Who Decides What Counts as Profit? Where Participation Deals Go Wrong

Almost nobody argues about the percentage.

Ten percent, twenty percent, or one-third often gets settled early. It feels like the deal. But when a profit-participation arrangement later produces a dispute, the fight is usually about the other half of the sentence: a percentage of what?

One party runs the business, keeps the books, decides which costs are charged to the project or business, and sends the calculation. The other party sees a payment figure without necessarily seeing how it was built. Both may believe they are honoring the agreement. The problem is often not dishonesty; it is that the definition of profit was asked to do more work than the contract actually assigned it.

This article explains where those disagreements arise, why calculation discretion matters, and how Arizona, California, and Texas law can approach contractual discretion differently. For a companion drafting checklist, see our guide to profit-participation agreement key terms. It is general information, not legal advice for a particular agreement or dispute.

Why can the same business produce two different profit numbers?

“Profit” is not a single, self-executing number. It is what remains after a series of choices about revenue, costs, timing, and accounting treatment. Even commercially reasonable choices can generate very different results in a particular period.

Common pressure points include:

• Revenue scope. Does the calculation include all company revenue, or only revenue from a defined project, product line, property, territory, customer, or transaction?
• Collection timing. Is revenue counted when invoiced, earned, received, or finally collected? How are refunds, credits, chargebacks, or bad debt treated?
• Allowed deductions. Direct production costs may be clear; allocated overhead, executive compensation, headquarters expenses, and management fees often are not.
• Capital expenditures. A substantial asset replacement or platform rebuild may be expensed immediately or capitalized and recognized over time. The chosen treatment can materially change a payment for one period.
• Reserves. Amounts reserved for taxes, claims, repairs, contingencies, or future obligations may reduce current distributable profit. The agreement should address whether reserves are permitted, by whom, and on what standard.
• Related-party charges. A management fee paid to an operator affiliate may be a real business expense, but the agreement may need to address whether the charge must be disclosed, commercially reasonable, or consistent with an identified formula.

These are ordinary operating questions. In a participation arrangement, however, they also determine how much someone is paid.

Who decides whether an expense counts?

That question sits underneath the others, and many agreements answer it only by accident.

If an agreement promises a participant a percentage of “net profit” but does not define the term, identify permitted deductions, or provide a calculation process, the party preparing the books will ordinarily make the day-to-day judgments required to produce the number. That is not necessarily improper. A business needs someone to operate it. But the contract may leave the participant with no agreed standard for testing whether a particular charge belongs in the calculation.

A useful agreement separates at least four issues:

1. Definition. What does “net profit” mean for this particular arrangement?
2. Decision-maker. Who prepares the calculation and has authority to make ordinary accounting judgments?
3. Limits. Which deductions, allocations, reserves, related-party charges, and accounting methods are permitted, prohibited, capped, or subject to a stated standard?
4. Verification. What information must be delivered, how often, and what review, objection, audit, or dispute-resolution process applies?

A reporting right is not the same as a definition. An audit right is not the same as a limit on deductions. And a statement that the operator has “sole discretion” is not the same as identifying what discretion exists and what the parties intended the participant to receive.

The contract usually does the first and most important work

Courts generally begin with the agreement’s words. A defined calculation formula, identified accounting standard, express list of permitted deductions, and a clear treatment of affiliates and reserves give the parties — and later, if necessary, a court — something concrete to apply.

That does not mean a long definition is always better. The needed level of detail depends on the business model and the relationship. A participation tied to a single real-estate asset, a single software product, a film, a lending transaction, or an operating business will present different cost and revenue questions.

But the agreement should address the choices that are most likely to change the number. The more the payment turns on an operator-controlled judgment, the more important it is to say whether that judgment is constrained by a formula, consistency requirement, accounting convention, reasonableness standard, disclosure obligation, or express contractual discretion.

Arizona: discretion may be tested against the bargain’s reasonable expectations

Arizona recognizes an implied covenant of good faith and fair dealing in every contract. The covenant protects the parties’ reasonable expectations and can be implicated when a party exercises discretion retained or left open by the agreement in a way that denies the other party an expected benefit of the bargain. At the same time, the covenant does not simply erase or contradict an express contractual term. Bike Fashion Corp. v. Kramer, 202 Ariz. 420 (Ariz. Ct. App. 2002)

For a participation agreement, that means the precise language still matters. A court does not replace the parties’ agreed calculation formula with a preferred one. But if the contract leaves an operator with discretion over a calculation issue, the question may include whether the discretion was exercised consistently with the benefit the parties reasonably expected from the agreement.

Arizona entity law may provide separate information rights in some structures. For example, Arizona LLC members and managers may have statutory access to specified records and, subject to statutory conditions, other company records related to the company’s activities, affairs, and financial condition. Those rights are not a substitute for tailored contract reporting provisions, and they depend on the claimant’s status and the statute’s requirements. A.R.S. § 29-3410

California: good faith matters, but express discretion can still control

California recognizes an implied covenant of good faith and fair dealing, and the covenant can have particular importance when one party holds discretionary power that affects another party’s contractual rights. That principle should not be reduced to “every discretionary calculation is subject to a free-standing fairness review,” however.

In Third Story Music, Inc. v. Waits, the court held that the implied covenant did not restrict an unambiguous, express grant of discretion where the agreement was otherwise supported by adequate consideration. The court explained that an implied covenant cannot ordinarily be used to obliterate a right the parties expressly gave in their written agreement. The analysis can differ where a good-faith limitation is necessary to avoid an illusory promise, reconcile ambiguity, or effectuate the parties’ evident intent. Third Story Music, Inc. v. Waits, 41 Cal. App. 4th 798 (1995)

The practical lesson is not that California ignores good faith, or that express discretion automatically ends the inquiry. It is that the wording and structure of the agreement remain central. A participant should not assume that a court will add a limitation the contract clearly declined to include. An operator should not assume that an undefined discretionary power will be read without regard to the transaction’s overall bargain.

Texas asks a different question first

Texas does not recognize a general implied covenant of good faith and fair dealing in every ordinary arm’s-length commercial contract. The Texas Supreme Court rejected a universal implied covenant that would apply to all contracts simply because one party’s conduct affects another’s benefits under the agreement. English v. Fischer, 660 S.W.2d 521 (Tex. 1983)

For a straightforward contractual participation right, that makes careful drafting particularly important. A party should not assume that a court will supply a general good-faith limitation on the other side’s calculation discretion merely because the agreement gives that side substantial operational control.

But the entity structure can change the analysis.

Under Texas partnership law, a partner must discharge duties and exercise rights and powers in the conduct or winding up of partnership business in good faith and in a manner the partner reasonably believes to be in the partnership’s best interest. Tex. Bus. Orgs. Code § 152.204 For partnerships generally, the statute also provides that a partnership agreement may not eliminate that good-faith obligation, though it may establish standards for measuring performance if those standards are not manifestly unreasonable. Tex. Bus. Orgs. Code § 152.002

There is an important qualification. Senate Bill 29 added Texas Business Organizations Code § 152.002(e), which permits a limited-partnership agreement to eliminate the stated duties and obligation of good faith if the agreement expressly so provides. But new § 152.006 limits the statutory operation of § 152.002(e) to partnerships with a class or series of partnership interests listed on a national securities exchange. Section 152.006 also states that it does not prohibit a partnership from adopting agreement provisions that duplicate the effect of § 152.002(e), regardless of whether it is exchange-listed. The entity form, governing agreement, and exact source of the claimed payment right therefore remain central to the analysis. S.B. 29, §§ 21–22, 89th Leg., R.S. (2025)

That distinction is why a dispute should not be analyzed solely by asking whether a payment is called “profit participation.” The threshold question may be whether the arrangement is a bilateral contract, a general-partnership relationship, a limited partnership, an LLC arrangement, or something else.

Drafting questions to resolve before the first calculation

The percentage is only one part of a workable participation deal. Before signing, the parties should decide — and state in the agreement — answers to questions such as these:

• What revenue is included and excluded?
• Is the calculation cash-based, accrual-based, tax-based, GAAP-based, or based on a defined contractual method?
• Which direct costs may be deducted?
• Are overhead allocations permitted? If so, how are they calculated and capped?
• Can the operator charge management fees, owner compensation, or affiliate fees? Must they be disclosed or tied to a formula?
• How are capital expenditures, depreciation, amortization, reserves, write-offs, refunds, and bad debt treated?
• May losses from another project, product line, affiliate, or time period reduce the calculation?
• When are statements delivered and payments made?
• What supporting information accompanies a calculation?
• Who may inspect records, under what confidentiality protections, and at whose cost?
• How long does the participant have to raise a calculation objection?
• If there is a dispute, does the agreement require negotiation, an accountant determination, mediation, arbitration, or litigation?

The appropriate answers are commercial choices. The legal drafting work is making sure the agreement states those choices clearly, consistently, and in a way that fits the transaction’s entity structure and governing law.

A profit definition is also an allocation of control

A participation deal often looks simple because the percentage is simple. The definition of profit is where the control over the result is allocated.

If one party will operate the business and prepare the calculations, that can be a sensible arrangement. The agreement should then say what that party may decide, what it may deduct, what it must disclose, and how the other party can test the calculation. If the parties want flexibility, they can state the scope of that flexibility. If they want protection against a particular accounting treatment, affiliate charge, or reserve practice, they should address it directly.

The goal is not to predict every future disagreement. It is to make the decisions most likely to affect payment visible before a disagreement begins.

Need help with a participation agreement?

Accord & Shield Legal, PLLC drafts, reviews, and negotiates commercial agreements, including profit-participation arrangements and related transaction documents. A well-structured agreement can define the payment calculation, allocate decision-making authority, and establish reporting and dispute procedures that fit the parties’ business deal.

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