If you’re starting or investing in a business, you may have wondered What is a holding company? So, what is a holding company, and what does it do?
Here’s an overview of holding companies, how they work, and their advantages and disadvantages.
What is a Holding Company?
A holding company is a company, typically a corporation or LLC, that is in the business of owning other companies. They don’t actually produce anything, or sell any products or services. Holding companies are also known as “umbrella companies.”
What is the Purpose of a Holding Company?
A holding company’s purpose is to maintain a controlling interest in other companies. In addition to businesses, holding companies may own other assets, such as patents, real estate, stocks, bonds, and non-controlling stakes in other countries.
Holding companies retain the right to hire and fire the managers of their subsidiary companies. However, those managers run their own businesses independently. The only control a holding company has is the some control any other majority owner has: to vote on broad matters of shareholder discretion, set executive pay, and choose senior management.
How Does a Holding Company Make Money?
A holding company typically makes money off of its investments. If its subsidiaries gain share value, that share value is reflected as part of the holding company’s assets. Similarly, bonds can pay off, and other stocks can gain value or pay dividends. Real estate can earn rent.
Subsidiaries will oftentimes make direct payments to the holding company. For instance, one subsidiary may rent a commercial property from another subsidiary, which returns the profits to the holding company. This is common practice for many types of services, from payroll to inventory management.
Different Types of Holding Companies
Holding companies fall into four different categories: pure, mixed, immediate, and intermediate. Here’s what those terms mean:
- Pure holding companies are companies that exist for the sole purpose of owning other companies, in whole or in part. It does not conduct any other kind of business.
- Mixed holding companies are holding companies that also do business of their own. For example, some very large businesses insure their operations through an insurance company which they own as a subsidiary. The most extreme example of a mixed holding company is a conglomerate, which is a company that does business in two or more completely different fields.
- Immediate holding companies are subsidiary companies that own stock or a non-controlling interest in another company..
- Intermediate holding companies are holding companies that are themselves controlled by another company. For instance, a car company may be owned by a larger holding company, and simultaneously own a financing company to supply its customers with loans.
Advantages of a Holding Company
So, why would you want to run a business via a holding company, rather than just running it directly? There are a few reasons:
- Liability protection. Much like an individual owner is exempt from liability for losses at an LLC, a holding company is exempt from losses at its subsidiaries. If a subsidiary declares bankruptcy, the holding company can lose value, but it can’t be held liable for any outstanding debts.
- Control subsidiaries with a partial investment. Holding companies don’t have to own all of a subsidiary in order to exercise control. As long as they own a majority stake, they can control the subsidiary.
- Easier access to credit. A holding company is, by definition, larger than its subsidiaries. If a subsidiary is struggling, and doesn’t have ready access to credit, a strong holding company might be able to provide a lifeline by securing credit.
Disadvantages of a Holding Company
That said, holding companies are by no means a perfect solution. There are some very good reasons to avoid owning one, if you can help it.
- Complexity. When one company performs all the operations, it’s easy to keep track of who is responsible for what. With a holding company with multiple subsidiaries, matters can get far more complex. Keeping records, managing deliverables, and coordinating projects across multiple subsidiaries can be a daunting task. If you’re not careful and business between two subsidiaries gets mixed up, one subsidiary could end up being liable for another one’s debts.
- Compliance costs. There are certain costs that you incur each time you found a new subsidiary. Licensing, formation, and other fees add up, and don’t get discounted at scale.
How to Set Up a Holding Company
Starting a holding company isn’t as complicated as it might sound. To begin with, you need at least two companies, a holding company and a subsidiary. Next, you need to decide whether to form a corporation, LLC, or another type of entity. A lawyer can help with this. Similarly, you’ll need to decide whether the company will be taxable or whether it will be a pass-through entity.
Finally, you’ll need what’s called a registered agent. This is a person or company who will receive all official government communication, and who will receive the papers if the company is served. This is typically a lawyer, although there are also companies that specialize in this service.
Should I Have a Holding Company?
You probably think holding companies are only the realm of the uber-rich and major corporations. However, even individual business owners can take advantage of the benefits of a holding company.
For example, suppose you’re a landlord who owns a couple small residential properties. You want to invest in a small commercial property to diversify your income. However, you’ve never rented commercial property before, and there’s a part of you that’s worried about the risks.
You could create a holding company with two subsidiaries: one for residential rentals, and another for commercial rentals. That way, if your commercial venture fails, your existing residential properties won’t be in jeopardy.
Now, suppose your commercial business becomes successful and you want to buy another property, but the business can’t afford it. However, the holding company, which is bolstered by the value of the residential properties, could afford the loan. Now you can expand your commercial business immediately
The same is true for nonprofit and philanthropic organizations. If you’re trying to fund multiple causes, each can have its own subsidiary. If one of them doesn’t pan out, the other ones aren’t at risk.