Many people think of a holding company as a hollow organization in which faceless portfolio managers juggle investments much as they would in a Monopoly game. For a family company, however, such an organizational structure can assume a much more dynamic role. By providing needed boundaries between potential rivals, a holding company can help to head off succession problems. By providing flexibility in the allocation of capital, the structure can permit the core business to expand and diversify.
Holding companies literally hold the stock of operating companies and generally serve to coordinate their activities. They can be organized as partnerships or C corporations, or—as long as certain rules are observed—as Subchapter S companies. The holding company has its own officers and shareholders, which are legally separate from those of its constituent businesses (though some of the same people may serve in both). What makes these organizational structures potentially useful to family companies is that they 1) offer talented family and non-family managers opportunities to run their own business or even create a new business under the family umbrella, and 2) permit some outside ownership, even public ownership, of one or more of the operating businesses, without losing family control of the whole.
Imagine an extended family which establishes a holding company to oversee control of two operating companies, A and B. Company A is the family’s original business; it is 100 percent owned by the holding company and run by a family member. Company B is a division of the business which is growing and needs additional capital; as a result, it is 51 percent owned by the holding company and 49 percent owned by non-family investors.
With capital from a family venture fund, one of the younger family members has started a promising new enterprise, Venture A; the holding company owns 75 percent of Venture A and the entrepreneur, 25 percent. If the new venture prospers, it may eventually contribute earnings to the venture fund and help other family entrepreneurs start their own businesses.
The holding company structure keeps some distance between talented and ambitious siblings or cousins who might otherwise become rivals. By increasing the number of leadership opportunities, it also permits seniors close to retirement to remain in management while giving juniors the chance to run their own show. Cost efficiencies are achieved by centralizing some staff and functions, such as billing, data processing, and accounts receivable, in the holding company.
Despite these notable advantages, the holding company structure has a number of risks and pitfalls. First, this form of organization ties family members together financially. The holding company allows for separate management but still requires that the operating companies reach joint decisions regarding how earnings and other assets will be invested and distributed. Touchy issues, such as how family members will be compensated, must still be resolved. Not everybody will happy with this financial interdependence.
Second, funding of new ventures must be managed objectively if such ventures are envisioned under the holding company form. The family may have to sell some assets—businesses or real estate, for example, in order to fund new ventures. The decisions on financing of new ventures can become a political football, as, for example, when one senior partner complains to another: “Your daughter’s venture received support but mine did not!” For this reason, we recommend that all decisions on allocations of the venture fund be made by outsiders on the holding company board.
Third, just as in a single business, the management of the holding company will be stalemated if family members cannot agree. The family still has to figure out how the holding company itself will be run. Will it have a CEO to whom the presidents of the operating companies report, or will it be run by an executive committee? What will be the overall vision and rules that bind the separate businesses together?
To prevent family conflicts from disrupting management of the entire organization, we recommend that the holding company establish a board, with a majority of outsiders on it, which has the power to break ties. Legally, the operating businesses as well as the holding company must have a board. But in some family enterprises only the holding company board actively engages in formulating policy and strategy. Boards with real deliberative powers can provide fine training grounds for younger family members and enhance shareholder loyalty. In my view, however, only operating companies that are large or distinct enough need such a board.
Before adopting a holding company structure, the family must consider several important tax issues. Many family businesses are organized as Subchapter S companies. The holding company can qualify for Subchapter S status as long as it owns less than 80 percent of the subsidiaries’ assets and voting stock. If the holding company is organized as a corporation, the owners will have to pay both a corporate tax and an individual tax on dividends. And under the “personal holding company” rules, the holding company may be subject to tax penalties unless it pays a minimum dividend to shareholders.
Like any ownership interest, shares in the holding company will be subject to estate tax when the holders die. For that reason, seniors should consider reducing the amount of holding company stock they own. Indeed, the holding company is often used to facilitate the gifting of stock. The interest that is thus given away can often be discounted, or reduced for gift-tax evaluation purposes, since it is likely to be a minority interest and so illiquid because it is not readily marketable. These interests can be placed in trust, or made subject to voting trusts in which top family managers retain voting control.
Like all organizational options, this one must be weighed in the context of the specific needs of the business and the family members. For large and multigenerational companies in Europe and some Latin American countries, this form is viewed as a means of promoting growth while preserving family harmony. My colleague John Ward of Chicago-Loyola University views the holding company as a powerful vehicle for certain families. In Keeping the Family Business Healthy (Jossey–Bass, 1987), Ward spells out the dream and the challenge:
“A family of this sort believes that its business is a great resource around which to build both an empire and a closer, more vigorous family. Such a family is committed to high ideals and is not afraid of hard work. This spirit takes the shape of a holding company, that is, a corporate conglomerate containing several enterprises and governed by a family group…”
“This system benefits the whole family and simultaneously attends to business needs as they change. But it requires a great deal of hard work and intelligent planning. And only families that already have very successful businesses should consider this model.”
John A. Davis is president of the Owner Managed Business Institute in Santa Barbara, CA.