Navigating RIA Risk Mitigation for the Eight-Figure Exit

As the owner of a Registered Investment Adviser (RIA) business, you face a daily onslaught of risk. How you handle those risks can significantly affect your business. Having the right protections in place could decide the fate of your firm and your own financial future. In this entry, I’m going to look at some of the most important aspects of RIA risk mitigation and how they could support or thwart your progress toward the eight-figure exit. From basic insurance policies to the way your firm is structured, you won’t want to miss out on this blog, regardless of your industry or experience level!

Follow Along With The Financially Simple Podcast!

This week on The Financially Simple Podcast: 

• (02:00) Defining risk management

• (04:15) Advice policies you should carry as an RIA owner

• (08:52) Core business policies you should carry as a business owner

• (12:34) Cybersecurity insurance

• (14:12) Business Disruption Policy

• (16:11) Your business entity

• (18:14) C-Corporations, double taxation, and the eight-figure exit

• (21:52) When should you review your coverages?

• (23:13) Exit planning is good business planning

RIA Risk Mitigation: Protecting the Value of Your Greatest Asset

When it comes to running an RIA business, risk is an ever-present companion. But what if I told you that you don’t have to spend your life looking over your shoulder? You see, a comprehensive RIA risk mitigation—or management—plan can set you free from the worry of “what if.” Risk management, as defined by Marquette University, is an ongoing process that involves identifying, analyzing, evaluating, and treating potential loss exposures. Its purpose? To safeguard your business from the adverse consequences of unforeseen events. But why should you be concerned about risk mitigation in your RIA?

The answer lies in the potential ramifications of poor risk management. Picture this: a decreased valuation of your RIA, legal battles that drain your resources, or even the nightmare scenario of catastrophic business failure. These are not the stepping stones to the lucrative exit strategy you’ve been envisioning. Let’s take a closer look at some of the biggest and most effective tools in our toolbox for RIA risk mitigation.

Insurance Policies Every RIA Owner Should Carry

Regardless of the industry you operate in, insurance is an absolute necessity for business owners. In fact, I would take that a step further and say that it’s necessary for anyone who doesn’t want to gamble with their life’s savings. You see, insurance adds a layer of protection from unforeseen events such as natural disasters, personal injury, or even litigation as a result of human error.

It’s because of this that Charles Schwab recently announced that, “All Registered Investment Advisor firms that work with us must carry an aggregate minimum of $1 million of insurance coverage to protect against errors and omissions, social engineering, theft by hackers, and, if applicable, theft by employees.” So, in the financial advisory space, we’re seeing custodians demanding additional insurance coverage. So, what policies should you carry as an RIA firm owner?

Errors & Omissions (E&O)

Errors and omissions (E&O) insurance, also known as professional liability insurance, should be at the forefront of your RIA risk mitigation strategy. It serves as a protective shield against lawsuits that allege professional errors or negligence in your services. I like to think of it as the financial industry’s equivalent of malpractice insurance.

Regardless of how fastidious you might be when handling client accounts, mistakes happen. Sometimes an error doesn’t even have to have occurred. If a client became upset about a poor investment outcome, they could claim that you caused financial injury whether it’s true or not. Either way, E&O gives peace of mind that you won’t be on the hook for the damages in either scenario.

Surprisingly, despite more than half of business owners acknowledging professional mistakes as a significant risk, only 20% carry professional liability (E&O) coverage. Look, I’m well aware of CPA firms and law practices that don’t pay for E&O coverage. Likewise, I know of many financial advisory practices that refuse to pay for errors & omissions insurance. They simply believe they’re never going to “mess up” in a way that will cost them, but we’re all human.  So, what’s the real risk of not having E&O insurance?

Without it, liability claims can be financially crippling. Even if a client’s claim is eventually dropped, the legal expenses alone could amount to thousands of dollars. If you’re found at fault or opt for an out-of-court settlement, the costs could skyrocket. As per a survey on USCourts.gov, outside litigation costs per respondent averaged nearly $115 million in 2008, representing an alarming 73% increase from the year 2000. As you can see, these figures underscore the critical importance of E&O insurance for RIA owners.

Directors and Officers Liability Insurance (D&O)

Another coverage you might consider is Directors and Officers Liability (D&O) insurance. You see, it protects the officer’s personal assets. But why would you need this? Well, sometimes a mistake caused by an officer’s oversight can cause them to be in a position where they, individually, have to defend a claim.

This is especially important for Chief Compliance Officers, who can be held personally liable by regulators. In fact, a study cited by Schwab revealed that 30% of complaints that are settled or dealt with by D&O and E&O involve regulation matters. Additionally, the research showed that 14% of these claims involved the cost of correction and 10% dealt with closed-end fund matters. So, friends, you can see that these coverages help shield you from a variety of risks.

Business Overhead Policy (BOP)

I like to call this policy a wrapper. It controls a lot of different internals. A Business Overhead Policy (BOP) is tailored specifically for small to medium-sized businesses, bundling general liability insurance and property insurance into a single, cost-effective package. So, what does the BOP offer business owners?

General Liability Insurance

First, the BOP offers general liability protection. This shields you from financial loss due to bodily injury, property damage, medical expenses, libel, slander, lawsuits, settlement bonds, or judgments. The coverage amount depends on your business’s size and type. However, TechInsurance reports that the majority of small businesses (those with fewer than 500 employees) opt for a general liability policy with a $1 million per occurrence limit and a $2 million aggregate limit.

Friends, don’t be fooled into believing that it can’t happen to you. All it takes is one rainy afternoon to create a slip-and-fall incident in your office. In a survey by Insureon, 35.2% of respondents experienced events that could have led to a claim within the previous year, with 40% of small firms filing claims over a ten-year period. I don’t know about you, but I don’t want or need that type of risk in my life.

Property Insurance & Business Continuity Plans

Regardless of whether you rent or own the building your office is in, property insurance is a must for RIA owners. You see, it provides financial reimbursement for structural or content damage due to accidents, theft, or even natural disasters. For instance, I know an individual whose office had to be shut down due to a septic issue.

The tank backed up into their office, creating a hazardous environment. They were unable to meet clients in their office while the issue was resolved. This individual could have lost tens (if not hundreds) of thousands of dollars if not for the protection provided through their BOP. However, this situation would have been significantly worse if not for their required Business Continuity Plan. Folks, this is a great example of risk mitigation in action.

Without the BOP, they would have been financially liable for the repair and clean-up efforts. However, the Business Continuity Plan proved to be just as valuable. Without it, they would have had no recourse for carrying on with “business as usual” during their displacement. Instead, they were able to meet with clients in an alternate location (or virtually). Likewise, they continued to have access to their software, client data, etc., because of the secure backups they had in place.

The risk of not having these protections in place is significant – from property damage to employee injuries and customer claims, uninsured companies bear a concerning burden of risk. How big is that burden? BKS Partners, reports that insured losses from natural disasters approached $115 billion in 2022.

Stand-Alone Policies

Sometimes, you need more than what the standard BOP offers. In these instances, you could choose to go out and secure a stand-alone policy based on your unique needs. For example, if you own the building you operate out of, you might need to purchase individual property insurance coverage. Similarly, it may be wise for you to purchase renter’s insurance if you’re renting your office space. With this in mind, let’s look at a couple of the stand-alone policies business owners should consider.

Cybersecurity Insurance

It doesn’t seem that long ago when cybersecurity wasn’t even a risk. My how things have changed. If you have a computer in your business, cybersecurity insurance is a must. This is especially true for RIAs. These days, hackers and other bad actors can infiltrate your firm’s digital networks to steal client data, initiate fraudulent wire transfers, and even take your technologies hostage.

A single cyber-attack can lead to thousands (if not hundreds of thousands) of dollars in expenses, as well as lost trust from your clients. Moreover, it could destroy the hard-fought value you’ve created in your company. So, what is cybersecurity insurance? It’s basically a contract that’s there to reduce the financial risk associated with online business activities. However, it often comes with some added responsibility.

In a previous blog, I explained that insurance claims can be denied if the insurer deems that the insured didn’t take proper measures to protect themselves (and their clients) from the threat of a cyber-attack. Therefore, cybersecurity is a great way to protect your RIA from damages when used in conjunction with an effective cybersecurity strategy.

Business Disruption Policy

Friends, this is an often overlooked policy that could literally save your business. Let me give you an example. I have a client who owns a medical practice. A while back, this client’s office had to be shut down due to a sewage line backing up. As you can imagine, this means that the office went through a thorough renovation to repair damages and clean the hazardous mess. The damages and cleanup were covered by this client’s Business Owners Policy, but what about the lost revenue?

You see, this single event caused their office to be shut down for about seven weeks. Because they own a medical facility, they couldn’t simply see patients virtually as many financial advisors did during the COVID closures. Their income was on hold, but their expenses were significant. They still had to cover employee salaries, rent, utilities, etc. Fortunately, this client heeded good advice and purchased a Business Disruption Policy before this event occurred. As a result, the policy went into effect and provided steady income for the duration of the closure.

Friends, we don’t know what tomorrow holds. Oftentimes, there’s no way to prepare for this type of disruption to our businesses. Without having a Business Disruption Policy in place, a backed-up sewer line, or downed tree, or even a Covid-like event could spell disaster for your future. Even if the tangible damage is covered by your BOP, you may not survive extended disruptions to your income.

Business Entities: Protecting Personal Assets & Mitigating Taxation

You’re probably familiar with the purpose of a business entity. In financially simple terms, it’s the structure under which you operate. However, there are different types of business entities, each with unique attributes and purposes. Let’s take a look at what each entity offers and how it differs from the others.

Limited Liability Companies (LLCs)

A Limited Liability Company (LLC) is a business structure in the United States that shields its owners from personal responsibility for debts or liabilities. It’s a hybrid entity that combines corporate characteristics with those of a partnership or sole proprietorship.

LLCs can be taxed in one of two ways: as partnerships or sole proprietorships. If an LLC is taxed as a partnership, it means profits or losses pass through to its members (owners). According to the IRS, “A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it “passes through” profits or losses to its partners. Each partner reports their share of the partnership’s income or loss on their personal tax return.”

An LLC taxed as a partnership offers its members the benefit of being insulated from the entity’s debts and liabilities. Likewise, the “pass-through” nature can make tax planning much simpler.

LLC Taxed as a Sole Proprietor

Much like an LLC taxed as a partnership, single-member LLCs offer liability protection to the entity’s owner. Single-member LLCs, however, are “disregarded” for federal tax purposes and treated as sole proprietorships. What does this mean? Basically, it’s saying that the IRS disregards the separation of the entity from its owner. Therefore, you are taxed as a sole proprietor but receive protection from your firm’s debts and liabilities.

It’s important to note that you will be required to pay the 15.3% Self Employment tax. Likewise, you could face employment and excise taxes.

Friends, the asset protection that LLCs offer is invaluable. Because business expenses are deductible against gross income, you could find yourself in a favorable tax position. However, to truly take advantage of this, you must practice meticulous record-keeping.

S Corporations

S Corporations are businesses that file under Subchapter S of the Internal Revenue Code (IRC). They also make up the largest percentage (55%) of U.S. business entities. Like their LLC counterparts, S Corporations are pass-through entities, meaning they don’t pay corporate taxes. Instead, profits, deductions, and losses are passed directly to shareholders, who are responsible for taxes.

S Corps offer advantages such as tax-favorable income characterization and asset protection, but they come with a few drawbacks, as well.

1. Tax Qualification Objections. Mistakes can be costly. This is especially true regarding the various election, consent, notification, stock ownership, and filing requirements. They could lead to losing S Corp status and being forced into a C Corp.
2. Closer IRS Scrutiny. Because shareholder distributions can be dividends or salary, the IRS closely examines payments to make sure they’re characterized accurately.
3. Stock Ownership Restrictions. S Corporations can only have one type of stock. However, an S Corp can have voting and non-voting shares.

C Corporations

C Corporations are distinct legal structures where owners—or “shareholders”—are taxed separately from the entity. While they limit personal liability, they face double taxation. This means that corporate income is taxed, and the profits distributed to shareholders are taxed again as personal income. Double taxation is a point of contention for many business owners. As such, it is perhaps the biggest drawback.

Although the 2017 Tax Cuts and Jobs Act reduced the C Corp tax rate to 21%, many small businesses still find S Corps more tax-friendly. However, C Corps may appeal more to investors due to fewer restrictions on share purchases. This provides an interesting conundrum when structuring your RIA for a business sale.

According to LegalZoom, “Buying out a C corporation is easier than acquiring an S corporation. C corporations face minimal restrictions on who can buy shares and when. On the other hand, S Corporations allow fewer shareholders, and investors must pay taxes on the income from their shares. As a result, C corporations appeal more to investors.” 

However, the same report highlights the value of an S Corp’s single taxation level on business sales. “When owners sell an S corporation, they pay taxes on the distribution. With C corporations, the corporation pays taxes first, and shareholders pay taxes again once they receive their proceeds,” according to the report. Therefore, the choice between S Corp and C Corp structure should be made carefully, considering factors like ease of sale and taxation.

Wrapping Up…

Friends, navigating RIA risk mitigation to achieve an eight-figure exit requires a multifaceted approach. The insurance policies you should be carrying exist to protect you from the unforeseeable. Whether it be natural disasters, human error, or personal injury, the right coverage can be a lifesaver when you’re in the midst of a storm.

On the other hand, corporate structures offer you a shield against personal liability, reducing the risk of financial ruin. Your choice of entity can significantly impact how you’re taxed, and even your eventual sale. So, I challenge you to conduct a thorough risk assessment in your firm. Where are the vulnerable areas? They might not be as protected as you think.

Look, I know life is hard. Nobody wants to think about the worst-case scenario. But as an RIA owner, taking the time to plan for the unexpected could be the difference between achieving your goals and disaster. Examining your firm’s risk mitigation plan and shoring up any vulnerabilities can make driving toward the eight-figure at least financially simple. Hey, let’s go out and make it a great day!

Are you confident that your firm is protected from all potential threats? If not, now’s the time to act. Reach out to our team to learn how we could help you accomplish your goals.