative, i.e., the
transferfromonetoanothersignificantlyreducesfamilyvalue. Thisobservationismostapparentifwe
rewrite the utility function using some equivalent formulations. Let vFamily =vSelf+vRelative represent
family value. Using vFamily, we can express the utility function of a family agent in the following three
forms:
uSelf=vFamily−(1−h)vRelative, (4)
uSelf=(1+h)vFamily−uRelative, (5)
uSelf=hvFamily+(1−h)vSelf. (6)
These reformulations are trivial from a technical perspective but provide crucial insights for the sub-
sequent analysis. Equation 4 shows that when choosing between two outcomes that produce the same
familyvalue,thefamilyagentalwayspreferstheoutcomethatproducesasmallervaluefortherelative.
Equation 5 expresses the principle that when choosing between decisions that leave the utility of the
8Theconditionthatthedegreeofkinshipbetweentheownerandmanager,h,doesnotexceed1/2ismotivatedbyinclusive
fitness,whichlimitsfornon-inbreed,non-monozygotic(i.e.,non-identicaltwins)haploids(e.g.,humans)kinshiptoatmost
1/2. Thisspecificboundaryforhisnotrequiredtoestablishourresults;however,someboundaryisfrequentlyrequired. As
kinaltruismbecomesunlimited,i.e.,h→1,themonitoringproblemgeneratedbyrelatednessvanishesbecauseeither(a)the
ownerconcedesallfirmvaluetothemanageror(b)managerialeffortconvergestothefirst-bestlevelevenintheabsenceof
anycompensation. Whether(a)or(b)occursfirstdependsoncomplexpolynomialexpressions. Becausethesecasesarenot
veryinterestingwhenaltruismismotivatedbyinclusivefitness,weeschewworkingouttheseboundaryconditions.
Blood&Money 18th May,2014 7/67
relative fixed, family agents always prefer the choice that is family-value efficient. This principle is
analogous to the principle in contract theory that, when all possible decisions of the principle hold the
agent to his reservation payoff, the principle makes the efficient value maximizing choice. We will see
thattheprincipleembodiedbyequation5imposesprofoundlimitationsontheabilityofkinshiptoaffect
firmbehavior. Equation6,showsthattheutilityoffamilymembersisaweightedaverageofselfishand
familyvalue,withtheweightonfamilyvaluegivenbyhandtheweightonselfvaluegivenby1−h.
3.2 Effort
Therandomcashflowfromtheproject,x˜,hasthefollowingdistribution

x¯, w.p. p
x˜=dist. . (7)
0 w.p. 1−p
Themanagerselects p∈[0,p¯], p¯∈(0,1]. prepresentstheprobabilitythatthecashflowfromtheproject
equalsx¯>0. Wecall ptheuptickprobability. Themanager’schoiceof pimposesanon-pecuniaryeffort
costofK(p)onthemanager, whereK(·)isaweaklyincreasingfunctionof p. Effortisnotobservable
byanyagentexceptthemanager. Ifthefirmfailstooperate,theprojectproducesapayoffof0,andthe
managerreceivesapayoffofv ,themanager’sreservationpayoff.
R
3.3 Kinshipandmonitoring
After the cash flow is generated, the manager observes the cash flow. The cash flow is the manager’s
private information. After observing the cash flow, the manager sends a message to the owner. This
message is observable and verifiable by third parties. We call this message “reported cash flow.” We
assumethatreportedcashflowcannotexceedthecashflow. Thus, wecanviewthereportofcashflow
asbeingequivalenttothedepositofthecashflowsinanescrowaccountasin,forexample,Harrisand
Raviv(1995). AsinHarrisandRaviv,bytherevelationprinciple,wecanalsoassumethatreportequals
either0orx¯. Cashflowsinexcessofreportedcashflowsaretermed“unreportedcashflows.” Theowner
hasaccesstoamonitoringtechnology. Iftheownerusesthetechnologyandmonitors,theownerincurs
anon-pecuniarycostofc>0. Wecallthiscostthe“costofmonitoring.” Themonitoringtechnologyis
perfectly effective, it completely returns all unreported cash flows to the owner. If the owner does not
monitor,themanagerreceivesallunreportedcashflows. Inthiscase,wesaythatthemanager“diverts”
cash flows. The owner decides whether to monitor after observing the manager’s report. Monitoring
cannot be verified by third parties but is observed by both the manager and the owner. Because only
reported cash flows are verifiable, contracts must be contingent only on reported cash flows. Contracts
are assumed to satisfy limited liability. Thus, when the reported cash flow equals 0, the only feasible
limited liability contract stipulates a payment of 0 to both the owner and manager. When the reported
cashflowequalsx¯,feasiblecontractsstipulatethatthemanagerreceiveswandtheownerreceivesx¯−w,
where 0≤w≤x¯. We term w “management compensation” or simply “compensation.” If the manager
reports x¯, reported cash flow equals the highest possible cash flow and the owner knows that the report
is truthful. In this case, the owner has no incentive to monitor. If the reported cash flow is 0, then it is
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eitherthecasethat(a)thecashflowis,infact,0andthemanagerreportedtruthfullyor(b)themanager
“underreported,” i.e., the cash flow equaled x¯ and the manager reported 0. If the manager reported 0
whenthetruecashflowis0,theunreportedcashflowequals0andthusmonitoringdoesnotbenefitthe
owner. Ifthemanagerunderreportedcashflows,monitoringpermitstheownertocapturetheunreported
cashflowofx¯. OurmodelofreportingandmonitoringisquitestandardandcloselytrackstheTownsend
(1979)modelofcostlystateverification. Themajordifferenceisthat,incontrasttoTownsend,theowner
cannot precommit to monitoring. Thus, the question of the renegotiation-proofness of the monitoring
decision,whichisimportantinTownsend,isnotrelevanttoouranalysis.
3.4 Parameterrestrictions
Throughouttheanalysis,weimposethefollowingparameterrestrictions:
max px¯−(v +K(p)+c)>0, (8)
R
p∈[0,p¯]
(1−h)x¯−c>0. (9)
(8) implies that the expected cash flow to the project exceeds the cost of effort, monitoring, and the
manager’s reservation payoff. Thus, absent any kinship between the agents, undertaking the project is
optimalevenifundertakingtheprojectrequiresthattheownerincurthemonitoringexpenditure,c. The
second restriction, (9), implies that the owner’s utility benefit from monitoring when the owner knows
thatthemanagerhasunderreportedcashflow,whichequalsthegainfromtransferringaconcealedcash
flowofx¯fromthemanagertotheowner,(1−h)x¯,exceedsthecostofmonitoring,c. Ifthisassumption
wereviolated,theownerwouldnevermonitorandthemanagerwoulddiverttheentirecashflow.
4 Kinship and monitoring when compensation and output are fixed
In this section we treat compensation, w, and effort, and thus the uptick probability, p, as fixed param-
eters. Thus, there are only two interesting choices we must analyze: the manager’s reporting decision
when x = x¯, and the owner’s monitoring decision when the manager reports 0. In later sections, we
will endogenize w using the manager’s participation or incentive compatibility conditions. We analyze
the monitoring/reporting problem in the case where the game is not trivial, i.e., when the cost of mon-
itoring, c, is positive. In this case, monitoring is costly and will only be undertaken when the gains
from monitoring exceed its cost. The gain from monitoring depends on the likelihood that managers
attemptdiversionbyunderreporting. Managerialunderreportingwilldepend, inturn, onthelikelihood
ofmonitoring. Inequilibrium,monitoringandunderreportingwillbesimultaneouslydetermined.
4.1 Incentivestounderreport
Whenthecashflowequalsx¯andthemanagerreportsx¯, hereceiveswandtheownerreceivesx¯−w. If
the manager reports 0, and the owner does not monitor, the manager receives x¯and the owner receives
0; if the owner monitors, the manager receives 0 and the owner receives x¯−c. Thus, conditioned on
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