What is a Subsidiary - Definition, Pros & Cons

Key Takeaways

- Subsidiaries are separate companies majority-owned by a parent corporation.

- Subsidiaries can help to limit liability and allow tax optimization for parent companies.

- Subsidiaries provide focus on regional markets but less direct control.

- Performance of subsidiaries can often impact parent company's stock price.

Subsidiary Meaning

A subsidiary operates as a separate entity but is majority-owned by another corporation known as the parent. The parent company has a controlling stake, typically over 50%, in the subsidiary. Majority ownership gives the parent company control over the subsidiary's operations and board while allowing the subsidiary to function as a separate legal entity. Subsidiaries can provide benefits like limited liability, tax advantages, and operational efficiencies to parent companies. Large corporations often have complex structures with multiple tiers of subsidiaries across different geographies and industries. Subsidiaries allow parent companies to diversify their business operations  and help to mitigate risk.

Example:

Google is a subsidiary of Alphabet Inc. In 2015, Google restructured to become a wholly owned subsidiary of the newly formed holding company Alphabet. This allowed Google to focus on its core internet-related businesses, while Alphabet took on other projects and acquisitions. Other Alphabet subsidiaries include Calico (biotech), Verily (life sciences), Waymo (self-driving cars), and Sidewalk Labs (urban innovation). This structure allows Alphabet to pursue diverse business lines while isolating risk. Google retains autonomy as Alphabet's most profitable subsidiary.

Source: What is a Subsidiary? - Robinhood

Why Set up a Subsidiary Company?

Tax Benefits - Subsidiaries in different locations can take advantage of favorable tax rates and structures compared to the parent company's location. Profits and losses can also be consolidated to potentially reduce overall tax liability.

Liability Protection - Subsidiaries limit the parent company's legal liability since they are separate legal entities. Losses or lawsuits against a subsidiary generally don't directly affect the parent company.

Operational Efficiency - Local subsidiaries can focus on regional markets and operations more efficiently compared to a geographically distant parent company.

Access to New Markets - Subsidiaries allow parent companies to expand into new regional markets with less risk than entirely new initiatives.

Diversification - Parent companies can purchase subsidiaries in new industries to diversify their business. This may also provide access to valuable assets like IP, technology, and expertise.

Flexibility - Subsidiaries can be used to test new products, brands, or strategies possibly reducing risk to the parent company. Underperforming subsidiaries can be sold off or shut down with more limited impact.

Raising Capital - Creating a subsidiary can isolate risky assets and operations, potentially making it easier to attract investment.

In summary, subsidiaries can provide parent companies strategic, operational, financial, and legal benefits compared to other structures. They also allow focus, diversification, and flexibility simultaneously.

How Subsidiary Financials Work?

A key feature of subsidiaries is that they maintain separate financial statements from the parent company. The subsidiary has its own balance sheet, income statement, and cash flow statement. However, the parent company typically consolidates the subsidiary's accounts into its consolidated financial statements. This provides a comprehensive picture of the entire corporate group. The subsidiary still files its own tax returns.

The parent usually funds the subsidiary's initial capitalization and working capital needs. The parent company can also implement financial policies over dividends, asset transfers, and approvals for major capital expenditures. However, the subsidiary's accounts are separate from a legal perspective, which usually limits financial liability for the parent company.

Pros and Cons of a Subsidiary

Forming a subsidiary company offers parent corporations potential strategic advantages but also has drawbacks to consider. A key benefit of the subsidiary structure can allow for more liability protection. As separate legal entities, creditors of the subsidiary cannot make necessarily claims against the parent company's assets, which shields the parent firm. Subsidiaries also allow for beneficial tax treatment since profits can be consolidated against losses across subsidiaries in different jurisdictions with favorable tax rates.

However, subsidiaries also come with increased bureaucracy and paperwork. Separate accounting statements, legal formalities, and regulatory filings must be maintained for each subsidiary. Operations can become less efficient as the parent company has less direct control over subsidiaries versus internal divisions. There is also the potential for conflict between subsidiary management and the parent company over strategy and resource allocation.

Potential Pros:

- Liability protection for parent company

- Tax optimization benefits

- Operational focus on regional markets

- Diversification into new markets/products

- Flexibility in testing new brands & products

Potential Cons:

- Increased bureaucracy and paperwork

- Less direct control over operations

- Potential for conflict with parent company

- Higher overall operating complexity

- Need to maintain separate accounting

How Subsidiaries May Impact a Parent Company's Stock Price

The performance and valuation of subsidiaries have a significant impact on the stock price of holding companies. As concluded from the analysis of MNC Group and Emtek Group, the varying degrees of correlation between the stock prices of the holding companies and their respective subsidiaries suggest complex interrelationships.

The strong positive correlation between BHIT and BMTR indicates BMTR's stock performance, as a major subsidiary, strongly influences BHIT's valuation. Meanwhile, the weakest correlations were found between BHIT and smaller subsidiaries like IPTV and MSIN, suggesting less impact on BHIT's price. For Emtek, the high positive correlations between EMTK and subsidiaries like BUKA, AMOR, BBHI point to these subsidiaries' stock prices moving in tandem with EMTK.

The correlations were also found to have changed over time, influenced by factors like ownership stakes, new IPOs, industry shifts, and market conditions. This implies that in some cases subsidiaries do not affect holding company stock prices statically.

Overall, subsidiaries can significantly impact holding company stock valuations, but the strength of influence depends on ownership, performance, industry ties, and evolving market dynamics. Monitoring key subsidiaries may provide insight into forces driving a holding company's stock price.

Conclusion

Subsidiaries can allow parent companies to optimize operations, limit liability, and diversify into new markets. However, the reduced control and increased complexity of subsidiaries pose risks. Parents must provide strong oversight to ensure subsidiaries are aligned with their overall corporate strategy. While subsidiaries may confer major strategic and financial benefits, their performance can also directly impacts the parent's valuation and stock price. Effective subsidiary governance is essential for parents to fully capture the advantages of this corporate structure, while avoiding pitfalls that could hurt the entire enterprise.