Whether you are just starting to invest in corporate assets like ordinary stocks, preferred stocks, or corporate bonds, or you are thinking about starting your own firm, you may come across something called a holding company. Many of the world's most successful corporations are holding firms. Discover the overall structure, purpose, and benefits of holding corporations, as well as instances of how they operate.
Definition of a Holding Company
A holding corporation is one that does not conduct any operations, activities, or other active business. The holding corporation, on the other hand, owns assets. Shares of stock in other firms, limited liability companies, limited partnerships, private equity funds, hedge funds, public stocks, bonds, real estate, song rights, brand names, patents, trademarks, and copyrights are all examples of assets. Johnson & Johnson, for example, is a holding firm that is one of the world's most recognisable blue-chip companies. The company itself does not create anything. Instead, Johnson & Johnson owns an interest in over 250 different firms. The ownership is similar to how you may own shares in several firms through a brokerage account. Johnson & Johnson's activities are divided into three primary categories: consumer health care, medical devices, and pharmaceuticals. However, each subsidiary is a separate entity with its own offices, bank accounts, and production facilities. They are located in various nations throughout the world and are operated by locals. Johnson & Johnson's investors elect a board of directors to safeguard their interests at the top. This board is in charge of, among other things, deciding dividend policy and choosing the CEO. In turn, the CEO employs their immediate subordinates. This group of persons has the collective authority to choose the CEOs and key executives at Johnson & Johnson's subsidiary firms. Because of its overall strength, the main holding firm helps the subsidiaries by cutting the cost of capital. For example, Johnson & Johnson can issue bonds at rock-bottom rates and then lend money to its subsidiaries at rates that the subsidiaries couldn't receive if they were independent businesses. This lowers interest expenditures, which raises both returns on equity (ROE) and returns on assets.A Sample Holding Company
Assume you and a friend decide to invest jointly to better grasp the notion of a holding company. You form a new corporation called Blue Sky Holding Company, Inc. Following the filing of the papers with the secretary of state, you issue 1 million shares of stock at $10 per share, raising $10 million in new funds. A board of directors is elected by you and a buddy. That board selects you as CEO. The next day, you and your friend begin investing the $10 million. You accomplish various things as Blue Sky Holding Company:- You form a new company named Frozen Treats of America, LLC. Blue Sky Holding Company owns the whole company. You invest $1.5 million in cash, hire a manager, and create a restaurant franchise that is predicted to make $170,000 in profit before taxes.
- Blue Sky Holding Company has been instructed to create a brokerage account with a bargain brokerage business. You deposit $3 million into the account and purchase a portfolio of high-quality, blue-chip equities. You anticipate that these stocks will yield $150,000 in pre-tax dividends every year.
- You establish Southworth Hospitality, LLC, which is wholly owned by Blue Sky Holding Company. You contribute $2 million of Blue Sky's cash and have this new subsidiary borrow an additional $2 million from a bank, giving it a capitalization structure of $4 million in assets: $2 million in liabilities: and $2 million in book value. The $4 million in cash will be used to purchase a hotel franchise, which is estimated to yield $320,000 in pre-tax profits after interest and other charges. Because you only allowed non-recourse obligations if the hotel failed, the controlling company does not guarantee this debt. That is, if the subsidiary fails, you are solely liable for the amount specified.
- You invest $2 million in tax-free municipal bonds, expecting to earn $100,000 in yearly interest income.
- You invest $500,000 in gold coins and silver bullion.
- You invest the remaining $1 million in institutional money market funds that yield 2% interest, providing $20,000 in pre-tax interest income each year.
Holding Company Financial Statements
This holding company's consolidated balance statement will show $12 million in assets, $2 million in debt, and a $10 million net worth, or book value. The balance sheet looks like this: Blue Sky Holding Company, Inc.—Balance Sheet- Frozen Treats of America, LLC: 100% ownership ($1.5 million in assets and no liabilities).
- Southworth Hospitality, LLC: 100% ownership ($4 million in assets, $2 million in liabilities, and a net worth of $2 million).
- Municipal bonds exempt from taxation ($2 million in assets, no liabilities)
- A brokerage account with blue-chip common stocks ($3 million in assets and no liabilities)
- Balances at the bank ($1 million in assets, no liabilities)
- Reserves of gold and silver ($500,000 assets, no liabilities)
How To Think About a Holding Company
What exactly do you do as the CEO of Blue Sky Holding Company, Inc.? You have no day-to-day involvement in any of the investments since Blue Sky is a holding company. Each has its own management staff. Your responsibilities include executive oversight, support, risk management boundaries, and putting the appropriate people in the right positions to match with business objectives. When subsidiaries pay dividends to Blue Sky, the funds might be invested in new ventures. At your restaurant franchise, you will not be making ice cream cones. Frozen Treats of America, LLC, a wholly-owned company with its own staff, managers, financial statements, contracts, and bank loans, is in charge of this. Instead, you will be watching the CEO of that firm to see that they meet the objectives set by the board. Both you and the subsidiary will face expectations from the board. The expectations for you are based on how well you can assist subsidiary CEOs in meeting their goals and how well you can improve profits while decreasing risk.The Benefits of the Holding Company Model
What if something terrible occurred? What if, for example, your hotel franchise went bankrupt? The holding company is not responsible for the loss if it does not co-sign on the loan. Instead, you would deduct $2 million from Blue Sky's net worth as a capital loss on your Southworth Hospitality, LLC shares. The holding company structure shielded the other assets from the loss suffered by this subsidiary. You will not lose your restaurant franchise because the hotel franchise failed. Similarly, the stocks, bonds, gold, silver, and bank accounts of your holding company remain untouched. You just lost the money you put into that one subsidiary. Large businesses defend themselves in this manner. To use a real-world example, Procter & Gamble is basically a holding corporation since it has many subsidiaries for various objectives. Some subsidiaries, such as Tide detergent, possess brand names. Other distinct businesses control the Tide production plants, and those manufacturers pay a license royalty to the brand-owning firm. If the company is sued, Procter & Gamble will never lose the Tide brand name. Instead, the manufacturing or distributor would go out of business.Frequently Asked Questions (FAQs)
How do you start a holding company?
Creating a holding company follows the same steps as starting any other business in your state. You must name the company, file articles of incorporation, open a separate bank account, pay fees, and comply with all other state regulations for launching a business.When should you set up a holding company?
If you manage many firms or want to invest in various cash-generating businesses, you might think about forming a holding company. The holding company can secure your firm's assets while also potentially providing tax benefits. Having a holding company adds extra administrative requirements and business taxes, so make sure the advantages outweigh the costs.