Clawback Provisions: Negotiating Now to Optimize Long-Term Benefit
Negotiating a suite of incentives for development projects is about more than striking a positive agreement from the outset; it’s also about ensuring that the financial benefits of the deal are preserved and not reduced over the lifetime of the project.
On the upside, clawback provisions link businesses and government agencies as shared stakeholders, reinforcing the commitment of both parties to common objectives. For businesses, however, poorly negotiated clawback provisions can create significant downside risk, particularly when markets are cyclical or local economies tend to fluctuate rapidly. What local agencies may appear to concede up front, they may recoup down the road by claiming lower than required performance against contractually agreed metrics.
What are some of the key strategies you should use when negotiating clawback provisions? Here are a few: Know the parties with whom you are negotiating, narrow the scope of the proposed provisions, and simplify reporting requirements. In addition, you should embed flexibility, in terms of timeframes and performances measures, into the agreement and, finally, ensure that your deal stands the test of time and changing government administrations.
Know the Economic Development Negotiators’ Mindset
State and local economic development agencies and officials vary significantly in their level of sophistication. Before beginning the negotiation process, do your research. Look at deals that have been negotiated previously, assess agency processes and internal resources, and gain a clear understanding of their primary objectives.
Listen to the questions being asked by top-level leadership, but also pay attention to questions that relate directly to state and local taxable income (or lack thereof) that are coming from key staff whose task it will be to calculate economic impact and enforce the clawbacks. From the moment the conversation begins, and long before negotiating the details, you can learn a lot about the level of sophistication of your counterparts by the questions they ask.
Identify the source of the funds allocated to the project. A substantial deal is normally negotiated from the office of the secretary of commerce who manages in-house programs. However, funds may rely on any number of other programs available through different state agencies or additional local governments. For the most part, you want to avoid clawbacks associated with capital programs or from other public agencies that are not included in the final project performance agreement, especially when those incentives are coming from existing programs that are simply reallocating funds.
Be prepared to negotiate firmly but fairly. Besides inking a deal, your company and the development agency are partners in creating a rewarding, sustainable future. Win-win agreements are almost always better than deals in which there are clear winners and losers or they may be deemed to create an unfair competitive advantage for your project over incumbent companies in the area.
Narrow Scope and Simplify Reporting
The broader the clawback provisions, and the more complex the metrics to which they are tied, the higher the likelihood that a business may have difficulty attaining the required levels of performance. To lower your risk, negotiate terms that focus on a limited set of measures and require simple, straightforward reporting.
For example, clawbacks should only be for items solely used for the project since you don’t want to obligate your organization into paying money back for things that are shared for public use. In addition, should some type of public infrastructure be offered that will require additional capital investment for the project, ensure that clawback provisions allow for a credit to be applied toward overall clawbacks to offset the capital improvement invested by the company.
Avoid onerous reporting obligations. For example, simplify job-creation reports by basing them on wages paid, not jobs, and reporting on the same forms that are reported to the department of labor. Accounting for capital investments may be somewhat less straightforward than tallying wages paid, but existing financial reporting forms and schedules (and their related metrics) can be used to demonstrate performance of specific obligations. For instance, if the project requires that a facility be built, your initial estimates for construction may be higher than what is ultimately expended simply due to good management by your project team. In instances such as this, commit to constructing the building, rather than investing a specific amount for the building. In this manner, if the building ultimately comes in at 95 percent of the original cost, you should not be penalized in the form of clawbacks. Tie the overall clawback to either wages paid or order of magnitude of the investment, but not both.
Embed Flexibility Into Agreements
We all know that the only constant is change. So why negotiate deals that assume that today’s economic and business conditions will remain static over the next year, five years, or decade?
Start at the top, by thinking about events that are truly out of your control. Among other things, the recent Caribbean hurricane season and its devastating impact on Texas, Florida, Puerto Rico and elsewhere serves as a good reminder to insert a force majeure clause into any development agreement. You don’t want to be held to performance obligations when unforeseen causes make those goals inadvisable, impractical, or simply impossible.
Besides inking a deal, your company and the development agency are partners in creating a rewarding, sustainable future. Market conditions often ebb and flow. For wages paid over a length of time, consider including a reserve option that allows you to count wages paid in excess of the agreed amount, within a specific period, toward future commitments. Another option may be to create a “bank” of wages from the outset, against which you can borrow during a given timeframe. You may also want to avoid having wage payment commitments for concurrent years of the agreement (i.e., make a wage commitment for full employment within five of the next seven years after ramp-up); wages paid during “off” years could be applied retroactively or to future reporting periods.
The fact that “there are no straight lines in business” doesn’t always count against a company. Favorable conditions can help accelerate positive results. Get an early-out clause so that the terms of the agreement are fulfilled even if you achieve performance objectives ahead of schedule. Conversely, it can also be helpful to include a hold clause, enabling you to put the project on hold for a period of time.
For funds needed for project investment, if you anticipate needing more money up front, try negotiating longer-term commitments for the back end of the deal. This will allow for a greater level of financial security during the earlier, ramp-up phases of a project. In addition, even with a new building, each year will require some level of capital maintenance or improvement. Calculate and utilize this lifetime of project investment to your advantage, especially when these additional expenditures are taxable.
When Administrations Change, Your Agreement Should Not
Although some of today’s voters may disagree, election cycles are relatively fast. Sooner than you think, you may find that a city, county, or state is under new leadership that has a new set of political and economic development priorities.
Make every effort to ensure that the commitments made by both parties transcend changes in an administration. The rules that applied on day one of the agreement should apply for the full term of the project, and not for the term of the political officials who sign the contract.
Perhaps most important, avoid boxing yourself in such a manner that you are not able to take advantage of other tax-incentive programs in the future. Participation in one economic development initiative with a few government agencies (commerce and an educational institution, for example) should not preclude you from exploring and taking advantage of future opportunities offered by other agencies (such as a transportation department).
In the end, fine-tuning clawback provisions should not be an overly onerous part of the negotiation process or impede agreement on mutually beneficial economic development projects. Done right, clawbacks can help incentivize government agencies and businesses alike to create jobs, improve profitability, and contribute to health of the economy.
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