Whether you are beginning to invest in securities issued by corporations—such as common stocks, preferred stocks, or corporate bonds—or you are considering investing in your own business, you may encounter something known as a holding company.
Many of the most successful companies in the world are holding companies. Learn about the overall structure, purpose, and benefits of holding companies, along with examples of how they work.
Definition of a Holding Company
A holding company is a company that doesn't have any operations, activities, or other active business itself. Instead, the holding company owns assets. These assets can be shares of stock in other corporations, limited liability companies, limited partnerships, private equity funds, hedge funds, public stocks, bonds, real estate, song rights, brand names, patents, trademarks, copyrights—virtually anything that has value.
For example, one of the most respected blue-chip stocks in the world, Johnson & Johnson, is really a holding company. The firm itself doesn't actually produce anything. Instead, Johnson & Johnson holds ownership stakes in more than 250 separate businesses. The ownership isn't much different from the way you might own shares of different businesses through a brokerage account. Johnson & Johnson's businesses are grouped under three major headings—consumer health care, medical devices, and pharmaceuticals—but each of the subsidiaries is a stand-alone company with its own offices, bank accounts, and manufacturing facilities. They are located in countries around the world and staffed by local employees.
At the top, Johnson & Johnson's stockholders elect a board of directors to protect their interests. That board is responsible for (among many things) determining the dividend policy and hiring the CEO. The CEO, in turn, hires their direct subordinates. This group of people collectively has the power to determine the CEOs and key executives at the subsidiary companies under Johnson & Johnson's control.
The parent holding company supports the subsidiaries by lowering the cost of capital due to its overall strength. For example, Johnson & Johnson can issue bonds at rock-bottom rates, then lend money to its subsidiaries at rates the subsidiaries couldn't get if they were stand-alone enterprises. This reduces interest expenses and, in turn, increases both returns on equity (ROE) and returns on assets.
A Sample Holding Company
To better understand the concept of a holding company, imagine that you and a friend decide to invest together. You create a new company called Blue Sky Holding Company, Inc. After you file the paperwork with the secretary of state, you issue 1 million shares of stock at $10 per share, raising $10 million in fresh cash. You and your friend elect a board of directors. That board hires you as a CEO.
The next day, you and your friend start investing the $10 million. As Blue Sky Holding Company, you do several things:
- You incorporate a new business called Frozen Treats of America, LLC. It is 100% owned by Blue Sky Holding Company. You contribute $1.5 million in cash to the business, hire a manager to run it, and open a restaurant franchise that's expected to earn $170,000 in profit before taxes.
- You have Blue Sky Holding Company open a brokerage account with a discount brokerage firm. You deposit $3 million in cash into the account and buy a collection of high-quality, blue-chip stocks. You expect these stocks to generate $150,000 in pre-tax dividends each year.
- You start a new company called Southworth Hospitality, LLC, which is 100% owned by Blue Sky Holding Company. You contribute $2 million of Blue Sky's cash and have this new subsidiary borrow another $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 company will use the $4 million in cash to buy a hotel franchise, which is expected to generate $320,000 in pre-tax profits after interest expense and all other costs. The holding company does not guarantee this debt because you decided only to allow non-recourse liabilities in case the hotel isn't successful. That means that if the subsidiary goes bankrupt, you are only on the hook for the equity Blue Sky has invested in it.
- You buy $2 million worth of tax-free municipal bonds, which you believe will generate $100,000 in annual interest income.
- You use $500,000 to buy gold coins and silver bullion.
- You park the final $1 million at the local bank in institutional money market funds that pay 2% interest, generating $20,000 in pre-tax interest income each year.
Holding Company Financial Statements
The consolidated balance sheet of this holding company is going to show $12 million in assets, $2 million in debt, and a $10 million net worth, or book value. The balance sheet appears as follows:
Blue Sky Holding Company, Inc.—Balance Sheet
- Frozen Treats of America, LLC: 100% ownership ($1.5 million assets, no liabilities)
- Southworth Hospitality, LLC: 100% ownership ($4 million assets, $2 million liabilities, $2 million net worth)
- Tax-free municipal bonds ($2 million assets, no liabilities)
- Blue-chip common stocks in a brokerage account ($3 million assets, no liabilities)
- Bank balances ($1 million assets, no liabilities)
- Gold and silver reserves ($500,000 assets, no liabilities)
The holding company income statement is going to show $760,000 in operating income (profit before taxes from all the holdings). That would be a 7.6% return on equity because the $760,000 income divided by the $10 million net worth is 7.6%. It would be a 6.3% return on assets because $760,000 divided by $12 million in assets (which includes borrowed cash) is 6.3%.
How To Think About a Holding Company
As the CEO of Blue Sky Holding Company, Inc., what do you actually do?
Because Blue Sky is a holding company, you have no day-to-day role in any of the investments. Each is run by its own management team. Your job is executive oversight, support, setting risk management parameters, and putting the right people in the right places to align with corporate strategy. When subsidiaries pay out dividends to Blue Sky, that money can be invested in other opportunities.
You aren't going to be making ice cream cones at your restaurant franchise. That is the job of Frozen Treats of America, LLC, a wholly-owned subsidiary with its own employees, managers, financial statements, contracts, and bank loans. Instead, you are going to watch the CEO of that company and make sure they hit the targets that the board expects.
The board will have expectations for both you and the subsidiary. The expectations for you have to do with how well you can help subsidiary CEOs reach their targets and how well you can increase profits while reducing risk.
The Benefits of the Holding Company Model
What if something horrible happened? For example, what if your hotel franchise went bankrupt? If the holding company didn't co-sign on the debt, it isn't liable for the loss. Instead, you would record a $2 million write-off in Blue Sky's net worth as a capital loss on your shares of Southworth Hospitality, LLC.
The holding company model protected the other assets from the loss experienced by this subsidiary. You won't lose your restaurant franchise just because the hotel franchise went bankrupt. Similarly, your holding company's stocks, bonds, gold, silver, and bank balances are unaffected. You only lost the money you invested in that one subsidiary.
This is how large corporations protect themselves. Procter & Gamble, to give a real-world illustration, is effectively a holding company because it has different subsidiaries for different purposes. Some subsidiaries own brand names, such as Tide detergent. Other separate subsidiaries own the manufacturing plants that make Tide, and those manufacturers pay the brand-owning company a licensing royalty. That way, if the firm is sued, Procter & Gamble could never lose the Tide brand name. Instead, the factory or distributor would go bankrupt.
Frequently Asked Questions (FAQs)
How do you start a holding company?
The process for starting a holding company is the same as the process for starting any business in your state. You'll need to name the company, file articles of organization, set up a separate bank account, pay fees, and meet any other state requirements for starting a business.
When should you set up a holding company?
If you're managing multiple businesses or looking to invest in several cash-generating businesses, it might make sense to consider starting a holding company. The holding company can provide protection for your business assets along with potential tax benefits. Having a holding company will create additional administrative needs and business fees, so be sure the benefits outweigh the costs.