What Is a Holding Company?
Investopedia defines a holding company as a “business entity” — usually in the form of a corporation. For the most part, a holding company is not in the manufacturing business, nor sell any products or services. They don’t conduct any other business operations other than controlling the stock of other companies.
A holding company is usually called an “umbrella” or “parent company.”
I know, it’s all Greek to you, right?
Here’s the long and the short of it.
A holding company is a distinct kind of business that doesn’t do or undertake anything itself. However, a holding company may own stocks, bonds, gold, silver, real estate, art, mutual funds, or any other type of investments.
That could also include private companies, patents and copyrights, licenses — practically anything or everything of value.
You name it, a holding company can own it.
As the name “holding company” suggests, the business has only one sole job — that is to “hold” investments.
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Table of Contents
Here are some key points about a holding company:
It is a type of financial establishment or organization, which owns the controlling interests in its subsidiaries — or other businesses. Okay, let’s spell this out for you. A subsidiary is a business that is owned either in part or entirely by another company, typically called the parent company. The sole purpose of this parent company is to own its subsidiaries.
The parent company has jurisdiction in the subsidiary’s management decisions and policies. It can also manage the subsidiary’s daily operations and functions.
The parent company or the holding company is protected from the losses and deficiencies brought about by the subsidiaries. So, if the subsidiary goes in the red, its creditors can’t go after the parent company or the holding company.
The holding company serves two purposes:
- It serves as a way for private investors to pool their money for future investments
- It serves as a way for larger companies to mitigate risk
It is necessary to know its similarities, what differs one from the other and why both forms are used.
For most investors and real estate investment groups, a holding company (or parent company) offers the opportunity to invest in a wide variety of assets which can include smaller stakes in a business.
So, let’s say you’re a member of a wealthy family and all of you decide to pool you money together and invest it. You then decide to develop a holding company by filling out all the necessary paperwork with the Secretary of State. Once your holding company is registered with the state, you should then contact an attorney to draw up a management contract. To do all this could cost anywhere from a couple hundred dollars to as much as a thousand dollars.
Now, imagine there are about 10 members in the family and each one writes a $1 million check for the new parent company or holding company’s bank account in pursuance of owning 10% of the company. This is how the balance sheet of the new holding company looks like as soon as all the contributions are collected:
- Assets: $10 million
- Liabilities: None
- Member Equity (Book Value): $10 million
Now let’s say you would like to invest that $10 Million into something that, over a period of time, could grow into a net worth of $500 Million. The question is how would you do this without opening yourself up to a great deal of risk?
To do that, let’s set aside all the mundane details. Here’s an over-simplified example just to help clarify things a bit and show you how a holding company operates.
This is the part when structural leverage comes into play. Let’s go back to the above hypothetical situation. Let’s say, the family reaches a decision to construct a building worth six million dollars but they only want to lay out one million dollars of their own and then receive a management fee. They make a new company and contribute one million dollars and write a management agreement so that other investors can buy two-thirds ownership, that would be two million dollars. And then the bank can bestow three million dollars through debt financing. The agreement would require that 5% of rental fees be paid to another business, which is a new subsidiary that the parent company has formed.
If you look at it, the family is using only 10% of its assets to control a six-million-dollar building. They are receiving 33.33% ownership on top of the 5% rental fees. Basically, they have a 6-to-1 leverage with a fairly small debt. Then they could begin investing in other opportunities by buying stocks, taking small stakes in the businesses and launching new companies. They can also come up with a mutual fund adviser and millions of dollars of small investments while earning from the capital reserve.
The outcome is, the family can be now in control of more than hundreds of millions in assets, with very minimal risk, on a rather small investment.
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