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The risk and the reward of an earnout when selling your Canadian

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Most Canadian business owners encounter the word “earnout” for the first time when a buyer puts one on the table. By then, the owner is negotiating in real time, often without the vocabulary to push back. The owners I meet through Selling Your Canadian Business tend to land in one of two camps. Some dismiss the earnout as a buyer trick. Others accept it as the price of getting a deal done. Both reactions cost money.

An earnout is a contractual mechanism that ties a portion of the purchase price to the future performance of the business after closing. The seller receives a fixed amount on closing, and additional contingent amounts over a defined post-closing period if the business hits negotiated targets. Used well, it can lift the total price the seller realizes. Used badly, it can leave the seller with less than the deal looked like on paper.

This is not a fringe deal feature. Earnout provisions appeared in 28 per cent of surveyed Canadian private M&A deals in 2023, and the 2024 SRS Acquiom Private Deal Terms Study found 33 per cent of U.S. deals included an earnout. In the Canadian lower middle-market, owners selling a business with $5 million to $50 million in annual revenue should expect to see one offered.

What an earnout is meant to do

Earnouts exist because buyers and sellers rarely value the same business at the same number. The seller looks at what the business could become. The buyer looks at what it has already produced. The gap between those two views is the valuation gap, and an earnout bridges it without forcing either side to concede.

The mechanics are straightforward. A portion of the purchase price is held back. Over a defined period after closing, typically 12 to 36 months in Canadian transactions, the business must achieve negotiated performance targets. If the targets are met, the seller receives the contingent payments. If the targets are missed, the seller receives less, or nothing, on that portion.

The targets can be financial, such as revenue, gross margin or EBITDA. They can be operational, such as customer retention, regulatory approval or the closing of a specific contract. The choice of metric matters enormously, for reasons explained below.

The reward side

For a seller, three benefits make an earnout worth considering.

First, a higher headline price. An earnout lets the seller capture upside the buyer is not willing to pay for at closing. If the business performs as the seller believes it will, the total consideration can exceed what the buyer would have paid in an all-cash deal. In a typical lower middle-market transaction, the earnout portion of the purchase price usually represents between 15 and 30 per cent of the total purchase price, although in some cases it can be 50 per cent or more.

Second, a wider field of buyers. Earnouts can broaden the bidder pool because a buyer who could not justify the seller’s asking price in cash may be willing to commit if part of the price depends on future results. More bidders means more competitive tension, which usually lifts the certain portion of the price as well.

Third, a possible tax advantage. Under the Canada Revenue Agency’s cost recovery method, earnout amounts received are effectively treated as capital gains in the year the amounts become determinable. This treatment is available only on share sales, and only where specific conditions are met, including that the parties are at arm’s length, the gain is clearly capital in nature, and the earnout feature ends no later than five years after the end of the taxation year in which the shares are sold. The mechanics are set out in CRA Interpretation Bulletin IT-426R, Shares Sold Subject to an Earnout Agreement. Sellers contemplating an earnout should retain Canadian tax counsel before signing anything. The wrong structure can convert what should be a capital gain into fully taxable income.

The risk side

The risk side is where most sellers underestimate the exposure.

The first risk is that the earnout pays less than expected, or not at all. A widely cited industry study found that less than 60 per cent of deals with an earnout resulted in either a partial or full payment. Four out of 10 sellers received nothing on the contingent portion. This does not mean the earnout was a bad bargain at signing. It means the seller bore the performance risk, and the performance did not materialize.

The second risk is loss of control. The moment the deal closes, the buyer owns the business. The buyer chooses where to invest, how to price, who to hire, what to integrate and what to discontinue. Each of those decisions can move the earnout metric. An earnout structure can restrict the buyer’s management of the acquired business and limit or delay post-acquisition integration, and during the earnout period short-term decisions may be prioritized differently than in a deal without an earnout. Sellers without strong contractual protections find themselves watching the buyer take perfectly defensible business decisions that nonetheless shrink the earnout.

The third risk is dispute. Disputes are less likely to arise when terms are highly specific, and yet many earnout provisions are drafted at a level of generality that invites litigation. Canadian and Delaware courts have heard seller claims that buyers diverted revenue, deferred contract wins, raised prices to unaffordable levels, declined to negotiate distribution terms favourable to the seller, or restructured the business in ways that frustrated the earnout. The pattern is clear: where the contract is vague on what the buyer may and may not do, sellers and buyers fight about it. Litigation costs money and time, and most sellers do not want either after they have already left the business.

Recent Canadian case law shows how technical these disputes become. In Project Freeway Inc v. ABC Technologies Inc., 2025 ONSC 1048, the Ontario Superior Court interpreted an accelerated earnout provision and observed that commercial realities matter, that courts will not favour an interpretation that leads to a commercially absurd outcome, and that disputes are less likely to arise when terms are highly specific. Generic earnout language is not protection. It is exposure.

How sellers can shift the odds

A seller who decides to accept an earnout should do four things before signing.

First, choose the metric with care. Top-line revenue is harder for the buyer to manipulate than EBITDA, which is sensitive to cost allocations, intercompany charges and management fees the buyer may impose post-closing. Operational milestones, such as a regulatory approval or a customer renewal, are cleaner still where they apply.

Second, write the covenants. The contract should spell out what the buyer can and cannot do during the earnout period. Possible acceleration triggers include a subsequent sale or change in control of the buyer or the acquired business, a material change by the buyer in the nature of the acquired business, the buyer’s failure to retain the key management team, and the buyer’s breach of material obligations to the seller.

Third, secure the payment. Where the buyer’s credit is uncertain, sellers should consider negotiating that a portion of the earnout amount be held in escrow, backed by a parent guarantee, or charged against assets of the buyer.

Fourth, get the tax structure right at the front end. The choice between a classic earnout and a reverse earnout, and the question of share sale versus asset sale, will determine whether contingent payments are taxed at capital gains rates or at full marginal rates. The CRA has stated that the entire amount received by a vendor under a reverse earnout should be capital, and paragraph 12(1)(g) of the Income Tax Act should not apply, where the maximum purchase price represents the fair market value of the property sold and there is a reasonable expectation at the time of the sale that the conditions or milestones would be met. The structural choice belongs at the term sheet stage, not at closing.

The honest summary

An earnout is neither a gift nor a trap. It is a risk transfer mechanism. The seller takes on performance risk in exchange for the chance at a higher total price. The buyer takes on payment risk in exchange for protection against overpaying. Whether the trade is worth making depends on the business, the buyer, the metric, the period and the words on the page.

The owners who do well with earnouts negotiate the protections that increase the chance the contingent payment arrives, choose metrics that align with how the business will be run after closing, and price the certain portion of the deal so the outcome at closing is acceptable on its own. The owners who do badly assume the earnout will pay in full and discover, two or three years later, that it did not.

Selling Your Canadian Business: A Step-by-Step Guide to Maximizing Value and Securing Your Legacy covers earnout structures, valuation gaps, deal protections and the full sale process in detail.

Read a free sample or order at Amazon.ca: amazon.ca/dp/B0GFXWJVXQ.

Sources

  1. Aird & Berlis LLP, Closing the Value Gap: Examining the Utility of Earnout Provisions in M&A Transactions (July 16, 2024). https://www.airdberlis.com/insights/publications/publication/closing-the-value-gap--examining-the-utility-of-earnout-provisions-in-m-a-transactions
  2. McCarthy Tétrault LLP, Rare Earn-out Decision Provides Guidance for M&A Transactions (citing Project Freeway Inc v. ABC Technologies Inc., 2025 ONSC 1048). https://www.mccarthy.ca/en/insights/blogs/ma-and-private-equity-perspectives/rare-earn-out-decision-provides-guidance-for-m-a-transactions
  3. McCarthy Tétrault LLP, Earn out disputes: practical considerations when negotiating and drafting earn-outs. https://www.mccarthy.ca/en/insights/blogs/ma-and-private-equity-perspectives/earn-out-disputes-practical-considerations-when-negotiating-and-drafting-earn-outs
  4. Kroll, Earn-Outs in M&A: Key Deal Tool or Source of Post-Closing Disputes? (Nov. 5, 2024). https://www.kroll.com/en/publications/expert-services/earn-outs-m-and-a-key-deal-tool-source-post-closing-disputes
  5. Whiteford, Taylor & Preston LLP, Private Company M&A: Earn-Outs: Gravy on Top?. https://www.whitefordlaw.com/news-events/private-company-ma-earn-outs-gravy-on-top
  6. Miller Thomson LLP, The increasing popularity of earnouts. https://www.millerthomson.com/en/insights/corporate-tax/increasing-popularity-earnouts/
  7. Canada Revenue Agency, Interpretation Bulletin IT-426R, Shares Sold Subject to an Earnout Agreement (archived). https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/it426r/archived-shares-sold-subject-earnout-agreement.html

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