What Is a Net Profits Interest?
A net profits interest is an agreement that provides a payout of an operation's net profits to the parties of the agreement. It is a non-operating interest that may be created when the owner of a property, typically an oil and gas property, leases it out to another party for development and production. The owner is guaranteed to be paid a portion, or has an interest in, the net profits generated by the operation.
A net profits interest may be granted instead of a royalty interest, where the holder receives a share of gross revenues rather than net profits. A net profits interest is most common in oil and gas companies.
- A net profits interest is an agreement that provides a payout of a percentage of an operation's net profits to the parties involved.
- A net profits interest is a non-operating interest that is created when the owner of a property leases out the property to another party for development and shares in the venture's profits.
- The risk to the owner in a net profits interest agreement is minimal as they do not share in the losses, only in the profits.
- A net profits interest is separate from a royalty interest, where the holder receives a share of revenues as opposed to net profits.
- The oil and gas industry is the most common user of net profits interest.
Understanding a Net Profits Interest
A net profits interest may arise when the owner or a property does not have the ability, either financially, or otherwise, to generate revenue from their property. In the case of an oil and gas property, the owner may own the property but not have the equipment to search for and extract oil. They also do not have the financial capital to buy the equipment or hire a contractor to do so.
In this case, the owner can still generate income from their property by leasing it out to an oil drilling company and share in any of that company's profits.
Another upside to a net profits interest arrangement is that the owner of the property is not liable for any losses. Their percentage of net profits does not equate to a shared percentage in losses. If the oil drilling company incurs losses during the course of business or does not discover any oil, all the losses associated with the venture are on the operator not the owner. It is a risk free venture for the owner of the property.
However, depending on the stipulations of the lease contract, the operator may recover these losses from future payments of net profit from the owner of the property.
Example of a Net Profits Interest
Company A owns the rights to explore and develop an oil and gas property. Company A leases it to Company B to drill and extract the oil. Company B and Company A agree on a 15% net profit interest to be paid to Company A in exchange for allowing Company B to extract oil on Company A's oil property.
In a given year, if Company B makes $10 million in net profits after deducting all allowable and applicable expenses from revenue generated from the property, $1.5 million would be payable to Company A as its share of net profits.
To avoid legal complications down the road, the exact definition of net profits and the expenses that are allowed to be deducted from revenue to arrive at it should be specified in the lease contract. Accounting transparency is another prerequisite.