What is a holding company

Understanding holding companies: benefits, types, and how they work

Have you ever wondered what a holding company is and why it’s crucial for businesses? How do these companies make money, and what different types are there? Are there specific advantages and disadvantages for companies that use them? This blog post will explore the answers to these questions and provide practical tips for businesses considering a holding company structure.

What is a holding company?

A holding company is a type of business that owns the stocks and assets of other companies. It doesn’t produce goods or services itself. Instead, it exists to control other companies, known as subsidiaries. This setup allows the holding company to influence and manage its subsidiaries’ policies and decisions.

For example, a holding company might own a majority of shares in several smaller companies. It controls these companies without being involved in their day-to-day operations. This structure helps manage investments more efficiently and centralise control.

Why is it important for businesses?

Holding companies are essential for businesses because they offer several benefits:

Risk reduction

A holding company can diversify its investments by owning various subsidiaries. This helps protect against losses because the risk is spread across different sectors.

Efficient management

Holding companies can more effectively manage and coordinate their subsidiaries. This central control allows for strategic decision-making that benefits the entire group of companies.

Resource allocation

Resources can be allocated where they are most needed within the subsidiaries, improving overall efficiency and productivity.

For instance, if one subsidiary faces financial difficulties, the holding company can support it using resources from a more profitable subsidiary, stabilising the overall business.

Different types of holding companies

Holding companies come in various forms, each serving a different purpose. Understanding these types helps businesses decide on the best structure for their needs and goals.

Pure holding companies

These only own stock in other companies and do not engage in different activities. Their sole purpose is to control their subsidiaries.

Mixed holding companies

These own stock in other companies and also run their business operations. They manage both their subsidiaries and their business activities.

Immediate holding companies

These directly control another company. They own significant shares and have substantial influence over their subsidiaries.

Intermediate holding companies

These are in between; they hold stock in other companies and are controlled by a larger holding company.

How does a holding company work?

A holding company works by owning a controlling interest in other companies, known as subsidiaries. Its typical functions involve,

Control and influence

The holding company owns enough voting stock in the subsidiaries to influence or control their policies and decisions. This does not necessarily require 100% ownership; owning more than 50% of voting shares is often sufficient.

Management and oversight

While the subsidiaries operate independently daily, the holding company oversees their performance and provides strategic guidance. This helps maintain consistency and achieve long-term goals across the group of companies.

Financial support and resource allocation

The holding company can allocate resources and provide financial support to its subsidiaries. This is particularly useful for stabilising underperforming subsidiaries or funding new ventures.

Centralised services

Holding companies often centralise legal, accounting, human resources, and marketing services. This reduces costs and ensures uniformity in operations across all subsidiaries.

How are holding companies set up?

Setting up a holding company involves several steps:

Choose a structure

Based on the business goals, decide whether it will be a pure or mixed holding company.

Register the company

Follow the legal procedures to register your holding company. This involves:

Choosing a company name

Ensure the name complies with local regulations and is not already used.

Drafting articles of incorporation

These documents outline the primary details of the company, including its name, address, and purpose.

Filing with relevant authorities

Submit the necessary documentation to the local corporate regulatory body. This may include paying a registration fee.

Obtaining necessary licenses and permits

Depending on the jurisdiction, additional permits might be required.

Acquire subsidiaries

To establish control over other companies, you must acquire significant shares. This can be done in several ways:

Direct purchase

Buying shares directly from the market or through a negotiated sale can be an efficient way to invest without intermediaries. This often leads to lower transaction fees and greater control over the purchase timing and price.

Acquiring controlling interest

This usually means obtaining more than 50% of the voting shares, giving you the power to influence or outright control the subsidiary’s management and policies.

Negotiations and due diligence

Before acquiring any company, conduct thorough due diligence to understand its financial health, operational stability, and potential risks.

Establish management

Once the holding company and its subsidiaries are set up, establishing an effective management structure is crucial:

Forming a board of directors

Appoint a board to oversee the strategic direction of the holding company.

Hiring a Management Team

This team will oversee the subsidiaries’ daily operations and strategic decisions.

Implementing corporate governance policies

Establish policies and procedures to ensure compliance with legal requirements and to facilitate efficient management.

Example

A business aiming to diversify its investments might establish a pure holding company. This company would own several different subsidiaries in various industries. For instance:

• One subsidiary might manage real estate investments.
• Another could be focused on technological innovations and startups.
• A separate subsidiary might operate in the retail sector.

Each subsidiary operates independently but is overseen and strategically guided by the holding company, allowing for diversified investments and risk management.

How do holding companies earn money?

Holding companies make money primarily through two sources:

Dividends

They receive dividends from their subsidiaries. When a subsidiary makes a profit, a portion is distributed to the holding company as dividends.

Capital gains

Holding companies can sell their subsidiaries for a profit. If a subsidiary’s value increases, the holding company can sell its shares at a higher price, earning capital gains.

Also, holding companies might charge management fees to their subsidiaries for administrative support, strategic planning, and financial management.

For instance, if a holding company owns a profitable technology firm, it might receive regular dividends. If the technology firm’s value increases significantly, the holding company could sell its shares for a substantial profit.

Advantages and disadvantages of holding companies for businesses

Advantages

Holding companies offer numerous benefits, including risk reduction, tax advantages, and enhanced control over subsidiary operations. These advantages can significantly contribute to a business’s overall stability and profitability.

Risk reduction

Spreading investments across multiple companies can minimise losses if one company underperforms. A holding company can mitigate the impact of sector-specific downturns by owning a diverse portfolio of subsidiaries in different industries. This diversification helps stabilise income and protect the business from significant financial setbacks.

Tax benefits

Holding companies can use various tax strategies to reduce their overall tax burden. For instance, they can offset profits from one subsidiary with losses from another, leading to lower taxable income. Additionally, certain jurisdictions offer favourable tax treatments for dividends received from subsidiaries, allowing holding companies to optimise their tax liabilities effectively.

Control

Holding companies can strategically manage and coordinate the operations of their subsidiaries for better overall performance. With a centralised management structure, holding companies can streamline decision-making processes, implement uniform policies, and ensure that all subsidiaries align with the overarching corporate strategy. This centralised control can lead to more efficient operations and improved profitability.

Disadvantages

Despite their benefits, holding companies face increased complexity and heightened regulatory scrutiny. Overcoming these drawbacks may require substantial resources and careful management.

Complexity

Managing multiple subsidiaries can be complex and require substantial resources. Each subsidiary may operate in a different industry, have distinct regulatory requirements, and require specialised management expertise. Coordinating and overseeing these diverse entities can be challenging and may require significant investment in management systems, personnel, and administrative support.

Regulatory scrutiny

Due to their structure and activities, holding companies may face increased regulatory scrutiny. Regulators may closely monitor their financial practices, inter-company transactions, and compliance with corporate governance standards. Ensuring compliance with various regulatory requirements across different jurisdictions can be burdensome and may involve considerable legal and administrative efforts.

Example

To understand the advantages and disadvantages, consider a holding company with subsidiaries in the manufacturing, technology, and retail sectors. The diversification helps mitigate risks, as a downturn in the manufacturing industry can be offset by gains in the technology or retail sectors. The holding company can also leverage tax benefits by consolidating profits and losses from these different subsidiaries. However, managing diverse operations and ensuring compliance with industry-specific regulations require a robust management structure and significant resources.

Practical tips for businesses

For businesses considering a holding company structure, here are some practical tips:

Consult legal and financial experts

Ensure compliance with laws and optimise financial benefits. Experts can provide valuable advice on setting up and managing a holding company.

Develop a clear strategy.

Define the goals and structure of your holding company. This includes deciding which companies to acquire and how to manage them effectively.

Monitor subsidiaries closely

Regularly review the performance and management of subsidiaries to ensure they are meeting the overall business goals.

Stay informed about regulations.

Keep up to date with legal requirements to avoid penalties. This involves understanding the regulations governing holding companies in the relevant jurisdictions.

Takeaway note

Holding companies can offer significant business benefits, including risk reduction, better management, and financial advantages. However, they also come with challenges like complexity and regulatory scrutiny. By understanding what a holding company is and how to set one up, businesses can make informed decisions to leverage this structure effectively.

FAQs

What is a personal holding company?

A personal holding company (PHC) is a corporation where five or fewer individuals own more than 50% of the stock. At least 60% of its income comes from passive sources like dividends, interest, rents, and royalties. PHCs are subject to specific IRS rules and taxes designed to prevent tax avoidance by accumulating income instead of distributing it to shareholders. The goal is to manage passive investments efficiently, often within families or small groups.

Is a holding company good or bad?

A holding company can be advantageous due to risk reduction, tax benefits, and enhanced control over subsidiaries. However, it also comes with challenges like increased complexity and regulatory scrutiny. Whether it is good or bad depends on the specific business context and management capabilities.

What is the difference between holding and trading?

A holding company owns shares in other companies primarily to control and manage them, while a trading company is actively involved in buying and selling goods or services for profit. The main difference lies in the purpose and nature of their operations.

Why is holding better than trading?

Holding is often better than trading for long-term strategic control, risk diversification, and potential tax benefits. It allows for a stable income through dividends and capital gains from subsidiaries, whereas trading involves higher risk due to market volatility and requires active management.

Can a holding company be a trading company?

Yes, a holding company can also engage in trading activities. In such cases, it is referred to as a mixed holding company, as it owns shares in other companies and conducts its business operations.

What is a company opposite to a holding company?

A company opposite to a holding company is an operating company. An operating company is directly involved in producing goods or services, whereas a holding company primarily exists to own shares in other companies and manage their operations.