Holding companies are those that own the outstanding stock of another company. A holding company will not usually produce any goods or services on its own. The purpose of the company is to form corporate groups instead through their stock ownership. This reduces the risk for the owners, while still allowing for the control or ownership of several different companies at once.
The structure of the modern holding company was first implemented in 1889, when it replaced other forms of corporate control, such as trust forms, that were falling out of favor after the U.S. Civil War. Early lawsuits against holding company structures were successful, most notably when the government sued Northern Securities Company in 1902, which set back the structure for several decades.
Since these initial setbacks, holding companies have formed to become an essential element of corporate structure throughout the world. Here are some of the advantages and disadvantages which are present when evaluating holding companies and the services they provide.
List of the Advantages of a Holding Company
1. It offers potential tax consolidation benefits.
In the United States, holding companies are required to own 80% of outstanding stock, either in voting or total value, before any tax consolidation benefits are permitted. Once that threshold is reached, then tax-free dividends can be claimed, since that process is treated as one company transferring cash assets to the other company. To be eligible for other benefits, more than 50% of the value of its outstanding stock must be owned directly or indirectly by five or fewer individuals during the last portion of the tax year.
2. It reduces the legal risks of those involved.
Holding companies are basically just a major shareholder for the companies where they own outstanding stock. That means there is a reduced risk of legal action taken against them for the goods and services being produced by the company they own. The primary risk that most holding companies face is a loss of stock value because of performance issues that are directly related to the companies they own.
3. It permits companies to perform traditional functions if they choose.
If 60% of the adjusted gross income of an organization comes from dividends, interest, royalties, or rent, then it qualifies as a holding company in the United States. Even with this qualification, it is still permissible for the company to create its own products or services. The only stipulation is that the adjusted gross income from these other activities must stay below the 40% threshold.
4. It offers diversity within the business world.
Holding companies make it possible for a diverse array of businesses to exist, providing products and services for their customers. They invest into companies that provide a strong possibility of profitability, which then creates profits for the holding company. Many of today’s top performing companies are owned by holding companies. Berkshire Hathaway, for example, owns $49.6 billion in Apple, holding over 239 million shares. They own 679 million shares of Bank of America, worth $21.2 billion. They even own 400 million shares of Coca-Cola, valued at $18.4 billion.
5. It creates more opportunities for low-cost loans.
Shares are usually classified as a tangible asset. That means they can be used as collateral when lending products are required for some reason. These secured loans are often made available at a very low interest rate because there is virtually no risk for the lender in the transaction. If a default occurs, then the shares are used to pay off the debt. That makes it easier and cheaper to finance new expansion opportunities, support businesses, and even keep prices lower for consumers.
6. It is very easy to form a holding company.
To form a holding company, you must first incorporate your business. Then you purchase shares of the companies you wish to hold from the open market. You don’t require the consent of the shareholders within the targeted companies under this structure because you’re not completing a full takeover.
7. It becomes possible to gain a competitive edge.
Holding companies present an opportunity that is similar to a strategic partnership. The resources of the holding company can be combined with the resources of the acquired organization to create unique market opportunities. When both companies are involved within the same industry, this benefit is magnified even further. It becomes possible to work on large-scale operations instead of trying to funnel strong market shares from small demographics.
8. It can be implemented on a personal scale.
Holding companies aren’t just for Warren Buffet. They are for individuals too. If you set up a personal holding company, then you gain an opportunity to avoid potential estate taxes. It gives your heirs the ability to avoid probate while still investing and growing your wealth. Investors who hold the possession of a person’s assets at death are able to transfer those assets to heirs. Although these companies can be very complex, and sometimes cost more than the benefits they provide, it is a way to protect personal wealth that you may wish to pass along one day.
List of the Disadvantages of a Holding Company
1. It creates disadvantages for individual investors.
Holding companies hold an influential number of shares in most of the companies they own. If the holding company decides to liquidate their holdings, then the effects on the individual investor can be very traumatic. Imagine what would happen if Berkshire Hathaway sold their 4.9% stake in Apple tomorrow? People with only 100 shares might see a strong, unanticipated dip in their holdings because of those actions. Holding companies can dramatically change the landscape of a trading day by initiating a handful of transactions.
2. It reduces the level of transparency available to the consumer.
Most holding companies are not required to report on how their company is being internally managed. Their responsibility is to their own shareholders, which means reporting on the status of the dividends they receive. Consumers are often doing business with companies that are owned, in part or in whole, by holding companies without realizing it. Without transparency, it makes things more difficult for the average consumer to make informed investment or purchasing decisions.
3. It is not always easy for holding companies to sell their shares.
Holding companies can sometimes find themselves unable to sell their shares in a company, even if they wanted to do so. Dumping a large number of shares on the open market does not guarantee that they will all be sold. Forcing a holding company to hold onto some of their shares is the one option individual investors have to limit their own potential losses. Although strong holding companies should have a diversified portfolio of companies that provide them with stable income, one big loss could destabilize the company and make life difficult.
4. It forces a heavy reliance on a single income resource.
Because 60% of income must come from dividends, interest, or other revenues that are not related to products or services, it forces a holding company to be reliant on the performance of the market. They are only as strong as the strategies they use to procure shares in consistent companies. If there is a bad run on dividends for the company, it could be enough to put it out of business. Even with products or services available to supplement income, there just isn’t enough time to develop new revenue streams during a strategy collapse.
5. It may create competing interests.
One of the biggest criticisms of Warren Buffet is that he invests into dividend shares with his holding company, then fails to provide a dividend to his own investors. Although Berkshire Hathaway does use an aggressive buy-back policy, Buffet feels like funneling resources into expanding the reach of his holding company or improving existing products or services is a better investment for his shareholders. There are times when a holding company may find itself competing with itself for market share within its holdings.
6. It creates management challenges for the parent company.
Many holding companies prefer to hold shares of a subsidiary rather than a true parent company if a controlling interest is preferred. That is because there are management challenges in play when diversity in holdings is present. Imagine requiring a manager to be knowledgeable about the banking industry, real estate, sugary beverages, and smartphone manufacturing simultaneously. When there is decisional control, the structure makes the process ineffective because there may not be enough experience present to make the correct decision.
7. It can create issues of control.
Holding companies are sometimes forced to implement a change of control when they turn a newly acquired business into one of their own subsidiaries. The former managers in the new subsidiary still represent a large percentage of shareholders. These competing interests in management are similar to the competing interests of shareholders. The end result in this type of situation is an increase in turnover, poor decision-making processes, and quite possibly a reduction in share valuation.
8. It may require a large amount of capital to get started.
You must have financing resources in place to have a holding company be able to remain operational. Without sufficient personal capital, equity partners are required to provide enough funding to make the initial investments. This capital must be in place before making acquisitions. At the same time, the owners of any companies you intend to acquire, even if it is only a minority stake, will want assurances that you are able to complete the financial transactions as promised.
9. It can centralize an industry.
Although a holding company does not technically form a monopoly, the process of acquiring company shares does begin to consolidate certain industries if enough capital is used. When that occurs, consumers are presented with fewer choices instead of more. There is less competition in the market instead of more. That means the prices for items tends to be higher, not lower, unless specific safeguards are implemented to prevent this from happening. That is why the first holding companies were ordered to be disbanded in the early 20th century.
10. It can result in decisions for personal, not professional, gains.
The information that is received from subsidiaries or minority stakes in businesses allows the management of a holding company to create the potential for personal financial gains. It might be used to create speculative activities in the market, which could negatively impact individual investors. It may even lead to the exploitation of certain companies, forcing them to purchase goods at high prices from companies under the control of holding company management.
These advantages and disadvantages of a holding company do create some investing challenges that everyone must face. There may be issues in volatile markets for such a structure, which could reduce, if not eliminate, the chances at profitability. At the same time, however, holding companies are able to provide supplementary resources to numerous industries, allowing for more variety and competition in the marketplace.
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