What it means
Imagine a company that owns the right to drill on a piece of land. It might grant someone a net profits interest of 20%, meaning that person is entitled to 20% of whatever profit the property makes.
Profit here means revenue minus operating costs, drilling and development costs and other agreed expenses. The arrangement is attractive to the owner because the holder only gets paid when there is a surplus.
If the property loses money, the holder typically receives nothing, and many contracts let the unrecovered costs carry forward and be deducted from later income. That makes it a flexible way to pay for land, expertise, finance or services without giving up ownership.
For the holder, the main advantage is protection from costs: the person does not usually fund drilling bills or bear the day-to-day running expenses. The trade-off is that they depend on how accurately and honestly the operator calculates the net profit.
The contract definition of costs is therefore the most important part of the deal. The idea is also used in partnerships and limited liability companies, where a profits interest gives a person a share of future growth and profit but not of the value that exists today.
It is a common reward for managers or service providers, and tax treatment can be favourable in some jurisdictions. Anyone using it in this way should take professional tax advice because the rules are technical and change over time.
An important distinction is that a net profits interest differs from a royalty. A royalty is usually based on gross revenue and is paid before costs, so it arrives even when the project is unprofitable.
A net profits interest comes after costs, which makes it riskier but sometimes cheaper to grant.
In practice
Real-world examples.
Example
A landowner leases drilling rights to an energy company in exchange for a 15% net profits interest. In a year with $600,000 of net profit, she receives $90,000. In a loss-making year she receives nothing but is not asked to cover the shortfall.
Example
A property developer gives the architect on a residential project a 5% interest in the net profits instead of a higher fee. The project sells apartments for $12,000,000 against costs of $9,000,000. The architect receives 5% of the $3,000,000 profit, which is $150,000.
Example
A private equity-backed software business gives its chief technology officer a profits interest in the holding company. The interest only shares in value created after the grant date. If the company's value rises by $10,000,000 and the interest is 2%, her share of the gain is $200,000.
Formula
Calculation
Net profit = revenue - operating costs - capital and development costs (as defined in the contract)
Payment to holder = net profit x net profits interest percentage
A gas property earns revenue of $2,000,000 in a year. Operating costs are $700,000 and agreed development costs are $500,000, so net profit = $2,000,000 - $700,000 - $500,000 = $800,000. The holder has a 20% net profits interest, so the payment is $800,000 x 0.20 = $160,000. In a poor year with revenue of $1,000,000 and costs of $1,200,000, there is no net profit and the payment is $0.Case study
Seen in the real world.
Redwood Energy Partners is a fictional operator used for illustration. In this illustrative story, it needed a geologist to review a group of underperforming wells but had little cash to spare. It offered her a 10% net profits interest on the wells instead of a $300,000 fee.
Her recommendations lifted production, and net profit on the wells rose from $400,000 to $1,500,000 a year. She received $150,000 annually, so her total payments passed the $300,000 fee in the third year. Redwood kept ownership of the assets and avoided the cash outlay at the start, and both sides agreed that clear cost definitions in the contract had prevented any dispute.
Watch out
Common mistakes.
- Confusing a net profits interest with a royalty. A royalty is based on revenue, while a net profits interest is based on what is left after costs.
- Ignoring how costs are defined. The contract wording on what can be deducted determines the size of the payment.
- Assuming the holder owns part of the asset. The holder has a right to a share of profit, not ownership of the property.
Questions
People also ask.
Does the holder pay any of the costs?
Usually not directly, but costs reduce the profit on which the payment is based.
What happens if the project makes a loss?
The holder generally receives nothing, and the contract may carry forward the deficit before future payments resume.
Can a net profits interest be sold?
Often yes, subject to the contract terms, and it is valued by estimating future net profit and discounting it to today.
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