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A holding company is a type of investment company that owns other
assets and investments. A holding company itself doesnt do
anything. It owns things. Image Comstock/Thinkstock
How a Holding Company Works
OCTOBER 2 1 , 2 01 0 BY JOSHUA KENNON 41 COMMENTS
A holding company is a special type of
business that doesnt do anything
itself. Instead, it owns investments,
such as stocks, bonds, mutual funds,
gold, silver, real estate, art, patents,
copyrights, licenses, private businesses,
or virtually anything of value. The
term holding company comes from the
fact that the business has one job: to
hold their investments.
History is filled with examples of
amazing holding companies, such as
Allegheny, Loews, Berkshire
Hathaway, The Marcus
Corporation, Cascade Investment,
and Walton Enterprises. Many modern
day corporations such as General
Electric or Bank of America are really
holding companies because they own a
bevy of smaller businesses; e.g., Bank
of America is actually a bank holding
company, owning control of the stock of
other private companies including the eponymous bank, insurance businesses, asset
management companies, securities underwriters, and more. That is, when you buy shares of
Bank of America on the New York Stock Exchange, the company you are buying
doesnt do anything itself. It is merely a conduit through which it controls and owns the stock
of underlying businesses.
Personally, I like to think of holding companies
as coming in two forms:
1. Holding companies that serve as investment
vehicles for investors
2. Holding companies that serve as risk
management tools for large corporations
Although they have some similarities, they
are different. It is important you understand
which you are thinking about and why both
types are used.
How a Hypothetical Holding Company
Could Be Formed
For investors, a holding company provides the
ability to make investments in a wide range of
assets, including taking minority stakes in
businesses. It would be easier to just provide
a fictional example to illustrate how this would work.
Imagine you were part of a rich family that decides to invest together. You think a holding
company is your best vehicle so you decide to form one. You incorporate a new business
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called Arlington Investment Group LLC by filing the documents with the Secretary of State
and paying a lawyer to draw up the operating agreement, all of which costs less than a few
thousand dollars (and it can even be done or less than $200 if necessary).
There are 10 family members, each of whom writes a check for $1 million to the new holding
companys bank account in exchange for 10% ownership. Once everyones contribution is
received, the holding company has the simplest balance sheet in the world:
Assets: $10,000,000
Liabilities: None
Member Equity (Book Value): $10,000,000
Im going to show you how the holding company could use that $10 million to control $500
million or more without a lot of risk. This is an extreme over-simplification but the idea is to
teach you how holding companies work so we can ignore the details for now.
Holding Companies Allow for Structural Leverage Opportunities
First, say the family decides they want to build a $6 million apartment building in town, but
they only want to invest $1 million of their own plus receive a management fee. The new
holding company is the perfect way to achieve this. They create a new company, Oak Lane
Apartments LLC, and contribute $1 million in cash and write the operating agreement so that
other investors can buy $2 million in ownership (2/3), and the bank can provide $3 million in
debt financing through a secured non-recourse mortgage. The operating agreement requires
that 5% of rents be paid to a business called Arlington Property Management LLC, which is
another new subsidiary the holding company formed.
In effect, the family is using only 10% of its assets, or $1 million, to control a $6 million
apartment building. They are receiving 33.33% ownership in the building, plus 5% of rents,
giving them a form of synthetic equity. But if they wrote it correctly, they would only have
$1 million at risk. They have achieved 6-1 leverage with a relatively small amount of debt; it
is the structure that did it for them.
Then, they could start making investments in other companies, taking minority stakes in
businesses, buying stocks, launching new companies, etc. They could even create a mutual
fund adviser and manage hundreds of millions of dollars on a tiny investment, earning fees on
that giant pool of capital.
The result is, the family is now controlling more than half a billion in assets, with very little
risk to itself, on only $10 million.
Assets In a Holding Company Can Be Put in Silos.
Just as important, if one of the investment fails, the others are isolated. Say the Arlington
Property Management LLC business had an employee embezzle all the money and it went
bankrupt. The parent holding company could put it into receivership, create a new property
management group the next day, and the only loss would be the $100,000 they put into the
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business to get it off the ground. Their investment in the chocolate candies company, the
mutual fund adviser, and the apartment building itself were beyond reach.
Money managers often refer to this as putting assets in self-contained silos because if one is
destroyed, it burns to the ground in the middle of a field without taking down anything else of
value.
Consider Dunkin Donuts. It is actually a holding company. All of the intellectual property,
such as the Dunkin Donuts name, logos, etc., are owned by a subsidiary known as DD IP
Holder LLC. Take a look at the side of one of the cups
Get it? It stands for Dunkin Donuts Intellectual Property Limited Liability Company.
This subsidiary will license the brand name assets to the franchisees or company owned
locations. They may hold the real estate in another subsidiary, which rents the storefronts to
the business. They may have the equipment owned by another company that leases it to the
business. Then, they may have the actual operating company that sells the donuts called
101 Main Street Donuts LLC, but it is paying fees to the other subsidiaries to rent the
Dunkin Donuts name, rent the real estate, rent the equipment you get the idea.
The result is, if someone walks in, falls, sues the company and bankrupts it, only that location
that operated is going down. Within 30 seconds, a Dunkin Donuts could open a new restaurant
at that same location called 101 Main Street Donuts Version II LLC, with the sister
subsidiaries leasing all of the assets right back to it. The person who sued may walk away with
little or nothing.
To put it another way, if you were going to own a manufacturing business, you might consider
creating a parent holding company structure like this:
Acme Factory Holding Company LLC
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Acme IP Holder LLC (brand names,
trademarks, etc.)
Acme Real Estate LLC (the building and real
estate)
Acme Equipment LLC (the equipment)
Acme Human Services LLC (the employees)
Acme Manufacturing LLC (the operating
company)
All of the subsidiaries would be owned by the
holding company, but Acme Manufacturing
LLC would be the business in the traditional
sense. It just that it would pay a fee to lease
employees from the human service
subsidiary, equipment from the equipment
subsidiary, the building from the real estate
subsidiary, and the brand name from the IP
Holder subsidiary. If an employee sued the
company, only the human services business
would be at risk.
A lot of multi-national mega corporations use this structure and then have the IP holders
located in very low tax rate countries because the income paid to it by the operating
companies, which may be in high tax rate areas, will be charged a lower rate. Bloomberg ran
a story today about how Google had gotten its tax rate down to 2% or 3% in some
jurisdictions by using companies in the Cayman Islands and Ireland. Imagine that Dunkin
Donuts charged each location $100,000 per year to use the name, shoving all of that income
in the DD IP Holder LLC subsidiary, which may be in the Isle of Man. This is why the big
accounting firms can be so lucrative. People who do this stuff and know the tax code spend
their whole lives studying.
Likewise, British American Tobacco has an entire page of its massive major subsidiaries. It
would be almost impossible for someone to bankrupt it unless they went after the parent
holding company. You couldnt just sue the local cigarette factory. Its like a lawyers dream.
Keep in mind, each of these main subsidiaries may have dozens of subsidiaries of their own.
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Now, to be perfectly clear: The rules are so incredibly complex that this is just a theoretical,
incredibly simplified broad overview example of how something like this would work. It
probably wouldnt be worth the effort to setup a structure that complicated unless your
business were generating massive annual profits. In most cases, a guy running a little bakery
in a small town is going to be covered by his insurance policy. To him, the odds are good that
a holding company would be an expensive, mind numbingly painful paperwork nightmare.
Transferring and Pooling Assets Through a Holding Company
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Another big advantage of a holding company is that it allows families to pool their assets or
transfer wealth in a far more efficient way. Imagine trying to give shares of each of the above
businesses to dozens of grandchildren. It would be a logistical nightmare. With a
conglomerate structure, you could just issue shares of the holding company to your grand
kids and they would indirectly own part of everything. They would only have to deal with
one tax filing, one stock, and one shareholder meeting. Plus, you could write the holding
company operating agreement so that you retained 100% voting control.
Holding Company Taxation
It is extremely important that you use the best, most respected and most qualified
accountants, attorneys, and advisers because the rules surrounding investments can be
complex. In the case of taxes, there is a special holding company tax that is only applied to
regular c-corporations in the United States that have 50% or more of the stock held by 5 or
fewer investors! It is a double-digit surcharge tax that could be devastating to your profits.
That is why so many families seem to be opting for holding companies structured as limited
liability companies, also known as an LLC, or limited partnerships, also known as an LP. You
can elect pass-through taxation, just like an old-fashion partnership, so that no holding
company tax should apply. Each partner reports his or her share of the pro-rata gains and
losses and pays tax on their personal filing with the IRS.
For regular c-corporations, it is important that the holding company own at least 80% of the
outstanding stock because then it wont be double taxed on the dividend distributions from
the subsidiary. That is, if your holding company owns 65% of a business, and it pays
dividends at Christmas, you would owe regular corporate tax on those dividends. If you
owned 80% of the company, though, you would not have to pay corporate tax on the
dividends because it was already taxed once at the subsidiary level.
The Reason Tycoons and Investors Prefer Holding Companies
In addition to all of the above reasons, a holding company is often the preferred vehicle of a
true investor because it allows you to open an office and have that office devoted to nothing
but finding places to put your money to work.
Once you have the capital, all you need is a good fireplace, some nice paintings, a cup of coffee,
and a stack of annual reports. Or, if youre Walter Schloss, a desk next to a water cooler in a
space the size of a closet.
You show up each day, try to do intelligent things, avoid stupidity, and keep costs low. As
Ive said a million times, compounding will do the rest. You can pay yourself a salary and
watch your net worth, through the holding companys book value, grow higher each year if
you run it well.
Holding companies are as diverse as their owners. Some specialize in hotels and other real
estate, some own restaurants, some build coffee shops, some invest only in publicly traded
stocks, others focus on making investments in high-tech start-ups, some fund movie projects,
while still others acquire silver mines or mineral rights.
The point is, a holding company is worth too much effort and doesnt provide enough benefits
for most small investors. You should never add an extra layer of management unless it is
necessary. There are some expenses involved, such as preparing another set of tax returns,
that must be taken into account. If those are even a rounding error, you probably should
wait until it is going to be worth the expenditure. You should never want a holding company
simply for the sake of owning one. They have very specific purposes. An exception might be
a family who has a few hundred thousand dollars and wants to invest together through a
single entity.
Summary of a Holding Company
A holding company:
Is any regular corporation, LLC, or LP that owns investments
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in othercompanies but doesnt engage in any operations itself. That is, Berkshire
Hathaway is a holding company because it doesnt do anything. Instead, it owns 100% of the
stock of GEICO, which is an insurance company. It owns 80% or 90% of the stock of
Nebraska Furniture Mart, which is a huge furniture retailer. It owns more than 8% of the
stock of Coca-Cola through its insurance holdings. But Berkshire itself just has a handful of
employees and a bank vault full of stock certificates. That is it. Any money it has comes from
dividends paid by the subsidiaries on June 30th and December 31st of each year.
Can be used to silo investment assets and protect them, such as Dunkin Donuts
putting its intellectual property into its own LLC.
Can be used to transfer wealth to friends and family. If you own a collection of
businesses, rental properties, or other valuables, it is far more convenient to transfer shares
in a parent company than it is in each individual asset.
Can permit you to structure deals so you control far more money than you
otherwise could afford. If you had $10 million and used it to buy control of a $20 million
insurance group that had $70 million in float, you would be controlling $70 million from your
holding company.
In essence, a holding company is in the business of providing capital and people. That is
it. Some dont even do that (Berkshire Hathaway refuses to provide management to the
subsidiaries it purchases; they dont run businesses. General Electric, on the other hand, is
one of the greatest machines of all time and can have someone else running a company within
12 hours.)
I hope that helps you understand the concept and why they are so useful.