Betting on the Success of Your Business

This post is part of a series in which we are sharing our experience of founding a company in Germany. We hope it might help others working their way through the foundation process. Read the first post in the series for more details.

Holding structures enable re-investment and value creation

A founder in the process of starting a company in Germany may be confronted with the concept of a holding structure. Holding structures are popular among startup founders because they offer many benefits. In this ownership model, each founder first forms a limited liability company (such as a UG or a GmbH), which he or she owns 100%. These companies become the parent companies of a joint subsidiary, which becomes the operating company for the venture. The operating company is the one that builds the product and markets it to customers. The holding companies are generally passive and do nothing except hold shares in the operating business and potentially in other ventures.

For us, creating a holding structure meant founding three separate companies. It was definitely more complicated and expensive than forming a single company. This is the structure we chose:

The rationale for creating a holding structure

Holding companies enable founders to invest jointly in the operating business, but also to engage independently in other business ventures or investments. The holding company gives each founder a degree of freedom to act entrepreneurially without always needing the consent of his or her co-founders. It also allows the founder to distribute entrepreneurial risk across multiple ventures. The model can provide limitation of liability as well as protection in case of insolvency. One of the most compelling benefits of the holding structure is the flexibility it gives the entrepreneur to allocate capital among different investments.

Proper allocation of capital is an investor’s number one job.

— Charlie Munger, Poor Charlie’s Almanack

The holding company makes it easier for the founder to re-invest capital from a profitable business into new and promising ventures. Re-investing in a new business is possible without a holding structure, but has the significant drawback that any funds extracted by a business owner from the company will be treated as personal income by the tax authorities leading to an income tax charge. As such, the funds available for re-investment would be reduced. Most states want businesses to re-invest profits to generate economic growth and create jobs. A holding structure facilitates re-investment.

To be clear, a holding structure is not about avoiding taxes, it’s about value creation. Tax plays a vital role in our society. It’s how we fund the state and finance infrastructure, defense, education, research, healthcare, arts, and culture — to name a few. Paying tax is part of being a good citizen and part of running a business, but so is ensuring that the individual or company is not paying more tax than is legally required. In any tax system, there are decisions to be made that will affect the total tax to be paid such as defining the legal structure of the company or determining which deductions and tax relief that can be applied. Tax law can be very complicated and making a mistake can severely restrict a business’ liquidity and ability to invest. My co-founder learned this the hard way when he exited his family’s business to start a new company — without a holding structure.

When a shareholder of a company extracts money from a business and puts it into his private bank account, he needs to pay income tax. This tax needs to be paid even if the goal of extracting the money was to re-invest in a new business venture. The holding structure puts a holding company between the operating business and the founder, which makes it possible to take funds from the operating business and invest them in another venture without passing them through the founder’s private bank account. Thus, the funds are not treated as income and income tax doesn’t need to be paid (yet).

Of course, the income tax payment is only deferred. As soon as the founder extracts money from the business to use personally (say to buy a house or to go on holiday) then income tax is due.

By creating a holding structure, you’re betting on the success of your business

You only need to consider a holding structure if there is a chance that you might invest in another venture in your lifetime. In essence, you’re betting on the success of your company. If you believe it will one day make enough money that you can take some out to re-invest in something new, then a holding company makes sense.

Many new businesses fail, and even if yours doesn’t, you may never make enough money within the operating company to invest in something else. In that case, any money you spent founding and maintaining the holding company would be lost.

On the other hand, your business could do really well. It could begin producing more profit than it can sensibly re-invest. In which case the founders may decide to take some money off the table and invest it somewhere else (diversification). If there is a holding structure in place, it is easy to re-invest profits. If the money goes through the founder’s private bank account, a large chunk of it will go directly to the taxman.

So as a founder, you need to decide how confident you feel about your business success. Creating a holding structure is a bet with limited downside, namely the cost of founding and maintaining the holding company. A holding company provides a founder with increased flexibility to make entrepreneurial decisions. It can limit liability and distribute risk. Most importantly, it maximizes the funds available for re-investment.

What does your company expect to make annually in profit in your most optimistic scenario? Imagine, ten years down the road you want to re-invest some of that money into a great new idea. Now imagine paying Germany’s peak income tax rate of 45% on any extracted funds before being able to re-invest. The funding for your new venture would be drastically reduced if you didn’t have a holding structure in place.

Read the other posts in this series:

Disclaimer: We’re not lawyers or tax advisors, to stay on the safe side consult an expert before doing anything 😉