The Advantages & Disadvantages of Creating Subsidiary & Operating Companies

An operating company is a subsidiary of a parent company, which itself could be a holding company that has several other subsidiaries. A subsidiary is a separate legal business and could be a publicly traded company. The degree of control the parent company exercises over the subsidiary depends on the management style of the parent company's executives and the share ownership structure.

Advantages

The parent-subsidiary structure isolates risks because the two companies are separate legal entities. The losses at a subsidiary do not automatically transfer to the parent company. The parent can exercise control over a subsidiary if it owns a large block of its stock, but not necessarily a majority of the shares. Even a fractional ownership of the shares of a widely held company could result in effective control. The parent-subsidiary operating structure allows for greater diversification and increased efficiencies, partly because senior management at the parent company does not have to be involved in the operational details of its subsidiary, according to "Rating Parent/Holding Companies and Their Subsidiaries," a 2010 document by the Dominion Bond Rating Service.

Disadvantages

The parent company does not have complete access to the cash flow of the subsidiary, unless the parent controls 100 percent of the shares. To maintain its image and reputation, the parent company may have to pay for the subsidiary's debts even if it has no legal obligation. Lending institutions may require guarantees from the parent before lending to one of its subsidiaries. The parent company could be liable for damages if an operating subsidiary violates the law or is subject to enforcement actions, says Dominion Bond Rating Service.

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Issues: Publicly Traded Companies

In a November 2006 "New York Law Journal" article, Jeffrey W. Rubin, partner in the law firm of Hogan & Hartson, suggests that governance issues are important in corporate structures that involve publicly traded subsidiaries and parents. The board of directors and senior management of the two companies must understand the roles and responsibilities of the other, and there should be coordination between the audit committees of the two boards. The two companies must avoid conflicts of interest when setting executive compensation. Rubin recommends that the subsidiary should not enter into a business relationship with a director or senior executive of the parent without considering the implications. The companies should coordinate their regulatory disclosure documents, such as quarterly reports, to make them easier for investors to follow.

Considerations: Integrated Organizations

An alternative to the parent-subsidiary structure is the integrated organizational structure, according to "Vertical Integration," an article adapted from Tom Hindle and published in "The Economist" in 2009. A vertically integrated company results from the merging of two companies at different stages of production, such as a commercial bakery and a grocery store chain. A horizontally integrated company results from the merging of two companies at the same production stage, such as two computer manufacturers.