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The Subsidiary

By Thomas McLaughlin - November 1, 2013

There are certain words that seem to practically cry out their message. One of those words is the term “subsidiary” as it is used to describe a particular kind of corporate structure. Here the word “subsidiary” seems to embody a subordinate position.

The phrase “take-over” is sometimes associated with the concept of a subsidiary. This offers a kind of double condemnation. In a freedom-loving culture, being a “subsidiary” of any kind reeks of lost privilege and status.

But, hold on. The story is more complicated than it seems. Subsidiary as the word is used here means a corporation that holds a certain position and is in a defined relationship with at least one other corporation. Some of that relationship is legally defined and even legally required. But a lot of it is left to the judgment of the corporations and their respective managers. This is why digging into the actual terms and requirements of subsidiary relationships may produce some surprising, counter-intuitive results.

 

Accountability vs. Power

Although it might seem otherwise, the subsidiary structure is more about accountability and protection than it is about power. In a corporate sense, power often refers to the ability of a person such as a CEO or a department head to compel certain behavior on the part of those who report to that person. This is the classic power imbalance that is usually muted but unmistakably underlies classic relationships in a corporation: the boss is in charge.

In a parent/subsidiary model the word “parent” refers to the corporate entity that is in charge of the subsidiaries. It might also be called a holding company or a management company. There is a power imbalance between the two entities, but it is nothing like that between boss and employee. In fact, for those employed in a subsidiary it is not unusual for the parent company to seem more like it’s located somewhere else on a cloud (and not the computer kind). The parent is a recognizable organization but employees of each corporation may well regard each other as though they are simply citizens of moderately allied countries.

The reason for this apparent estrangement is that it is a by-product of a major advantage of subsidiaries — they represent boundaries. This is one of the most compelling reasons for subsidiaries, because corporate boundaries represent a kind of firewall between the parent corporation and outsiders who might be intent on suing a subsidiary. Rarely does an aggrieved outside party succeed in attacking the parent company by first trying to go through a subsidiary. Lawyers refer to this as piercing the corporate veil and it is rarely accomplished because each corporation is expected to stand on its own in all legal proceedings.

This isn’t a corporate version of dodgeball. Different types of services have different risk patterns, and there could be dramatically negative economic consequences of treating all services in a parent-subsidiary environment alike. For example, major hospitals that co-exist in a complicated multi-corporate structure will virtually always run nursing homes or home care services as subsidiaries. This is because a successful lawsuit against a hospital could potentially bankrupt a nursing home if it were part of the same subsidiary.

Boards of directors represent a good example of subsidiary corporations’ roles in ensuring accountability. Not only will a smart parent company taking on a new subsidiary be open to the latter’s board continuing, they might insist on it. Apart from the fact that the parent company board might have to begin a crash course in running the new subsidiary, dismissing the board would destroy all institutional knowledge at a governance level.

 

Brand management

Well-run nonprofits know how to manage their brand(s). While it is possible to manage a brand through many different departments — even through many different corporations — it is much easier if that brand has implicit boundaries. Brand management is a top-down function, which is why parent companies will not usually meddle in the promotion of a successful subsidiary’s brand.

 

The Top Line, not the Bottom Line

Many nonprofit board members and some executives feel that a successful merger should save money. This is a worthy goal, but subsidiary corporations still need CEOs, audits, executive staff, and other expenses. Skeptics will ask why a nonprofit should do something like this if it doesn’t save money.

The answer is that, while the bottom line is important, in many sectors of the nonprofit field today, the top line – revenue – is even more important. Hospitals began creating numerous parent-subsidiary models two and even three decades ago. Arts groups are doing a similar version of the same thing in many locations.

Behavioral health care providers in many states are entering a new phase of consolidations that often involve parent-subsidiary models. Providers of services to developmentally delayed persons in some states are facing similar changes.

Integrated systems of care almost always have more power with funders – who themselves are often enlarging their scope as well — than individual organizations do. Larger arts groups can reach bigger audiences, etc. When parent-subsidiary models are used in these situations ‘savings’ may or may not be realized. But what often does happen is that the newly enlarged organizations, simply put, increase their power at the bargaining table.

This kind of scaling up is fairly rare in the nonprofit world, which is why subsidiary corporations are still rarely found outside of hospitals, universities, research institutes and other large entities. But forces like managed care, shifting risk management requirements and health care reform are providing fertile ground for more parent-subsidiary relationships.

 

What You Should Do

What should you expect if your current organization becomes a subsidiary of a larger one?  Or if you are a CEO contemplating making your organization a subsidiary, what should you attempt to achieve in the process? The key indicators are much the same for both viewpoints.

 

Board Integration

The parent company’s board will likely become the “sole corporate member” of the new subsidiary, giving it official control of the entity. This creates a legal tie in lieu of a “purchase” which for-profit corporations routinely carry out. In practical terms, however, this too is an accountability mechanism, not a control technique.

In practice, wise parent companies will seek board integration. Ideally the subsidiary board of directors will contribute at least one or two board members to the parent company board. This is important symbolically and it also helps build cultural compatibility. Note that this individual or individuals abruptly must do “double-duty” between the board of origin and the new parent board, but it is nearly inconceivable to create a smooth integration of parent and subsidiary any other way.

 

Treatment of Brand Name

In most cases this element will be an early topic of negotiations and may be especially important for the smaller organization. Brand name philosophy – and the systems that support it – should be an early topic of discussion unless the future subsidiary has a damaged brand or the parent has a far stronger one.

 

CEO Role in New Entity

For obvious reasons this is both a symbolic and very real indicator. While most of a subsidiary’s employees are unlikely to have intense, sustained contact with the parent company, the CEO should be deeply involved in these relations. Ideally the subsidiary CEO’s role will be articulated and important.

 

Same Funder Positioning

Another key indicator is the new subsidiary’s role in future relationships with a shared funder. The parent company is likely to take the lead in these negotiations, so the most important cue will be how the subsidiary CEO’s role changes. Note that this and the previous indicator is the only instance in which staff of the parent and the subsidiary play the classic boss/subordinate roles.

 

Money Decisions

Relatively small, ordinary financial de­ci­sions might be largely unchanged by a sub­sid­ia­ry designation. But acquiring and using capital for things like buildings or specialized equipment are almost certain to change in some fashion.  The decision-making process around major ex­penditures will often change, and some decisions will be made, or at least af­firmed, at a higher level than before.

 

Subsidiary prerogatives

There is a whole category of what we would call subsidiary prerogatives that could change – or remain untouched. These are things such as purchasing decisions, marketing, fundraising and development activities, and personnel management practices. The future direction of these kinds of items is a good potential clue about future relations between the two entities.

Subsidiary corporations are a valid and effective way of managing risks, distinguishing brands and other assets, and approaching consumers in different yet coordinated ways. Most nonprofits will not become part of a parent-subsidiary structure, but external demands and internal strategies are boosting the use of this time-tested option.  NPT

Thomas A. McLaughlin is the founder of the nonprofit-oriented consulting firm McLaughlin & Associates and a faculty member at the Heller School for Social Policy and Management at Brandeis University. He is the author of “Streetsmart Financial Basics for Nonprofit Managers” (3rd edition), published by Wiley & Sons. His email address is [email protected]

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