Earn-outs in an Ontario business sale:
how they work and where they go wrong
An earn-out closes the gap when a buyer and seller can't agree on what the business is worth. It also ties part of the price to a business the seller no longer runs, which is why the wording matters more than the headline number.
The seller says the business is about to have its best years. The buyer says it will pay for results it can see. An earn-out lets both of them sign: a fixed amount at closing and more later if the business performs.
An earn-out is a part of the purchase price that's paid after closing only if the business meets agreed targets, usually revenue or profit over one to three years. It moves risk from the buyer to the seller, and most earn-out disputes come from the same place: the buyer now controls the business that decides what the seller gets paid.
This article is general information, not legal, tax or valuation advice. Earn-out terms are specific to each deal. Have the clause reviewed by a lawyer and an accountant before you sign a letter of intent that mentions one.
How does an earn-out work?
The purchase agreement sets a target, a measurement period, and a formula for what the seller is paid if the target is met. A simple example: the buyer pays most of the price at closing and agrees to pay an extra amount for each of the next two years in which revenue exceeds an agreed figure. After each year the buyer prepares a statement showing the result, the seller has a set time to review it and object, and any payment follows.
Earn-outs show up most often where the value is hard to prove in advance: a business that's growing fast, one that depends on a few large customers, one where the seller's relationships are the main asset, or one with a new product that hasn't sold yet.
What should an earn-out be measured on?
The simpler and harder to adjust the metric, the fewer disputes. Revenue is the simplest. Profit measures are fairer to the buyer but need much more drafting.
| Metric | Usually preferred by | Main risk |
|---|---|---|
| Revenue or gross sales | Seller | Buyer pays for sales that weren't profitable. Needs rules on discounts, returns and uncollected accounts. |
| Gross profit | Either | Depends on how cost of goods is defined and whether the buyer changes suppliers or pricing. |
| EBITDA or net income | Buyer | Buyer controls expenses. Head-office charges, new salaries and accounting changes can erase the payment. |
| Milestones | Either | All or nothing. Works for clear events such as renewing a key contract or keeping a named customer. |
Whatever the metric, the agreement should say how it's calculated: the accounting standard, that it's applied consistently with the seller's past practice, and a list of specific items that are included or left out. A worked example attached as a schedule prevents a lot of arguments. An accountant should help write this part.
Who controls the business during the earn-out period?
The buyer does, unless the agreement limits it. After closing the buyer can change prices, cut the sales team, move customers to another company it owns or merge the business into a larger one. Any of those can sink the earn-out without the buyer doing anything it wasn't entitled to do as owner.
Sellers protect themselves with operating covenants. Common ones:
- Run the business in the ordinary course, consistent with how it was run before closing.
- Keep it separate, or at least keep separate books, so the results can still be measured.
- Don't divert customers, staff or opportunities to the buyer's other businesses.
- Maintain agreed resources, such as a minimum marketing budget or headcount.
- Charge only agreed overhead to the business when profit is the metric.
- No action taken mainly to reduce or avoid the earn-out.
Buyers resist long lists because they've just paid for the right to run the business. The usual compromise is a short set of specific promises plus the general one in the last bullet.
Does the buyer have a duty to help the seller earn the payment?
Not a general one. Canadian law requires honesty in performing a contract, but it doesn't require the buyer to run the business for the seller's benefit.
The Supreme Court of Canada recognized a duty of honest performance in Bhasin v. Hrynew (2014) and applied it in C.M. Callow Inc. v. Zollinger (2020): a party can't lie to or knowingly mislead the other about matters linked to performing the contract. In Wastech Services Ltd. v. Greater Vancouver Sewerage and Drainage District (2021), the Court added that a discretion given by a contract has to be exercised in good faith, meaning in a way connected to the purposes it was given for.
Those duties are a backstop. They don't stop a buyer from making honest business decisions that happen to reduce the earn-out, and proving bad faith is hard and expensive. A seller is far better off with a specific covenant the buyer has clearly breached than with an argument about good faith.
Been offered an earn-out, or thinking of proposing one?
Have the clause reviewed before the letter of intent locks in the structure. Free 30-minute consultation.
How does a seller make sure the earn-out actually gets paid?
By treating it like a debt: get information rights, security and clear consequences for non-payment. The main protections are:
- Information rights: regular financial reports and the right to inspect the books behind each earn-out statement.
- Security: a general security agreement over the business assets, registered under the Personal Property Security Act, a guarantee from the buyer's owner or parent, or funds in escrow.
- Acceleration: the remaining earn-out becomes payable if the buyer resells the business, becomes insolvent or breaches the operating covenants.
- Limits on set-off: whether the buyer can deduct indemnity claims from earn-out payments, and if so, only for claims that are agreed or finally decided.
- A floor or a sliding scale, so missing a target by a small amount doesn't wipe out the whole payment.
If the seller is staying on to run the business, the employment or consulting agreement matters just as much. A seller who can be dismissed without cause halfway through the earn-out period has lost the ability to hit the target. The agreement should say what happens to the earn-out if that occurs.
What does the buyer need in an earn-out clause?
Freedom to run the business, a cap on what's payable, and a metric that can't be inflated at the buyer's expense. Buyers usually ask for a maximum total earn-out, an express statement that the buyer has discretion over operations and owes no duty to maximize the payment beyond the listed covenants, the right to set off established indemnity claims, and rules that stop short-term tactics such as deep discounting to pull revenue into the measurement period.
A buyer should also be honest with itself about integration plans. If the business will be folded into existing operations within a year, an earn-out based on its stand-alone profit will be nearly impossible to measure, and a different structure is probably better.
How are earn-out disputes resolved?
Calculation disputes usually go to an independent accountant, whose decision is final. Disputes about whether the buyer broke its promises go to court or arbitration.
The agreement should set out the steps: the buyer delivers an earn-out statement by a deadline, the seller has a fixed period to deliver a written objection, the parties try to settle it, and anything left goes to a named accounting firm or one chosen by an agreed method. It should also say who pays the accountant and that undisputed amounts are paid in the meantime. Keeping the two kinds of dispute separate matters. An accountant can decide whether an expense was properly counted. An accountant isn't the right person to decide whether the buyer acted in bad faith.
What are the alternatives to an earn-out?
A vendor take-back loan, a holdback, or having the seller keep a minority stake can each bridge a price gap with less room for dispute.
- Vendor take-back financing: the price is fixed and the seller lends part of it to the buyer. The seller is owed the money whatever the results are.
- Holdback or escrow: part of the price is held to cover specific risks, such as a customer not renewing, and released if the risk doesn't happen.
- Retained equity: the seller keeps some shares and benefits from future growth as an owner, with a shareholders' agreement setting out the exit.
- A price adjustment at closing based on the most recent results, for gaps that are really about the last few months.
The guide to valuing a small business explains where price gaps come from. A Chartered Business Valuator can sometimes narrow the gap enough that no earn-out is needed.
When should the earn-out be negotiated?
At the letter of intent stage, at least for the metric, the period, the maximum and the main seller protections. A letter of intent that says only "plus an earn-out of up to" a stated figure leaves every hard question for later, when the seller has less leverage and both sides have spent money on the deal. The guide to letters of intent and term sheets covers what's binding at that stage and what isn't.
The full mechanics then go into the share purchase agreement or asset purchase agreement. Tax treatment should be settled with an accountant at the same time, because the way an earn-out is drafted can change how the seller's proceeds are taxed.
Key takeaways
- An earn-out is deferred, conditional price. The seller carries the risk that the targets are missed or the money isn't paid.
- Pick a metric that's hard to argue about. Revenue is simplest. Profit measures need detailed accounting rules and a worked example.
- Control belongs to the buyer unless the agreement includes operating covenants.
- Good faith is a backstop. Specific written promises are what a seller can enforce.
- Secure it and plan for disputes. Security, acceleration and an independent accountant process belong in the agreement from the start.
Frequently asked questions
What is an earn-out?
An earn-out is a part of the purchase price that the buyer pays after closing, and only if the business hits agreed targets. The seller gets a fixed amount at closing and can earn more over the following one to three years, depending on results such as revenue or profit.
Is an earn-out good for the seller or the buyer?
It shifts risk to the seller. The buyer pays the extra amount only if the business performs, while the seller waits for the money and depends on a business they no longer control. A seller who believes in the business can end up with a higher total price, but the wording of the agreement decides whether that money is realistic to collect.
How long do earn-outs usually last?
One to three years is typical for small and mid-sized businesses. Longer periods make the result depend more on the buyer's decisions and less on the business the seller built, and they keep the two sides tied together longer.
Should an earn-out be based on revenue or profit?
Sellers usually prefer revenue because it's hard to manipulate and easy to measure. Buyers usually prefer a profit measure such as EBITDA because revenue can be bought with discounts. If profit is used, the agreement needs detailed rules on how expenses are counted, or the buyer's accounting choices can erase the payment.
Does the buyer have to try to hit the earn-out targets?
Only to the extent the agreement says so, plus the duty of honest performance that applies to every contract in Canada. A buyer generally isn't required to put the seller's earn-out ahead of its own business judgment. If the seller wants the business run a certain way during the earn-out period, that has to be written into the agreement as a covenant.
What happens if the buyer sells the business during the earn-out period?
Whatever the agreement says. Without a clause, the seller may be left chasing a new owner or measuring a business that has been merged out of recognition. Sellers usually ask for the remaining earn-out to become payable in full, or at an agreed amount, if the buyer resells or there's a change of control.
Can an earn-out be secured?
Yes. A seller can ask for a general security agreement over the business assets, a guarantee from the buyer's owner or parent company, part of the price held in escrow, or a combination. An unsecured earn-out is only as good as the buyer's ability and willingness to pay.
How is an earn-out taxed in Canada?
It depends on whether shares or assets are sold and how the earn-out is drafted, and the difference can be significant. Some earn-outs can affect capital gains treatment and the timing of tax. Have an accountant review the earn-out clause before the letter of intent is signed, not after.
Talk to a Toronto business lawyer about an earn-out
Jonathan Kleiman acts for buyers and sellers of Ontario businesses, from small owner-operated shops to multi-million dollar deals, and negotiates and drafts earn-out terms as part of the purchase agreement. Book a free 30-minute consultation and bring the letter of intent or the draft clause.
Negotiating an earn-out?
Bring the letter of intent or the draft clause. Jonathan Kleiman helps Ontario buyers and sellers set the metric, the protections and the dispute process before signing. Free 30-minute consultation.