Financing for OpCos and HoldCos
When you start a business, the first advice you normally get is to incorporate a company to limit the potential liabilities against yourself, the owner. The business will run and carry out its day to day operations as an operating company, hence the term “OpCo”.
Over time, layers of complexity begin to stack up onto your business as it grows. For example, new business ideas will form, creating separate businesses of their own. Or you’ve built up enough capital to purchase a property for the business. Or you are making a strategic acquisition to complement your OpCo’s business. Each of these are set up as their own separate OpCo. When any of these occur, it is time to consider establishing a holding company as a separate legal entity that holds the assets and shares of the OpCo. This is known as a “HoldCo”.
Having the business structured by way of OpCos and a HoldCo has its advantages and disadvantages.
Today, I want to introduce you to the world of OpCos and HoldCos and how these structures may differ in their financing arrangements
In this issue, you will learn:
- The differences between an OpCo and HoldCo
- Financing under an OpCo
- Financing under a HoldCo
The differences between an OpCo and HoldCo
Before you can decide which structure is best for your company, you need to understand the differences between an OpCo and a HoldCo. These boil down to 5 main differences:
Ownership and Control
Under an OpCo structure, the owners of the OpCo have direct control over the business operations. There is no separation between the individual human owners to the OpCo.
For a HoldCo, owners will have indirect control of the business operations since the HoldCo owns the shares of the OpCo. One key difference is that a HoldCo can have control over multiple OpCos without having to directly manage them. The individual human owners will own the HoldCo, and the HoldCo will own the individual OpCos.
Liability and Risk
An OpCo structure can expose the owner to any legal or financial issues that can arise as a result of the regular operations of the business.
For a HoldCo, the liability is limited to the assets of the HoldCo. This means that if an OpCo is exposed to any legal issues, these issues are held within the legal entity of the OpCo, which will protect the HoldCo from its liabilities.
A common example is the use of a property HoldCo. The HoldCo will create a separate legal entity to own the property where the OpCo operates on, the OpCo pays rent to the HoldCo. If the OpCo gets sued and the business is forced to liquidate its assets, the property is sheltered away from the OpCo and would not be subject to liquidation. Hence, the HoldCo’s assets are protected.
Flexibility
In an OpCo structure, all of the business’s assets are comingled under one legal entity.
Under a HoldCo structure, separate OpCos can hold separate business assets.
This can be beneficial if you are contemplating a future sale or purchase of a business. When considering the sale of the business, this may attract certain buyers as they may be more interested in acquiring specific business assets. The process becomes easier because it will be easier to determine the value of the segregated assets based on separate financial reporting held.
Conversely, a disadvantage of a HoldCo is the requirement to maintain separate records for multiple OpCos, which consumes a lot of time and resources.
Tax
In an OpCo structure, the profits earned by the business are taxed at the corporate level with any dividends paid to shareholders being taxed at the owner’s personal level.
Under a HoldCo, the income of the HoldCo would still be taxed at the corporate level. The HoldCo may be able to take advantage of tax planning strategies to reduce its overall tax burden (legally).
In these situations, it is best to consult a tax accountant fully understand the tax implications based on your own requirements.
Funding and Investment
Funding options vary between an OpCo and a HoldCo because fundamentally, the control over the operations and its assets differ. Let’s dive deeper into this topic below.
Financing under an OpCo
Financing an OpCo is fairly straight forward.
There is typically one lender and one borrower with funding provided to finance the day to day operations of the business. OpCos benefit from all types of financing available: line of credits, term loans, equipment loans, acquisition loans, and etc.
In exchange, all of the OpCo’s assets are pledged to the lender as security. For smaller OpCos, the lender may ask the owner(s) for personal guarantees. For larger OpCos with a track record of solid financial performance, personal guarantees may be avoided.
From the credit approval lens, the risk assessment is done purely on the financial strength of the company and the tangible net worth of the owners. As a result, banks will rely heavily on tangible assets held by both the OpCo and the owners. This means the owners are still tied 100% to support the business.
Financing under a HoldCo
Once you move into a HoldCo structure, financing arrangements can take some interesting turns. This is because financing can be structured at the OpCo level or the HoldCo level.
Financing at the OpCo level can mean financing is provided on a standalone basis to one single OpCo, financing for a few OpCos, or even financing for a few groups of OpCos.
Financing at the HoldCo level generally means financing is provided at the top of the house with all the OpCos included.
Financing for a single OpCo or a few OpCos
While financing a single OpCo within a HoldCo structure can be as simple as the explanation above, financing arrangements become more complicated when different OpCos within the HoldCo each have their own separate financing arrangements.
The biggest difference in financing OpCos separately is that the bank will have limited recourse from the HoldCo. In simpler terms, the HoldCo typically doesn’t provide a downstream guarantee to support the loans held by the OpCos. Since the intention on establishing a HoldCo is to minimize its potential liabilities from the OpCos, withholding a downstream guarantee makes sense. However, this causes a few issues for the bank.
Banks don’t like this arrangement because there is a potential conflict of interest. When financing is provided to one (or a few) OpCo, there is risk that the funds will be used to support the operations of another OpCo outside of the financing structure. When businesses are struggling, the HoldCo will always try to provide the OpCos with funding to keep the business afloat. To mitigate this risk, banks will create a ringfence preventing distributions to the HoldCo or other related parties. Ultimately, the bank wants to ensure that the financing provided is intended for the use of the OpCo within the ringfenced structure.
If you are looking to establish this type of financing within the HoldCo, you need to understand why you want it to be structured this way because it can become complicated, really fast. Some reasons could include:
- Each OpCo has its own unique business and a separate management team. The intention is to keep these OpCos operating completely independent of one another.
- Some OpCos are located in jurisdictions/countries that make it easier to obtain financing locally. Financing arrangements that span international borders can be complex and expensive.
Keep in mind that every independent financing arrangement will incur their cost of financing. The more independent arrangements you have, the more costly it becomes.
Financing for the HoldCo
When financing is provided to the HoldCo level, financing is provided at the top of the house. The HoldCo can then use the loan proceeds to fund its OpCos as it desires.
In this scenario, financing will include the HoldCo and all of its present and future subsidiaries. This means all of the OpCos will be wrapped into the structure and unlimited cross corporate guarantees in place. In some ways, this financing structure is simpler because everything is combined. All financial reporting, security, cash flow, and risk assessments are all pooled together.
The key advantage in financing a HoldCo lies in the scale of the business. Since HoldCo’s business is the sum of all its OpCos, this gives the HoldCo more bargaining power to access greater access to capital, more customized financing solutions, and potentially lower interest rates and more relaxed covenant structures. If the HoldCo is big enough, personal guarantees are usually off the table.
One thing to note is that HoldCo financing usually involves pledging the shares on the HoldCo to the bank. This gives the bank the ability to control and make all decisions of the HoldCo when the company is in distress. While it’s uncomfortable to relinquish control over your company, banks will use this as leverage to pick and choose how they can use an OpCo as a means to repay the HoldCo’s outstanding loans.
When you are considering financing at the HoldCo level, think about whether:
- All OpCos are integrated components that serve the HoldCo.
- Leveraging the combined strength of the OpCos increases financing optionality.
- Having one financing structure keeps costs and administration light.
If these hold true, then it may be best to pick this financing option.
Conclusion:
There are numerous pros and cons to both OpCo and HoldCo structures.
OpCo financing is generally simpler and easier to manage while HoldCo financing provides greater optionality to satisfy to your specific needs.
Regardless of the structure, the business should be able to get the financing it needs.
The key here is to keep things simple.
Remember that the decision in choosing between either legal structures should ultimately be based on your best interest only.
Everything (including the financing) will work itself out around the structure you have chosen.
That's it for this week. Thank you for reading Financing Journey. See you next Saturday.
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