Whether you are beginning to invest in securities issued by corporations—such as common stocks, preferred stocks, or corporate bonds—or you are doing case studies on private companies because you are considering investing in your own business, it won't be long before you encounter something known as a holding company.

Many of the most successful companies in the world are holding companies.

This basic introduction was designed to help you understand what holding companies are, why they play such a vital role in the modern economy, and some things you might consider before investing in one (or forming one yourself).

Please note that this article is designed for beginners looking for an academic overview. Those looking to dive deeper into the topic can find a more advanced explanation of how a holding company works, including asset protection elements like "silos," which are used to isolate valuable intellectual property. Here, we'll stick to the overall structure, purpose, and benefits of holding companies, along with a few specific examples for context.

The Basics: A Holding Company Definition

© The Balance, 2018

So, what is a holding company? Broadly defined, 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, in which you are buying shares, doesn't actually do anything in the sense that people think it does. Instead, as a result of its complex history, 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 healthcare, medical devices, and pharmaceuticals﻿﻿—but each of the subsidiaries are stand-alone companies with their 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 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 two, along with any other partners or family members who want to get involved, create a new company called Blue Sky Holding Company, Inc. You file the paperwork with the secretary of state and pay the fees. Then, 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 one of you two as a CEO. You build an office.

The next day, you and your friend start investing the $10 million. You (meaning Blue Sky Holding Company) 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 Dairy Queen 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 such as Charles Schwab ﻿ ﻿ or another major institution. 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.

﻿ or another major institution. 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 that 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 Hampton Inn hotel franchise, which is expected to generate $320,000 in pre-tax profits after interest expense and all other costs. This debt is not guaranteed by the holding company because you decided only to allow non-recourse liabilities in case the hotel isn’t successful. That means, 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 our holding company is going to show $12 million in assets, $2 million in debt, and a $10 million net worth, or book value. Other than an office, which we will ignore for now for the sake of simplicity, our 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 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

Imagine you were the CEO of that fictional company, Blue Sky Holding Company, Inc. When you show up to the office each morning—after you turn on the lights, grab a cup of coffee, and sit at your desk—what do you actually do?

As you can tell, the thing that makes Blue Sky a holding company is that you have no day-to-day role in any of the investments. Each is run by its own management team. In other words: as a holding company, 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 can take the money from one slow-growing operation and plow it into expansion for a more promising subsidiary.

In other words, you aren't going to spend your workday making ice cream cones at your Dairy Queen franchise. That is the job of Frozen Treats of America, LLC, a 100% owned subsidiary with its own employees, managers, financial statements, contracts, bank loans, etc. 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 for 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 Hampton Inn hotel franchise went bankrupt? If the holding company itself 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 this one subsidiary. You won't lose your Dairy Queen franchise, just because the hotel franchise went bankrupt. Similarly, your holding company's stocks, bonds, gold, silver, and bank balances are all 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, totally 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.

Another excellent example is the Burlington Northern Santa Fe railroad. It is one of the largest railroads in the world. Many years ago, Warren Buffett used his holding company, Berkshire Hathaway, to buy all of the shares of the railroad, transforming it into a wholly-owned subsidiary. BNSF has billions upon billions of dollars in debt, which it borrowed to build tracks, railroad cars, and other infrastructure.﻿﻿ None of this debt is guaranteed by Berkshire Hathaway.