Earn-Out

An earn-out turns part of the price from a fixed number into a formula. The buyer pays a base price at closing and promises further payments if the business, now under the buyer's ownership, reaches targets set in the purchase agreement.

Earn-outs appear when the parties disagree about the future. A seller points to a strong pipeline or a new contract; a buyer prices only what the financial statements already prove, often as a multiple of normalized earnings such as seller's discretionary earnings. The earn-out lets the seller be paid for the upside if it actually arrives.

Unlike a vendor take-back note or a holdback, both compared below, an earn-out is contingent: if the targets are missed, the money is never owed. The metric and the maximum are usually first sketched in the letter of intent and then settled in the purchase agreement.

Every earn-out clause has to answer the same questions:

• Metric. Revenue is the hardest for a buyer to manipulate but ignores profitability. Gross profit and EBITDA reward margin but depend on cost allocations the buyer controls. Non-financial milestones, such as renewal of a key contract or retention of named customers, suit narrow risks.
• Measurement period. One to three years is common. Longer periods give the buyer more time to change the business, so the result says less about what the seller built.
• Target and formula. All-or-nothing targets invite disputes over the last dollar. A sliding scale between a floor and a ceiling reduces that pressure.
• Cap. The maximum total earn-out, which also fixes the top of the price.
• Accounting principles. Results should be calculated consistently with the business's historical policies, with listed exclusions: head-office overhead, integration costs, transaction expenses and buyer-imposed pricing changes.
• Payment and security. When each payment is due, interest if it is late, and whether it is subordinated to the buyer's bank.
• Set-off. Whether the buyer may deduct indemnity claims from earn-out payments.
• Acceleration. Whether the balance becomes payable if the buyer sells the business, merges it into another operation or ends the seller's role without cause.

Lamba Law's Vendor Take-Back and Earn-Out Calculator models how cash at closing, a vendor note and an earn-out combine, and what a contingent payment does to the buyer's debt service.

The structural problem is that the buyer controls the business while the seller's money depends on its results. Earn-out disputes usually trace back to one of three moves: the buyer folds the business into its own operations so separate results cannot be measured, shifts revenue or costs between entities, or underinvests during the measurement period.

Sellers answer with operating covenants: keep the business as a separate unit with its own books, maintain its name and key staff, fund it at an agreed level, and do not divert its customers or opportunities. Buyers resist covenants that freeze the business and offer instead a promise not to act with the purpose of reducing the earn-out.

Canadian contract law fills only part of the gap. The Supreme Court of Canada requires honest performance of contracts (Bhasin v. Hrynew, 2014 SCC 71) and, in Wastech Services Ltd. v. Greater Vancouver Sewerage and Drainage District, 2021 SCC 7, held that a contractual discretion must be exercised reasonably and for the purposes for which it was granted. Wastech also found that the party with discretion was not obliged to use it to help the other side reach a financial target the contract did not guarantee. A seller who wants the business run with the earn-out in mind needs that promise in writing. The duty of good faith in contracts entry explains both decisions.

Accounting disputes are the other flashpoint. A typical clause gives the buyer a deadline to deliver an earn-out statement, gives the seller access to books and working papers, sets a window for a notice of objection, and sends unresolved items to an independent accounting firm. The agreement should say whether that accountant acts as an expert or as an arbitrator, because the choice affects how the decision can later be challenged.

Share sales: the cost recovery method. Paragraph 12(1)(g) of the Income Tax Act includes in income any amount that depends on the use of or production from property, even if it is an instalment of the sale price. Because applying that rule, or valuing the earn-out right at closing, can produce unsatisfactory results, the CRA's archived Interpretation Bulletin IT-426R accepts a cost recovery method for share sales. The seller reduces the adjusted cost base of the shares as each amount becomes determinable and reports a capital gain once the cost base is used up. The conditions are:

• the parties deal at arm's length;
• the gain is clearly capital;
• the earn-out relates to goodwill whose value cannot reasonably be agreed at the sale date;
• the earn-out ends no later than five years after the end of the corporation's taxation year in which the shares are sold;
• the seller files the agreement, a request letter and an undertaking with the return for the year of sale; and
• the seller is resident in Canada.

Gains reported this way can still be sheltered by the lifetime capital gains exemption if the shares qualify. The CRA still applies these conditions in technical interpretations, although the bulletin is archived.

Reverse earn-outs. Here the price is stated at its maximum and reduced if targets are missed. The seller generally reports the maximum price in the year of sale, and a later reduction can produce a capital loss in a later year. In a 2013 technical interpretation, the CRA said a capital gains reserve is not available where a reverse earn-out leaves the proceeds uncertain. A net capital loss can be carried back only three years.

Asset sales. IT-426R does not cover asset sales. An earn-out measured by revenue or profit from purchased assets risks falling under paragraph 12(1)(g) and being taxed as income rather than as a capital gain, so the formula should be settled with tax advice.

The pieces also interact. If the buyer can set off indemnity claims against both the earn-out and the note, the seller's real exposure is larger than the indemnity cap suggests. For raising these points before the price is agreed, see our guide to negotiating a letter of intent as a seller.

Anika Sharma owns all the shares of a Mississauga managed IT services company with $2.0 million of recurring annual revenue. A strategic buyer agrees to a price of up to $3.2 million but will pay only $2.4 million at closing, because two large clients are up for renewal. The remaining $800,000 is an earn-out: $400,000 for each of the first two years, paid in full if recurring revenue reaches $2.1 million, nothing below $1.8 million, and pro rata in between.

Anika negotiates three protections: the business stays a separate subsidiary with its own books; the buyer will not migrate the company's clients to its own service platform during the earn-out; and the unpaid balance accelerates if the buyer sells the subsidiary. Disputes go to an independent accounting firm acting as an expert.

Year one recurring revenue is $2.2 million, so she receives $400,000. In year two the buyer moves 25 clients to its platform and recurring revenue falls to $1.95 million. The formula would pay $200,000, but Anika objects that the migration breached the covenant. With the separate books showing the lost revenue, the parties settle at $350,000.

The sale met the CRA's conditions, and Anika's accountant filed the request letter, agreement and undertaking with her return for the year of sale. Her shares had a nominal cost base, used up by the closing payment, so under the cost recovery method each earn-out payment was reported as a capital gain in the year it became determinable.