PROTECTING YOUR EARNOUT

Protecting Your Earnout: What Canadian Business Owners Need to Know Before Signing

A practical guide to negotiating share purchase agreements when part of your sale price depends on future EBITDA performance

If you're selling your Canadian business for $5 to $50 million, there's a good chance your buyer will propose an earnout structure. The pitch sounds reasonable: "We'll pay you X at closing, plus additional payments if the business hits EBITDA targets over the next 2-3 years."

But here's what keeps M&A advisors up at night: once you sign that share purchase agreement and hand over the keys, you lose control of the business. The new owners can implement policies, shift costs, redirect revenues, and make decisions that, intentionally or not, make hitting those EBITDA targets nearly impossible.

The stark reality: Earnout provisions appeared in 33% of Canadian private M&A deals in 2021, yet disputes over these arrangements are increasingly common. Even worse, the protective covenants that traditionally insulated sellers from earnout risks are becoming less popular in Canadian transactions.

This article provides a practical roadmap for protecting yourself when earnouts are tied to EBITDA, the metric most susceptible to buyer manipulation.

Why EBITDA-Based Earnouts Are Particularly Risky

Revenue is difficult to hide. But EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)? That's a different story.

After closing, a buyer can legitimately, or questionably, reduce EBITDA by:

Loading the business with acquisition debt and associated interest costs
Allocating corporate overhead from other divisions to your former business
Front-loading R&D, marketing, or capital expenditures
Transferring profitable contracts to other business units
Changing accounting policies or revenue recognition practices
Increasing management compensation or consultant fees

If an earnout is tied to EBITDA, a buyer can deflate the earnout amount by overspending on R&D, advertising, marketing, product development, excessive salaries to insiders, and so on. Some of these expenses reap benefits years into the future but reduce EBITDA now.

The challenge? Many of these actions could be justified as reasonable business decisions. That's why you need explicit contractual protections, not just trust and handshakes.

The Canadian Good Faith Context: What Bhasin Means for Your Deal

Unlike some U.S. jurisdictions where earnout law is well-established, Canadian earnout protections are evolving. The landmark case you need to know about is Bhasin v. Hrynew (2014), where the Supreme Court of Canada changed the game.

In Bhasin, the Supreme Court established that good faith is an "organizing principle" within Canada's common law of contract, creating a duty of honest performance that applies to all commercial contracts, including earnout provisions.

What this means for you: Buyers must refrain from misleading or lying to sellers about actions being taken regarding the earnout.

What it doesn't mean: Purchasers have no duty to work towards an earnout after taking over the business in Canada, but are likely bound by the implied duty of good faith performance not to actively frustrate earnouts except as a consequence of legitimate business decisions.

Translation: The buyer can't deliberately torpedo your earnout through deception, but they also don't have to maximize it. They can make business decisions that happen to reduce your earnout, as long as those decisions are legitimate.

Provincial Note: Quebec's Civil Code expressly recognizes a duty of good faith in contract performance (Articles 6, 7, and 1376), while in common law provinces (all provinces except Quebec), the strength of good faith claims is less clear, though courts are increasingly recognizing such obligations.

Bottom line: Don't rely on implied good faith to protect you. You need explicit, detailed contractual protections.

The Five Critical Protections Every Canadian Seller Should Negotiate

"Ordinary Course of Business" Operating Covenants

This is your foundation. The agreement should require the buyer to operate your business the same way you did during the earnout period.

The seller should ask the purchaser for covenants that, during the earnout period, the business will be run in a manner that represents the ordinary course, and may require the purchaser to obtain the seller's consent for any material changes to the business during that time.

Canadian market practice: Most Canadian agreements include a covenant to conduct business in ordinary course, typically qualified that conduct be consistent with past practices. What differs in Canadian practice from U.S. practice is that Canadian deals are more likely to include an efforts standard.

What to negotiate:

Business must be run "consistent with past practice" for the 12 months pre-closing
No material changes to business model, pricing, or marketing without your consent
Maintenance of adequate working capital
No transfer of contracts, costs, or revenues to/from other business units
Continuation of relationships with existing suppliers and customers

2. Detailed EBITDA Calculation and Expense Exclusions

The devil is in the details. You need crystal-clear definitions of what counts toward, and against, your EBITDA target.

Essential elements:

The drafting should account for potential changes to the business itself, such as shared usage of assets, new products or service offerings introduced after closing, and post-closing acquisitions. A model calculation included as an exhibit or schedule to the purchase agreement could assist in clarifying expectations.

Expenses to exclude from EBITDA calculation:

Integration costs and one-time expenses outside ordinary course
Interest on acquisition debt or new financing
Costs from buyer's other divisions allocated to your business
Tax implications from new ownership structure
Extraordinary or non-recurring expenses
Depreciation or amortization increases due to purchase accounting

Accounting hierarchy to specify:

Specific adjustments expressly agreed between parties
Accounting policies used in your pre-sale financial statements
GAAP/IFRS as fallback

Pro tip: Include a model earnout calculation as an exhibit showing exactly how numbers flow through the formula under different scenarios.

3. Governance Rights and Approval Mechanisms

If possible, maintain some control during the earnout period.

Earnout provisions can require the seller to have a contractual approval right or veto right over certain major decisions and include specific covenants for the purchaser during the earnout period.

Options to negotiate:

Board seat: Retain a board position during the earnout period
Approval rights: Unanimous consent required for major decisions (acquisitions, divestitures, significant capex, changes to product lines)
Minority shareholding: Retain equity with protective provisions in a shareholders' agreement
Information rights: Monthly financial statements, quarterly reviews, access to books and records
Management continuity: Key operational personnel must remain with approval over compensation changes

The seller may consider adding a liquidated damages amount if the purchaser breaches any covenants relating to the ongoing operation of the target business during the earnout period.

4. Acceleration Triggers

Sometimes the best protection is immediate payment. Negotiate for the full earnout to become due immediately if certain events occur.

The purchase agreement may provide for the earnout payments to be immediately due to the seller upon: bankruptcy or insolvency of the purchaser, termination of key employees of the target business, breach of covenants by the purchaser, actions detrimental to the financial well-being of the business, or sale of the acquired business or a significant amount of its assets.

Typical acceleration events:

Change of control (buyer sells the business)
Buyer bankruptcy or insolvency
Material breach of operating covenants
Sale of substantial assets (typically 25%+ threshold)
Termination of you or key management without cause
Buyer fails to maintain adequate working capital

Market reality: Acceleration upon change of control is not standard market practice in Canada, but that doesn't mean you shouldn't ask for it, especially in a seller's market.

5. Financial Security for Payment

An earnout is only valuable if the buyer can actually pay it.

To provide comfort that the earnout will be paid, the seller can require cash to be set aside by the purchaser, may ask for personal guarantees or security over the payment obligations, and should conduct due diligence on the purchaser to confirm its creditworthiness.

Protection mechanisms:

Escrow: Hold portion of cash consideration in escrow to cover minimum earnout
Personal guarantees: From buyer's principals or parent company
Security interest: Charge on business assets or buyer's shares
Parent guarantee: If buyer is a subsidiary, get parent company guarantee
Interest on late payments: Meaningful rate to incentivize timely payment

Due diligence: It is strongly advisable for the seller to conduct due diligence on the purchaser to determine its creditworthiness, as the seller will be relying on the purchaser to pay the earnout if and when due.

Additional Critical Provisions

Indemnity Offset Limitations

Here's a trap many sellers fall into: the buyer withholds earnout payments to cover indemnification claims, even disputed ones.

Canadian market practice: Unlike U.S. practice where offset provisions are standard, Canadian agreements are equally likely to either expressly permit offsets or be silent on this point.

What to negotiate:

No offset rights, or
Offsets only for finally determined claims (after dispute resolution), or
Cap offset rights at 50% of earnout payment

Dispute Resolution That Works

Parties should be mindful of blindly subjecting disputes over earnout provisions to a binding determination by an independent accountant. Instead, earnout payments should be subject to a dispute resolution process and arbitration if a negotiated resolution is not possible, as many disputes require a determination of contested facts and whether parties have acted in good faith.

Recommended structure:

Objection period: 30 days to review buyer's earnout calculation
Good faith negotiation: 30 days for parties to resolve disputes
Independent expert: For pure accounting/calculation disputes
Arbitration: For covenant breaches and good faith questions
Fee allocation: Loser pays, or proportional based on outcome

The Effort Standard Spectrum

The agreement will specify what standard of conduct applies to the buyer. This is highly negotiable and critically important.

Buyer-favorable (weak seller protection):

Buyer operates business "in its sole discretion"
Covenant not to act in "bad faith" or with "specific intention" of reducing earnout

Middle ground:

Operate business "in good faith"
"Commercially reasonable efforts" to achieve earnout

Seller-favorable (strong protection):

"Best efforts" or "reasonable best efforts" to achieve earnout targets
Operate "consistent with past practice"
Specific operational requirements and limitations

Reality check: In 2022, only 23% of U.S. transactions included requirements to run the business according to seller's past practices, and just 1% included covenants to maximize the earnout. Canadian practice is similar. You'll need to push for these provisions, they won't be offered.

Practical Recommendations for the $5-50M Market

Minimize Earnout Exposure

Best advice: Try to minimize the earnout portion of your deal.

It will generally be in the seller's interest to minimize both the portion of the purchase price subject to the earnout and the period of time in which the earnout occurs.

Target: Keep earnout below 20-25% of total consideration if possible.

2. Consider Revenue Over EBITDA

If you must accept an earnout, negotiate for revenue-based rather than EBITDA-based metrics. Revenue is much harder to manipulate.

Compromise position: Gross margin (revenue minus direct costs) as a middle ground.

3. Use a Sliding Scale

Earnouts can be "all or nothing" depending on if the threshold is met, or calculated on a sliding scale, which can reduce the likelihood of dispute.

Example: Rather than "$2M if EBITDA exceeds $10M, otherwise zero," negotiate "$1M at $9M EBITDA, scaling to $2M at $10M EBITDA."

4. Keep the Earnout Period Short

Longer earnout periods mean:

More time for the buyer to manipulate results
Greater risk of business changes beyond anyone's control
More opportunity for disputes

Target: 1-2 years maximum. If longer than 2 years, insist on annual payments rather than one lump sum.

Tax consideration: For Canadian tax purposes, CRA requires earnouts end within 5 years of the taxation year in which shares are sold.

5. Get Expert Advisors Involved Early

This isn't the place to cut corners on professional fees.

You need:

M&A lawyer with earnout experience (not your corporate lawyer)
Tax advisor for structuring and CRA reporting requirements
Financial advisor to model different scenarios
Accountant to help define EBITDA calculation precisely

As the structure of an earnout may cause certain tax consequences, parties ought to consult with tax and/or accounting specialists.

6. Document Everything Outside the Agreement

Parties should ensure that documents outside the M&A agreement (term sheets, letters of intent, board presentations, etc.) clearly and consistently describe how earnout payments will be calculated, as such extrinsic evidence may be used to interpret ambiguous provisions.

Why it matters: If there's a dispute, courts will look at the full context. Make sure your email trail, term sheets, and presentations align with the final agreement.

7. Watch Your Post-Closing Conduct

If you're staying on during the earnout period (which is common in the $5-50M market):

The buyer should be mindful of post-closing conduct, as such conduct will not only impact an assessment of compliance with covenants, but may also be used to interpret any ambiguity in the M&A agreement.

This cuts both ways,your actions during the earnout period may be scrutinized if there's a dispute.

Real-World Example: What Can Go Wrong

In Main Market Partners v. Olon Ricerca Bioscience, a U.S. federal court found potential bad faith where the buyer: steered business to its parent company, delayed customer payments, incurred unreasonable strategic costs, failed to track costs properly, and obscured expenses.

The business didn't meet its EBITDA target. No earnout was paid. The seller sued. The court allowed the claim to proceed based on these allegations.

The lesson: Even with an earnout agreement in place, you may face expensive litigation to collect what you're owed. Better to prevent the problem than to litigate it.

The Bottom Line for Canadian Business Owners

Earnouts are increasingly common in the $5-50M Canadian M&A market. They can be a useful tool to bridge valuation gaps and get deals done. But they're also complex, easily manipulated, and frequently disputed.

If you must accept an earnout structure tied to EBITDA:

Negotiate explicit, detailed protections, don't rely on good faith or trust
Minimize the earnout percentage of total consideration
Keep the period short; 1-2 years maximum
Get comprehensive legal and financial advice before signing
Consider revenue-based metrics instead of EBITDA if possible
Build in acceleration triggers for key events
Secure the payment through escrow, guarantees, or security interests

Remember: The covenants protecting sellers that would normally insulate them from earnout risks are becoming less popular in Canadian transactions. This means buyers are pushing for more control and fewer restrictions. Don't accept the first draft, negotiate hard for these protections.

Your business took years or decades to build. Don't leave money on the table by signing a share purchase agreement with weak earnout protections. The time to protect yourself is during negotiations, not after you've handed over the keys.