How RIAs Can Craft An Effective Operating Agreement That Aligns Owners’ Interests And Mitigates Risks

Operating agreements are foundational documents governing the affairs of a successful Registered Investment Adviser (RIA) business and are typically a key tool when it comes to succession planning. Well-drafted agreements align the interests of the owners and set clear expectations for how the business will operate and how profits will be distributed. However, as I've seen numerous times during my more than 25 years of law practice, when these agreements are poorly prepared – or neglected entirely – owners can face mismatched expectations, legal risks, and even costly business disputes that can potentially destroy the business. Therefore, to protect their interests, it's vital for RIA owners to carefully consider the terms of their relationship, memorialize them through the operating agreement, and update the agreement as circumstances change.

Key Features Of LLCs And Operating Agreements

To better understand how to approach preparing an operating agreement for an RIA, it's important to first consider the business structure through which the RIA operates. The Limited Liability Company (LLC) is the most common entity structure used by RIAs, as it combines the flexibility of a partnership with the liability protection of a corporation. This balance makes it an appealing choice for business owners who want to protect their personal assets while enjoying operational simplicity. Which is why it's the business structure of choice for most RIA owners.

One of the key features of an LLC is the limited liability protection it provides to its owners, known as members. This protection generally shields the personal assets of the members from the debts and liabilities of the business, meaning that creditors cannot come after the owners' personal assets. If the LLC faces a lawsuit or financial obligations, members are typically not personally responsible beyond their investment in and profits derived from the business. This layer of protection is one of the primary reasons business owners choose to form LLCs. However, RIA owners must be careful not to commingle personal assets with those of the LLC, as doing so could jeopardize their limited liability protection.

Unlike a corporation, which issues shares to shareholders, ownership in an LLC is represented by fractional membership interests that are allocated among one or more members based on the structure outlined in the operating agreement. Members may contribute cash, property (such as a book of business), or services to the LLC, and their ownership percentages are often based on these contributions – although this doesn't need to be the case. The flexibility of an LLC allows owners to divide ownership and profits in ways that may not correspond exactly to their capital contributions, offering a customizable structure that meets the unique needs of the business.

In an LLC, a capital account tracks each member's financial interest in the company. It serves as a ledger that reflects each member's contributions, allocations of profits or losses, and distributions received over time. Each member's capital account starts with their initial contribution – whether that consists of cash, property, or services – and fluctuates as the LLC earns profits, pays expenses, incurs losses, or makes distributions.

Profits and losses are allocated to members' capital accounts based on the terms set in the operating agreement. These allocations can be based on ownership percentages or other agreed-upon formulas. For example, two members who each own 50% of the LLC might agree to split profits evenly, or they may agree to a 60/40 split to account for one member providing additional services to the firm.

Even if the LLC doesn't distribute cash to its members, the profits or losses allocated to each member must still be reported on their individual tax returns. This means that members may owe taxes on allocated profits even if the LLC doesn't make any distributions to the members. When the LLC does make actual profit distributions, the payments reduce the members' capital accounts. These distributions are made in accordance with the parameters established in the operating agreement.

Beyond profits, LLCs can compensate their owners in additional ways, with the operating agreement defining the terms for such compensation. For instance, the operating agreement may call for certain "guaranteed payments" to be made to members, which function similarly to salaries of W-2 employees. It may also provide a mechanism for determining bonus compensation, whether tied to performance during a specific period or triggered by certain events. The operating agreement can further establish who is responsible for determining guaranteed payments and bonus compensation for members.

Contrary to popular belief, a member's capital account balance does not represent the value of their ownership interest in the LLC, like the value of shares would represent the value of a shareholder's ownership interest in a corporation. Rather, the value of a member's ownership interest is tied to the value of its membership interests and depends on what is perceived to be the overall enterprise value of the RIA multiplied by the fractional ownership of the company represented by such membership interests. For internal purchase and sale transactions among members, though, the operating agreement often defines the methodology as to how membership interests will be valued. The valuation methodology is typically either tied to a pre-defined formula such as a multiple of trailing revenues or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) or requires an independent appraisal of the value of such membership interests.

LLCs are managed either directly by members (member-managed) or indirectly through chosen "managers" who are typically members but not required to be members. These managers typically handle the LLC's day-to-day operations even though employees may be delegated specific responsibilities. To avoid giving too much power to managers, members generally retain consent rights over key decisions, such as merging with another firm or admitting new members.

LLCs can also have multiple classes of membership interests to provide different rights for certain members. For instance, one class might include voting rights while another does not. Classes can also vary in how profits are distributed among the members, depending on the parameters outlined in the operating agreement.

When it comes to leaving the firm, there are two principal ways that members can make an exit: either by withdrawing and selling their interests back to the firm or its members or by attempting to sell their membership interests to third parties. However, operating agreements often impose strict terms on when members can withdraw or sell their interests to ensure that the remaining members retain control over ownership and who can be admitted as a member.

Why Are Operating Agreements So Important?

Operating agreements serve as a critical tool for ensuring the smooth operation, stability, and long-term success of an RIA. By clearly defining roles, minimizing misunderstandings, and supporting the firm's growth, a well-prepared operating agreement serves as a cornerstone of effective business management.

Defining Roles And Reducing Legal Risks

Operating agreements provide a roadmap for more efficient and effective operation of the firm by clearly outlining each member's roles and responsibilities. This clarity ensures that members stay within their respective lanes and act or make decisions only when required. Additionally, defining clarity of key roles – such as who is authorized to sign legal documents – helps mitigate the firm's exposure to legal risks.

A clearly defined operating agreement also avoids disruptions in operations during unexpected events, such as the death or incapacitation of a key member. It should provide guidance on managing the firm in such scenarios and outline what happens to the ownership interest of the affected member, ensuring continuity and stability during difficult times.

Reducing The Risk Of Disputes

Clear and well-prepared operating agreements reduce the potential for misunderstandings among members. Because so many variables come into play when understanding each member's rights and obligations, misunderstandings and disagreements can easily arise if these issues are not addressed at the outset when launching the firm. Left unresolved, such misunderstandings can escalate into costly disputes or even a ‘business divorce', where one or more members leave the firm. This outcome can negatively affect all members, disrupt firm operations, and harm client relationships.

Supporting Growth And Future Planning

Well-structured operating agreements also enhance the firm's ability to attract new advisors, acquire other firms, or position itself for a future sale. By demonstrating intentionality and professionalism, a thoughtful operating agreement can convey the firm's value proposition to potential hires, demonstrating that the RIA is committed to growth and creating a welcoming home for new advisors.

Similarly, when the RIA is prepared for a potential sale, a well-crafted operating agreement demonstrates the firm owners' commitment to their business relationship. Even if a future buyer ultimately acquires only the firm's assets and not its equity, the operating agreement underscores the professionalism and organization of the RIA.

Common Mistakes In Operating Agreements

Avoiding Difficult Conversations

One of the most common mistakes RIA owners make when preparing an operating agreement is putting off difficult but necessary conversations. Owners often need to confront the reality that their personal interests may not always align – particularly when it comes to dividing profits or allocating managerial rights among members. At the outset of a new venture, there can be a temptation to avoid these tough topics to maintain harmony and keep everything running smoothly.

Similarly, members may hesitate to discuss unpleasant scenarios, such as what happens in the event of a member's death or disability. Yet, operating agreements are designed to address worst-case scenarios, including disputes among members. Failing to establish clear dispute resolution mechanics or provisions for these eventualities can leave the firm vulnerable to conflict and disruption.

Failing To Plan For The Future

Another common oversight is the failure to plan for the future. Sometimes, firm owners focus solely on the needs of the current members without anticipating how the business may evolve. While it's impossible to predict every scenario, the operating agreement should provide broad principles for addressing potential changes, such as admitting new partners, handling withdrawals, or responding to unexpected events.

For instance, how will the firm manage the transition if a key employee were to seek partnership? What would happen if a partner became permanently disabled or passed away? Without addressing these possibilities in the operating agreement, firms may find themselves scrambling to resolve these situations on the fly without a clear path forward.

Neglecting To Amend The Agreement

A third mistake that RIA firm owners make is failing to amend their operating agreement as the business grows and its operations change. With the many responsibilities that firm owners juggle, it's easy to lose track of the firm's operating agreement provisions. However, as firms expand, changes in personnel, business lines, compensation structures, and other key areas can lead to practices that inadvertently violate the operating agreement.

These oversights can create significant issues if disputes arise or if the firm is sold, requiring owners to certify that the operating agreement has been followed. Moreover, changes in the RIA industry may also warrant changes to an operating agreement. For instance, if the operating agreement sets a valuation formula based on multiples of revenue or EBITDA and if industry norms shift over time, the valuation process may no longer align with current expectations.

Steps For RIA Owners In Preparing Their Operating Agreements

Before addressing specific issues in the operating agreement, firm owners are encouraged to take time to strategically consider how they want their firm to be governed. Effective preparation involves thoughtfully defining key business principles, including the firm's philosophy, management structure, profit distributions, growth strategy, and succession planning. The following five steps can guide RIA owners in crafting a comprehensive and effective operating agreement.

Step 1: Define The Governance Structure For The Firm

The governance structure of the firm will shape how decisions are made and how responsibilities are distributed among members. RIA owners must decide whether the firm will be managed collaboratively by all members or by specific individuals or a committee. A collaborative approach promotes transparency and shared responsibility but may slow decision-making. By contrast, appointing managing members or forming a board of managers can increase efficiency, provided there is trust in the leadership and clearly defined boundaries for decision-making authority.

If more than one person has managerial authority, it's vital to establish voting thresholds required to approve certain management decisions. For an even number of votes, a clear process for resolving deadlocks is essential to avoid paralyzing the firm's operations.

While managers often handle the firm's day-to-day affairs, members may want to vote on certain key decisions that impact the business and/or their personal interests in the firm. As such, deciding when members have a say in firm decisions, even if they are not actively involved in actively managing the firm's daily affairs, is a vital part of the governance structure. Firms must also decide how voting rights will be allocated among members. Not all members need to be given voting rights – voting power can be distributed equally among members, tied to ownership percentages, or limited to specific individuals. For major decisions – such as admitting new members, selling the firm, or amending the operating agreement – a supermajority vote requirement (typically 66%–75%) is often necessary to ensure broad agreement.

Actionable Tips:

• Establish protocols to appoint and remove managers and outline any limitations on their authority.
• Determine how deadlocks among managers will be resolved.
• Identify key business decisions (e.g., approving new clients, hiring key employees, taking on significant borrowing or expenditures, entering into new business lines, dissolving the business, admitting new members, etc.) and specify whether managers can make these decisions independently or if they require a member vote. Clearly define the voting threshold required for each type of decision.
• Decide whether all members will have voting rights or if only certain members will participate in key decisions.

Step 2: Establish A Profit Distribution Philosophy

Profit distribution is one of the most sensitive areas of an operating agreement, directly affecting morale, retention, and the firm's growth trajectory. RIA owners must determine whether profits will be distributed based on ownership percentages, individual performance, or a combination of both.

In a collective enterprise model, profits are shared equally or according to ownership stakes. This approach promotes unity and shared responsibility for the firm's success, making it a good fit for firms focused on long-term growth. However, it may discourage top-performing advisors who want their efforts reflected more directly in their compensation (although this can be addressed through other methods).

By contrast, a production-based model allocates profits based on individual contributions, such as the revenue generated by each advisor. While this model incentivizes individual performance, it can also lead to internal competition and undermine collaboration if not carefully managed.

Actionable Tips:

• Determine whether the firm's culture will prioritize collective success or incentivize individual performance.
• For a production-based model, clearly define how contributions (e.g., revenue generation or client acquisition efforts) will be measured and rewarded.
• Consider building flexibility into the agreement to revisit profit distribution methods as the firm evolves, balancing short-term needs with long-term goals.

Step 3: Plan For Future Growth And Addition Of New Members

For RIAs focused on growth, the operating agreement must reflect this vision by including provisions for onboarding new members or partners. Key considerations include how new members will buy into the firm, how their ownership stakes will affect existing members, and whether they will be granted voting rights.

To attract and retain new talent, firms may also consider offering profit interests –payments that allow employees to share in profits without granting them full ownership. This approach can motivate high-performing employees while enabling existing members to maintain control.

Planning for equity dilution is also essential. Adding new members or issuing profit interests may reduce existing members' ownership percentages, which may cause friction if not carefully planned.

Actionable Tips:

• Define a clear process for onboarding new advisors, including buy-in requirements and how ownership percentages will be adjusted.
• Decide whether new advisors will receive voting rights and, if so, whether their decision-making authority will be phased in over time.
• Consider profit interests or other compensation structures to attract talent without diluting ownership too quickly.

Step 4: Plan For Member Exit And Succession

Every operating agreement should address how the firm will handle a member's departure – whether voluntarily, such as through retirement, or due to unexpected circumstances like death or disability. These provisions, often referred to as buy-sell provisions, establish rules for transferring ownership interests, maintaining business continuity, and preventing disputes.

Key considerations include whether members will forfeit their ownership interest upon departure or whether they will have rights to sell their interests to other members or outside parties. The agreement should also define how ownership stakes will be valued for sales transactions. Common valuation methods include formulas based on the firm's revenue or profits, or an independent third-party appraisal.

Succession planning is equally important. Establishing a clear process for valuing and transferring ownership stakes ensures a smoother transition in the event of retirement or an unplanned departure, minimizing disruption and providing peace of mind for both members and clients.

For firms with only one member, succession planning is a particularly important issue. Without an operating agreement providing specific instructions on what happens to the firm in the event of the death of the single owner, most state LLC statutes call for the dissolution of the firm after a set period unless the deceased member's estate steps in to provide instruction on what should happen to the firm and whether a replacement member will be admitted. Explicit provisions in the operating agreement can help avoid this outcome by clearly outlining how the firm should continue or be wound down in the event of the sole owner's death.

Actionable Tips:

• Evaluate what happens to a member's interests in the event of different types of departure including voluntary departure, death, disability, retirement, or expulsion for bad acts.
• Determine who may purchase such interests from the departing member.
• Establish how membership interests will be valued for sale of a member's interests based on different scenarios.

Step 5: Ensure Alignment With The Firm's Long-Term Vision

One of the most critical steps in drafting an operating agreement is ensuring that it aligns with the firm's long-term goals. This means thinking strategically about the direction of the business and ensuring that the governance, compensation, and growth strategies reflect that vision. For example, a firm focused on building a legacy business with multi-generational clients may prioritize stability and long-term growth over short-term performance. Conversely, a firm that plans to rapidly scale or prepare for a future sale may structure management and distributions differently.

Owners should also consider whether the firm will remain focused on managing separate accounts or if it plans to expand into new business lines, such as launching an Exchange-Traded Fund (ETF), offering a private fund, or building out tax and/or estate planning services. These strategic decisions will shape how the operating agreement should be structured.

Actionable Tips:

• Facilitate a clear discussion among members about the firm's long-term goals, including whether growth or stability takes priority.
• Ensure the operating agreement reflects this vision, addressing profit distributions, management decisions, and governance structures.
• Incorporate flexibility into the agreement to allow for amendments as the firm evolves and its strategy shifts.

A more in-depth questionnaire can be downloaded here for those who wish to dig deeper into the key questions to be answered when putting together an operating agreement.

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Although drafting an operating agreement may feel like an inconvenient and tedious task, it's an essential step in building a strong foundation for the firm's future. Taking the time to carefully think through and define how their firm will operate – whether it's establishing clear governance, structuring profit distributions, planning for growth, managing member transitions, or aligning with long-term goals – helps owners clarify the firm's philosophy and values. A well-thought-out operating agreement not only minimizes the potential for misunderstandings or disputes but also ensures that all members are working toward a shared vision for the firm.

Ultimately, investing time in this process sets the stage for the firm's success – building stability for a legacy business, enabling rapid growth, or preparing for a future sale. And a clear framework makes it easier to navigate challenges and take advantage of opportunities, giving RIA owners confidence that the firm they're building is well-positioned to thrive for years to come!