Holding Company
A parent corporation or limited liability company (LLC) that owns majority shares or full ownership of other public or private businesses
What Is A Holding Company?
A holding company is a parent corporation or limited liability company (LLC) that owns majority shares or full ownership of other public or private businesses. It has no operational control over the businesses, only the authority to change managerial roles.
Businesses under the parent company or "umbrella" company, other terms for holding company, are known as its subsidiaries. These subsidiaries can be your familiar everyday businesses selling products in healthcare, technology, food, clothes, etc.
You have probably purchased many products from multiple businesses without knowing a single-parent entity owns them.
Subsidiaries are not limited to businesses; they can be used to hold real estate, vehicles, intellectual property, and equipment at a privilege for operating companies to lease.
The subsidiaries can be "wholly-owned" to address if they are wholly owned by a parent company - 100% equity.
However, a partially owned subsidiary can be held and managed without interference if most shares are owned. The parent company would have to own 51% of the company's shares to instate majority voting power.
Parent corporations are advantageous for large enterprises. Instead of multiple divisions within a single company for many products that may appeal to different markets, a parent company could be created to form separate subsidiaries.
Each subsidiary will be an operational business with an appointed manager experienced in selling products.
As a majority shareholder, the parent company can permanently remove management roles and replace them with new professionals if the company fails to perform as expected.
Key Takeaways
-
A holding company is a parent corporation that owns majority shares or full ownership of other businesses (subsidiaries) but has no operational control.
-
Holding companies can be advantageous for large enterprises, allowing them to create separate subsidiaries for different products or ventures.
-
Parent companies can be financed through mergers, investments, and obtaining credit due to their significant capital and assets.
-
Holding companies provide liability protection for subsidiaries, isolating their assets from legal actions or financial troubles of other subsidiaries.
-
Partial ownership allows a parent company to have majority voting power and make decisions for a subsidiary, but it can lead to tensions with other shareholders.
How is a holding company financed?
Holding companies have to acquire or own a large sum of money to build a portfolio of equity investments for either their business ventures or control a majority stake in other businesses.
A merger between an existing operations company can allow it to be restructured into a parent company. Then, there is a shareholder's meeting for the motion to pass, and the proportions of shares are identically transferred to the holdings company unless some investors decide to sell.
A perfect example is Google's restructuring to form Alphabet in a holding company merger.
This enables new subsidiaries to be financed from investments and revenues redirected from the top performing subsidiaries containing Google's search and advertisement businesses.
Other Google subsidiaries are less profitable as they consist of many research and development projects that require the necessary finance to run.
Whereas Berkshire Hathaway, the world's largest holding company by revenue, generated 247.5 billion in 2020 by strategically choosing profitable companies and continuing to use their profit to make wise investment choices.
In these instances, Alphabet is run more like a venture capital firm, and Berkshire Hathaway a private equity firm.
The parent company's management is entirely responsible for where the money is invested or distributed.
Holding companies can sell equity interest for a stake within themselves or their subsidiaries to raise more capital. Buying shares of a parent company would mean you have made a proportional investment with all subsidiaries it owns.
If investors are interested in a particular business within a parent company, it is best to invest within that subsidiary. This is because the stock value of subsidiaries tends to appreciate faster than its accompanying parent company in a bullish market.
This is due to its diverse portfolio, with some companies underperforming and others captivating the market, keeping the value relatively stable. The parent company, therefore, provides a discount rate for investing in its subsidiaries at a more affordable price.
Credit is another relatively easy option for large holding companies to obtain in their name because of their significant capital and quantity of assets that can be used as collateral.
Not all subsidiaries are operating businesses but are created to hold property or equipment that can be leased out to companies generating additional revenue streams.
Liability protection for Holding Companies
The assets of a subsidiary are isolated and cannot be reached through other subsidiaries. For example, when a business becomes bankrupt or defaults on its debt, other subsidiaries cannot be legally pursued by the company's creditors.
Or, if a third party sues a company, it would not be able to target assets belonging to other subsidiaries. It is a strategic method that can be adopted to protect risky ventures a parent company may be invested in without its other successful businesses being made liable.
Holding companies use this method to split up their holdings, such as real estate, intellectual property, and equipment. Business operating subsidiaries may be leasing intellectual property, such as company trademarks held by a separate subsidiary.
Hence in the event of a lawsuit, the valuable trademark asset would be safe as it belongs to a separate entity and cannot be claimed by law. Once a subsidiary has been liquidated, the parent company may devalue due to its loss in capital.
Partial ownership of a holding company
A parent company does not have to own all the shares of a company to have majority voting power. However, at least 51% of the company shares must be held for complete control, making it less expensive than purchasing the whole company.
With the majority of the shares owned, the parent company can rearrange the management of a company without the other shareholders being able to contest any changes.
As the largest investor, they have the most to lose, making it reasonable to decide what changes should be made to position the company to succeed.
The holding company's shareholders may vote to make decisions for its subsidiaries, or it can rely on managerial supervisors to vet and appoint a manager, as they have the expertise and library of viable candidates.
Again, holding companies can appoint a new subsidiary manager; however, the new manager has complete control over changes within the subsidiary's business operations and hopefully can improve and expand operations, gaining more revenue.
Otherwise, he can be replaced after the manager's contract has expired. Problems that may be faced with partial ownership are that other shareholders' opinions about the company's direction may be ignored, causing tension.
Parent companies can be less educated about an industry; therefore, their decisions may be unfavorable. The remaining shareholders cannot change the vote as they possess a lower overall percentage of shares and, subsequently, less voting power.
The Impact of Holding Companies on Creditworthiness
Subsidiaries may need to accumulate funds on demand to help finance new development projects; therefore, they may decide to take out a business loan. Unfortunately, creditors may charge higher interest rates for the amount of risk they will endure.
An alternate option to raise capital is to sell equity interest; however, it may not be beneficial as ownership of the company would become more dilute with the increased number of shares, especially disadvantageous for the parent company attempting to hold majority shares.
Holding companies can mitigate risk by obtaining a loan at a considerably lower interest rate than their subsidiaries due to their financial strength. The loan can then be distributed among subsidiaries to support business operations.
A loan backed by the parent company must be paid off as if they were to default or become insolvent due to an unforeseen problem. The creditors can call for its assets to be liquidated, which includes all subsidiaries, to pay back its debt.
The structure of a parent company must be well fortified to prevent debt liabilities from affecting multiple subsidiaries. If there was any evidence proving the company's negligent or incompetent behavior, its other assets might be at risk.
A parent company may be liable if:
- The debt was present at the time the parent company was in command.
- The subsidiary was insolvent when pursuing credit financing or had become insolvent by proceeding with the debt.
- There was internal suspicion the subsidiary company would become insolvent.
How to Invest in Business Ventures Using a Holding Company
As previously mentioned, Google had restructured itself to form Alphabet. The idea was to separate its divisions into cash-flow-generating and innovation-developing businesses.
The risk of investing in start-ups with elaborate projects is that they may have a high probability of failure or require long-term financing, which is unappealing to many investors.
Therefore, a holding company would be a good solution where the raised capital or subsidiary revenue can be redistributed to new business ventures.
Debt liabilities would be less critical in the event of insolvency if correctly conducted, protecting other subsidiaries.
The fostering of new creations can allow companies, primarily technology companies, to progress into new domains to advance products and services.
If associated with an emerging market or can alter lifestyle decisions to become a normality, such as smartphones have conquested, it can be very profitable for the company and its affiliates.
Subsidiary Management for holding companies
Holding companies are not responsible for subsidiary business operations. Therefore they can own stakes in businesses that are unrelated to any of their current business operations.
Holding unrelated businesses could be to expand their market, or it may be a good investment opportunity in an emerging market with a visionary appeal to the holding company.
The hired management for a subsidiary, decided by the parent company, is the business operators who need to have relevant experience in the industry.
The parent company could have an internal board of management directors who select suitable candidates for a business. Then, the holding company's shareholders may vote on the final applicants.
The management can deploy their strategies for the business; however, if the company's performance shows little growth, they can be replaced.
A diverse business portfolio can provide steady growth and mitigate equity risks as different businesses thrive under certain economic conditions caused by consumer demand. While one company may remain stagnant, another could be providing exponential returns.
Tax efficiency for holding companies
Companies can be set up in various countries that impose lower corporation taxes. For example, the Cayman Islands does not charge corporate tax, dividend tax, income tax, or capital gains tax. Instead, the government sets a business licensing fee.
However, a company that executes business overseas will be taxed by the local government for conducting business on their land.
Dividends can be paid to the parent company by subsidiaries and are exempt from corporation tax. It allows dividend extraction to be more controlled and provides a feasible income.
Otherwise, if dividends were released individually, it would require more hassle for investors to extract.
Under the substantial shareholding exemption (SSE), the revenue from selling shares can prevent parent companies from paying corporate tax, given certain conditions are met.
An outline of the conditions is that the shares held must be greater than 10% of the company's stock and held for more than 12 months.
Creating A Holding company
The purpose for the creation of a holding company needs to be determined. The two primary reasons individuals set up these companies are tax reduction and asset protection.
For your parent company to fully support your plans, the business structure will need to be constructed precisely; otherwise, incidents in the future may bypass the security of all your assets.
Businesses can be structured as corporations or LLCs. LLC is more favorable to smaller businesses looking to maximize asset protection. Two separate LLCs must be formed, a parent company and an operating company.
The business agent for each company can be the same; however, the individual companies must be registered as separate entities. Consulting a business attorney for setting up a holding company in a less intensive tax jurisdiction would be advised.
Different states impose different laws, and the local government needs to be convinced that the business is competent by presenting a thorough business application. Independent bank accounts and records should be held separately.
The holding company should occupy most of the wealth and distribute it ad hoc to its subsidiaries. The financial prosperity would allow credit to be granted at low-interest rates to finance subsidiaries.
Suppose the operating company was formed before the parent company. In that case, all valuable assets should be transferred to the holding company, which can include other separate entities to hold these valuable assets for liability protection.
Detailed company accounting records should be updated and maintained to distinguish the separate entity's cash flows.
or Want to Sign up with your social account?