Holding Companies

I run a holding company - of a sort. It's called "Management Analytics" (manalyt.com). I use it for a few different things:

• I use it to start other companies (like Angel to Exit).
• I use it to hold the intellectual property I create.
• I use it for consulting work that has no substantial liability.
• I use it for other contracts I get unrelated to a specific other entity.
• I use it as a service organization for my other entities.

I don't have the holding company own portions of operating companies. The reasons are complicated, but this is potentially a flaw in the way I operate, and one I will not likely fix any time soon.

Holding companies and operating companies

In a lot of cases, there are advantages to creating a holding company and operating companies. The basic idea is simple. The holding company has intellectual property, special capabilities, common services, connections to partners, etc. The operating companies operate in their territories independently of each other, but tied to the holding company.

• Operating companies may license and get common goods and services from the holding company but has freedom of select actions on their own.
• Investors in the holding company may or may not invest in the operating companies, which may, and usually does, have different ownership in each such company.
• Operating companies may, for example, be in different legal jurisdictions meeting local laws and with local overhead and employees, provide different sets of services, and paying different tax rates to different juridical entities.
• Operating companies with different ownership limit liabilities and rewards associated with the approaches they take. Some may take bigger risks for bigger rewards while others may be more conservative.
• Operating companies may divide different parts of a larger market and diversify the risk of different sorts of failures.

Structural decisions

The division into holding and operating companies have different reasons, commonalities, differences, legal restrictions, tax implications, and so forth. Thus the reasons for and nature of structure depends on the specifics of the entities involved and their reasons and tradeoffs. Here are several examples I have seen recently:

• State-by-state: One holding company I work with has a state-by-state operating company strategy using a common holding company. In this case, the regulations regarding the industry are at the state level, and thus licensing and similar requirement practically mandate local entities.
• Operation-by-operation: Another holding company has high valued projects, each in its own operating company. The projects are independently invested by different partners with some equity by the holding company in each.
• Type-by-type: A different approach seeks to start a set of companies taking different market approaches to the same basic technology and function. One is a sales company, another a technology company, another a services organization, and so forth.
• Investment-by-investment: A different company holds shares in a large number of investments. The operating companies in this case are completely independent, but the holding company has common support functions (legal, accounting, HR, etc.) that the operating companies can use for the economies of scale.

There are many other such approaches, but this can give you a sense of the many ways this structure can be applied.

There is a catch... or two

There are three substantial problems with this approach that I have experienced first hand; (1) diffusion of resources and effort, (2) the overhead of it all, and (3) keeping arms length..

• Diffusion of resources: One of the hardest things many startups and small businesses have in growing is that they tend to chase diverse opportunities. If you need to do this, there is usually something wrong with your sales sieve. But the more general problem with multiple operating companies is that the small number of real experts at the top of the company end up with diffused interests and unable to focus on the core business(es) of the operating companies. That's why each operating company should really have separate teams, and the holding company should have a team oriented toward the core common functions and the hiring of management of the operating companies.

  My ongoing mistake in this regard has been, and remains, my unwillingness or inability to effectively engage separate operating teams in each company. As a result, I am diffused and unable to fully focus on any one business. It is a lifestyle choice I have made, but likely not a very good one for growth of each individual entity.

• The overhead: Each business has overhead. This includes taxes, fees, accounting, legal, and so forth. More entities means more overhead and thus more of the generated monies go to expenses. 10 companies translates into 10x the overhead. Of course there are economies of scale, but you lose something for what you gain.

  I use multiple entities to diffuse risk (legal, business, partnerships, etc.). It allows me to form partnerships, give stock to others, etc. in operating companies while maintaining full control over the holding company. But it costs me in time and money.

• Arm's length: Each separate entity must in fact be separate. This means that, in order to gain the financial, liability, and related advantages, the entities must operate as separate entities would reasonably operate. That means independent board meetings, buying decisions, etc. They cannot share bank accounts, handle each others transactions, etc. unless there are legal agreements between the entities that are reasonable for each party and comparable to what other commercial relationships would be. Overly cozy deals where the holding company takes 200% overhead on pieces of paper you can get from commodity stores will not fly legally. On the other hand, giving a better than market deal to your operating companies is reasonably allowable. Note the reasonable part.

  This I do reasonably well. I have written agreements for common services between my holding company and operating companies, I keep separate bank and other accounts, and use separate communications and services in most cases. The holding company does provide common services that are shared - for fees. And I also offer some of these services to advisory services clients (as they become usable for others) under similar terms and conditions.

How's that working out for you?

I have created about one new operating company per year for the last 25 years or so. On the average, I have closed almost as many. Each one broke even or better, because I don't create them as separate entities until they are able to do so - I run prototypes of them under my holding company first. 25 started, 3 still running with a profit - that's 12% "still undetermined", 88% returning greater than 1x. Several have returned 20x or better, but the investments have not been that large. An average perhaps $15K-$25K/ea. Most of these exits are essentially buy-backs and shut downs. So adding up the numbers, $20K average * 25 companies = $500K of investment in operating companies. Total returns have averaged something like $100K/y - or 5x returns - typically after 3-5 years, and excluding "pay" for time spent.

A critical thing to understand in this regard is that you don't have to have any huge wins in order to do reasonably well under this strategy. Many small startups with reasonable successes in small niches that last a few years can bring overall success for you and your partners in each of them as well as satisfied customers well served. Investments can be quite small and thus low risk with reasonable rewards. Singles and doubles are good enough.

I also ended up with "Management Analytics" (an operating company) buying "Fred Cohen & Associates" (the holding company) some years after "Fred Cohen & Associates" (an operating company) bought "Management Analytics" (an earlier version of the holding company). The details are for another article, but let us just say that learning how to do this properly and not making certain types of mistakes is a really good idea.

Not exactly suffering

Having said all this, I should note that I keep planning to operate lifestyle businesses, and some of them keep ending up in the venture space. Angel to Exit is a great example of this:

• My plan was to have 24 clients built up at the rate of one a month over 2 years and drop off one client a month at the end of two years, replacing them with a new one. I could handle 24 advisory board clients, not spend too much time trying to gain more, and maintain a steady state of income and interesting things to do without working too hard at it. I reached that level after about 6 months, adding about one per month.
• Now, I am dealing with 3 inbound channel partners trying to get to between 2 and 20 new clients a month each. If each of them only brings in one a month, that's 4 new clients per month. Ideally, each company would last 24 months, or 96 clients at steady state in 2 years. That's 100 2-hour meetings plus some additional time (at a minimum), or 200-400 hours a month! 2400 hours a year just for the official meeting times. I will need staff, more advisors for the clients, a management process, etc. And I still have several other operating companies that are moving forward.
• Fortunately (may seem the other way), many of these companies fail fast. As a rule of thumb, if you are going to fail, it is better to fail quickly than fail slowly. Fail Slowly:= The slow painful death on the hampster wheel of pain - work more - work harder - eek out a bit more but never really enough - get squeezed in more and more ways - borrow - beg - be tempted to do worse - chase anything that comes along - see your dream die slowly.

So much for my latest lifestyle business plan! Thank goodness I formed it as an operating company rather than making part of my holding company and later having to disentangle it. Now I can grow it independently, bring in management folks, staff it, and so forth, as an independent entity. I can give equity in exchange for effort, license the technolgy and support services from my holding company, take draws and fees from it as it grows, get involved in my advisory boards if and as I want to, and still live the lifestyle I was going for. But only after I try to grow it furiously for the next year or so...

And what if it fails to gain this much traction? No worries! The operating company can still operate as a lifestyle business if the channels don't work out. Or it can go out of business, or I can bring it back in by buying out investors and/or partners from the growth process.

In summary

Holding companies and operating companies are not for every situation or every entrepreneur. But there are situations where they apply. The trick is to figure out which, if any, apply to your situation. The basics are laid out here, but the decisions are rarely clear. As usual, it all depends.