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  • Writer's picturePeak Frameworks Team

What is a Subsidiary Company? (Structure, Pros and Considerations)

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Understanding the Subsidiary Structure

Subsidiary
Source: LinkedIn

Origins of Subsidiaries

Subsidiary companies aren't a recent concept. Historically, they emerged as entities formed for specific purposes, either by acquiring a majority stake in another company or spinning off a division of the parent firm. For instance, Google's reorganization under Alphabet Inc. in 2015 led to Google becoming a wholly-owned subsidiary while allowing other businesses to operate separately.

Legal Framework

Creating subsidiaries often stems from strategic needs. While they are established through acquisitions or spin-offs, they differ from divisions or branches. Facebook's acquisition of Instagram in 2012 transformed Instagram into a subsidiary, maintaining its unique identity while enjoying the resources of a larger entity.

Advantages of Having a Subsidiary

Risk Management

  • Subsidiaries can isolate liabilities, ensuring that financial or legal issues in one entity don't impact others.

  • Diversification benefits arise when different subsidiaries operate in varied industries, just as Berkshire Hathaway does with its vast portfolio of companies.

Operational Flexibility

  • Subsidiaries can craft strategies suited to their individual market needs.

  • Resources, including human capital, can be effectively allocated based on each subsidiary's requirements.

Tax Benefits

Cross-border subsidiaries can take advantage of lower tax regimes in different countries. For instance, tech giants like Apple have historically benefited from setting up subsidiaries in Ireland.

Financial Reporting and Performance Metrics

  • Subsidiaries maintain their financial statements, providing a clear picture of their performance.

  • They also have the liberty to raise finances independently, much like how General Motors' subsidiary, GM Financial, operates in the finance domain.

Market Penetration and Expansion

  • Subsidiaries can leverage local expertise to establish a foothold in new regions.

  • The success story of McDonald's in India, a subsidiary that tailored its menu to cater to local tastes, stands as a testament to this.

Disadvantages of Having a Subsidiary

Complexity in Management and Governance

  • Ensuring alignment with parent company goals can be challenging.

  • Amazon's acquisition of Whole Foods necessitated the meshing of two distinct corporate cultures, posing initial challenges.

Increased Regulatory and Compliance Burdens

  • Subsidiaries may need to navigate regulatory environments that the parent isn't familiar with.

  • Compliance can become intricate, as seen when HSBC faced regulatory hurdles with its Mexican subsidiary.

Financial Challenges

  • Capital allocation between the parent company and subsidiary can become contentious.

  • Financial transparency can be at risk, especially if there are no clear guidelines for inter-entity transactions.

Integration and Cultural Challenges

  • Synchronizing corporate cultures and business practices is crucial, yet often challenging.

  • Walmart's acquisition of Flipkart required adapting to the unique e-commerce landscape of India.

Reputational Risks

  • Any misstep by a subsidiary can reflect poorly on the parent company.

  • BP's reputation took a significant hit after the Deepwater Horizon oil spill, even though it was a subcontractor's error.

Considerations When Setting Up a Subsidiary

Considerations before putting up a subsidiary
Source: Chegg

If you're an aspiring investment banker or private equity professional looking to understand the complexities of global business structures, understanding the subsidiary model is crucial.

Strategic Alignment

A subsidiary shouldn't be an impromptu decision. Instead, it needs to be a strategic move that aligns seamlessly with the parent company's vision and objectives.

  • Purpose Identification: Before creating a subsidiary, the parent company must identify its core purpose. Is it for expanding into new markets, diversifying the product line, or isolating specific risks?

  • Synergy Creation: The subsidiary should be able to work in synergy with the parent. For instance, Disney's acquisition of Pixar was a strategic move. While Pixar brought in innovative animation techniques and storylines, Disney had a massive distribution network and brand equity. Together, the alignment proved fruitful.

  • Long-Term Viability: Beyond immediate benefits, the subsidiary's establishment should make sense in the long run. It should either consistently add value or provide strategic leverage to the parent company.

Operational Readiness

Operational intricacies can make or break the success of a subsidiary. A company needs to ensure that it's well-equipped to handle the operational demands of this new entity.:

  • Infrastructure Assessment: Before establishing a subsidiary, especially in a new geographic region, it's crucial to understand the infrastructural needs. This includes physical office space, technology, logistics, and more. For tech companies, data center accessibility might be paramount, while for manufacturing entities, transport links could be vital.

  • Management Competence: Having the right people to steer the subsidiary is vital. This might mean hiring local experts familiar with the subsidiary's target market or training current employees to take on leadership roles in the new entity.

Due Diligence and Compliance

Establishing a subsidiary, especially in a different country, can be fraught with regulatory hurdles. Proper due diligence ensures smooth sailing.

  • Legal Structure: The first step is to decide the legal structure of the subsidiary, which might differ based on the country or state. This could be a limited liability company, a joint stock company, etc.

  • Regulatory Navigation: Different industries have specific regulations. For instance, a subsidiary in the finance sector in Europe would need to be compliant with directives like MiFID II.

  • Taxation: Understanding tax implications, both in the subsidiary's location and how it impacts the parent company, is crucial to avoiding any legal issues and optimizing profits.

Financial Planning

Financial Planning in Subsidiaries
Source: The Association of Corporate Treasures

The financial aspect of creating a subsidiary is pivotal. Without proper financial groundwork, even the most strategically sound subsidiary can flounder.

Assessing the financial implications and potential ROI

  • Initial Investment: A clear understanding of the initial costs, from setting up office space to hiring employees, is necessary. This also includes any costs related to acquisitions if the subsidiary is being established by purchasing an existing entity.

  • Ongoing Costs: Beyond initial costs, the parent company should budget for ongoing operational costs, from salaries to utilities and more.

  • ROI Projection: An in-depth analysis projecting the subsidiary's revenue streams, potential profitability, and overall return on investment (ROI) should be conducted. This ensures that the parent company has clear financial expectations and can set realistic benchmarks for the subsidiary's performance.

Conclusion

Subsidiaries offer numerous advantages but come with their own set of challenges. A comprehensive understanding can lead to better decisions, whether you're at the helm of a corporation or at the deal table.

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