The bread-and-butter corporate structure for many small and medium-sized businesses is 1) an operating company and 2) a holding company. The goal of this structure is to separate the valuable assets of your business, like real estate or inventory, from the legal risks that occur in the process of running a business.
In a single-company structure, the valuable assets of your business are on the same balance sheet as your operating accounts. In the event you face a lawsuit and lose, these valuable assets are at risk of being liquidated and collected by the plaintiff.
To illustrate the value of an operating/holding company structure, let’s look at two examples where things go wrong.
Single-Company Structure
Bob owns a construction company called A1 Contracting LLC. A1 Contracting LLC owns a flex-space property, some heavy moving equipment, and a bank account with $100,000.
One day, an employee fails to observe safety precautions on the job and it results in a catastrophic injury to a bystander. The bystander sues A1 Contracting LLC and wins. At this point, all of the assets – from the flex-space property, equipment, and the bank account – are at risk of collection in a lawsuit.
In other words, Bob can lose everything. While Bob has an LLC (and assuming that he properly maintains limited liability), most of his assets are tied up in the company. So this is a nightmare scenario that could completely bankrupt his business.
Operating/Holding Company Structure
Bob owns an operating company called A1 Contracting LLC and a Holding Company B1 Assets LLC. The operating company maintains an operating account with $100K of assets. B1 Assets LLC owns the real estate and heavy moving equipment, and leases these to A1 Contracting LLC.
Now, the same catastrophic injury happens. However, this time the only assets the plaintiff can claim are in the bank account owned by A1 Contracting LLC. Again, we assume that Bob follows the best practices to maintain limited liability between his two companies.
The result is, though Bob can lose the funds in his operating account, his most valuable assets – his real estate and equipment – cannot be claimed by the plaintiff.
Thus, while the lawsuit likely wasn’t a fun experience, it did not completely wipe out his business.
Summary
Now, the best defense isn’t relying on limited liability, it’s using insurance and observing the best practices in safety and compliance. However, as your business grows and you accumulate more assets over time, setting up a dual company structure is a simple, cost-effective way to reduce legal risk. Businesses with large amounts of assets are a target for opportunistic lawsuits. By structuring your business in this way, you greatly reduce the target area and discourage litigation. Combined with strong contracts with your employees, vendors, and customers, this structure creates a powerful shield around your business.