Earn-Outs in an Ontario Business Purchase Explained

The buyer and seller cannot agree on what the business is worth. The seller points to strong growth, while the buyer sees risk. A common compromise is an earn-out: part of the price is paid at closing and the rest is paid later only if the business reaches agreed targets.

Earn-outs can bridge a gap, but they also keep the buyer and seller tied together after closing, and that is where trouble often starts. This article explains how earn-outs generally work, where disputes arise and what to settle in writing.

How an earn-out works

In an earn-out, the purchase agreement sets a payment, or several payments, that depend on future results. The measure might be revenue, gross profit, earnings or something else, such as keeping a key customer. There is usually a set period, with a calculation at the end of each year or at the end of the whole period.

For the seller, an earn-out is a chance of a higher price but also a risk of receiving less than hoped. For the buyer, it reduces the money paid upfront and shares the risk that the business does not perform. Neither side should treat it as a simple add-on. It is a continuing relationship that needs clear rules.

Where earn-out disputes come from

Disputes rarely arise because someone refuses to pay a clear number. They arise because the agreement leaves room to argue about how the number is reached. Common trouble spots include these.

• The measure. Does revenue include returns, discounts or new product lines? Is profit before or after the buyer's management fees and shared costs?
• Accounting method. Which accounting policies apply, and can the buyer change them after closing?
• Control. Can the buyer change prices, staff, suppliers or strategy in ways that reduce the earn-out? The seller often wants promises about how the business will be run, while the buyer wants freedom to run it.
• Integration. If the business is merged into the buyer's other operations, how are its results separated?
• Information. What reports does the seller receive, and can the seller review the books?
• Seller's role. If the earn-out depends on the seller staying on, what happens if the seller leaves or is let go?
• Security. What if the buyer sells the business or becomes unable to pay before the earn-out ends?

What each side usually wants

There is no standard answer. The right balance depends on the size of the earn-out, the seller's role afterwards and how much trust there is between the parties.

Other rules that connect to an earn-out

An earn-out sits inside a larger purchase, so other rules still apply. Tax treatment of deferred or contingent payments can be complex, and your accountant should confirm it before you agree to the structure. A few connected points are worth raising.

• Price allocation. For capital cost allowance, CRA says to use the individual asset prices in the sale agreement if they are set out and reasonable. If not, the price is allocated to each asset at fair market value, then to inventory, with any remainder going to goodwill (Class 14.1). Ask how any later earn-out payments will be treated in that allocation.
• GST/HST. The section 167 election lets the buyer and seller jointly elect to have no GST/HST payable on the sale of a business or part of one. It requires the buyer to acquire all or substantially all (at least 90%) of the property needed to carry on the business. How an earn-out structure fits with these conditions depends on the deal, so it is worth confirming with your accountant.
• Seller staying on. If the seller will work for the buyer, an agreed non-compete may fit within the ESA's sale-of-business exception, which applies where a business or part of one is sold or leased, the seller becomes the buyer's employee and a non-compete is agreed as part of the sale. Otherwise, the ESA prohibits employers from entering into agreements with a non-compete. The ESA does not prohibit them with executives such as a CEO, president, CFO or COO.
• Seller financing. If the seller also lends part of the price, the interest rate must not go over the criminal rate of interest, which is an annual percentage rate that exceeds 35 per cent on the credit advanced. Charging above it is an indictable offence carrying up to five years' imprisonment, or a summary offence carrying a fine of up to $25,000 and/or up to two years less a day in jail. Whether exemptions apply to a particular loan should be confirmed with a lawyer.
• WSIB. A buyer who does not obtain a valid purchase certificate may be held liable for all amounts the vendor owes up to the sale date. This is separate from the earn-out, but it affects how much risk the buyer is really taking.

What to do next

Whether you are the buyer or seller, put the earn-out in plain terms before the purchase agreement is signed. A short written example, with sample numbers and the calculation worked through, can prevent many arguments.

• Define the measure precisely, with the accounting rules and what is included or excluded.
• State the earn-out period, payment dates and what happens if the period is cut short.
• Set out what the buyer may and may not do with the business during the period.
• Agree on reporting, access to records and a process for resolving disagreements about the numbers.
• Decide what happens if the buyer sells the business, or the seller leaves, during the period.
• Ask your accountant how the earn-out will be taxed and treated in the price allocation.
• Have a lawyer draft or review the clause, since vague wording is the usual source of disputes.

Frequently asked questions