How Does a Holding Company Operate?

By Indeed Editorial Team

Updated March 8, 2021 | Published February 4, 2020

Updated March 8, 2021

Published February 4, 2020

A holding company does not conduct any business operations and can benefit greatly from the subsidiaries it owns. If you are considering turning your business into a holding company, it may be helpful to know how a holding company operates and ways you can benefit from operating as a holding company. In this article, we discuss what a holding company is, the advantages and disadvantages of holding companies and provide an example of how a holding company may operate.

What is a holding company?

A holding company is a corporation that doesn't run a particular business or participate in the daily operations of a business. Holding companies own or "hold" investments like private businesses, stocks, bonds, mutual funds, real estate, gold, patents, copyrights and others.

They are considered parent corporations that maintain the oversight capabilities of companies that they own, which means they can oversee all management decisions and control the policies of company's they own. These companies are known as subsidiaries of the holding company.

Related: Factors of Production: A Definitive Guide

Advantages of holding companies

Holding companies provide the companies they group together with advantages they would not be able to benefit from if they operated as their own entities. Here is a list of advantages a holding company has:

  • Minimizes taxes

  • Reduces risk

  • Protects assets

  • Increases growth and development

  • Maintains control with less capital

Minimizes taxes

Holding companies typically file consolidated tax returns that can offset the losses incurred in one subsidiary with the profits of the other companies. This results in a lower tax bill for all the companies.

Reduces risk

If a subsidiary performs poorly and fails or goes bankrupt, the holding company is not liable, and the loss will not affect them. They may sell their remaining shares in the failed subsidiary and continue.

A subsidiary is also protected from the issues other companies may have within the holding company. A plaintiff may not attach the assets of the other subsidiaries and a holding company may still be protected if it did not guarantee the debts of the subsidiary.

Protects assets

A holding company may hold the valuable assets its subsidiary possesses. They may hold assets such as property, equipment and intellectual property. The subsidiary would take on the trading responsibilities of the business and its daily operations, but the assets would be protected from creditors and any liabilities the operating company might incur.

Increases growth and development

When valuable assets are held by the holding company, the subsidiary may invest in new business ventures, exit old ventures and diversify their business more efficiently. The subsidiary will be more likely to try to grow and develop their business because there is less risk associated with a holding company. A holding company gives them greater power to invest in larger projects.

Read more: How To Calculate Growth Rate of a Company (With a Step-by-Step Example)

Maintains control with less capital

Holding companies may obtain control of a company by amassing 51% of its stock. Purchasing a portion of a business allows a holding company's firm to control a company with less capital. It is also possible for a holding company to acquire 25% of a company's stock and become the largest shareholder if the subsidiary has a diverse portfolio. When a business does not have to purchase 100% of a company, it can control more companies with smaller investments.

Disadvantages of holding companies

  • Overuse of debt

  • Exploitation of subsidiary companies

  • Minority shareholders are at a loss

  • Tax evasion

Overuse of debt

Holding companies typically finance their investments and acquisitions using debt such as corporate bonds and bank loans. When holding companies rely on debt instruments, it can leave them and their subsidiaries vulnerable to fluctuations in interest rates and over-capitalization.

This can harm the overall value of the holding company and its subsidiaries. High-debt obligations can also cause inaccurate financial reports and the numbers may appear more optimistic than the company merits.

Related: FAQ: How Do I Prepare an Income Statement?

Exploitation of subsidiary companies

Senior management and the employees of a subsidiary are not allowed to make any important decisions. The holding company makes all of the decisions and without much responsibility or accountability. This can lead to frustrated management teams and employees.

Minority shareholders are at a loss

Holding companies can shut-out minority shareholders from the decision-making process in a subsidiary. This happens due to a holding company's majority control of a subsidiary and they can appoint their own directors, management team and officers that promote its interests, instead of the interests of the minority shareholders. Minority shareholders likely won't have enough voting stock or adequate political power to stop the holding company from making certain decisions.

Tax evasion

Some holding companies use subsidiaries to evade taxes by manipulating accounting statements so that the tax liability of the holding company and the subsidiary is reduced.

Example of a holding company

There are several corporations that you may be aware of that operate as holding companies. Here is an example of a fictional holding company and how it may operate:

  1. You and a partner of your choosing decide to invest together. You acquire new partners who would like to get involved and you all create a new company called Orange Sunset Holding Corp. Once your business is established and fees are paid, you issue 500,000 shares of stock at $20 per share. You have now raised 10 million dollars in cash. You and your partner select a board of directors and they hire you as the CEO of this company.

  2. Orange Sunset Holding Corp (you and your partner) start to invest the $10 million.

  3. You incorporate a new business that is owned 100% by Orange Sunset Holding Corp called Summer Designs, LLC. You hire a manager to run the place and contribute 2.5 million to the business in cash and open a Sunglasses Shack franchise that you expect to amass profits of up to $200,000 before taxes.

  4. Orange Sunset Holding Corp opens a brokerage account with a major discount brokerage firm and deposits four million in cash. You then buy high-quality stocks that should generate $150,000 in dividends each year.

  5. You start a new company called Wealth Hospitality, LLC that is 80% owned by Orange Sunset Corp. You contribute three million of Orange Sunset Corp's cash to Wealth Hospitality and they borrow another two million from a bank, which is five million in the capitalization structure of the company; three million in assets and two million in liabilities.

  6. *The company then uses five million in cash to purchase a hotel franchise that is expected to generate $360,000 in profits before tax after all other costs and interest expense. The debt is not guaranteed by Orange Sunset Holding Corp since you only allowed non-recourse liabilities. If the subsidiary is unsuccessful in its hotel operations, you will only be responsible for the equity you have invested in

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