- Canadian contract law requires honesty in performing a contract, but it does not give you a general right to full disclosure from the buyer, so earn-out protections need to be written into the agreement.
- Where the buyer has discretion over costs, pricing or operations, that discretion must be used honestly and reasonably in light of why it was given.
- Deferred price can affect when you report the gain, and the usual reserve runs over no more than five years, or ten when qualifying small business corporation shares are sold to a child resident in Canada.
- The basic limitation period for a claim is two years from discovery, so a dispute over earn-out numbers should not sit unaddressed.
An earn-out means part of your sale price is not paid at closing. Instead, it depends on how the business performs after you sell, often measured by revenue, profit or another target. For a buyer, it bridges a gap in how the business is valued. For you, it means a meaningful part of your price rides on results you may no longer control.
That is the central risk. After closing, the buyer usually runs the business, sets the budget and decides how to account for it. This article explains what Ontario contract law does and does not do for you, the tax points to raise with your accountant, and the terms sellers commonly try to have written down.
Why earn-outs create tension
With a fixed price, you are paid and finished. With an earn-out, you and the buyer stay financially connected, but your interests can pull apart. The buyer may want to invest in growth, shift costs, change pricing or combine your business with another one. Each of those choices can lower the number the earn-out is measured on, even if the buyer is acting in good faith.
Disputes tend to start with how the target is defined and calculated. Revenue, gross profit and net profit each respond differently to the buyer's decisions, and overhead allocations can quietly shrink a profit-based figure. Before you agree to any formula, ask what the buyer could do after closing that would reduce it.
What the law gives you, and what it does not
Canadian contract law recognizes a general duty of honest performance. Parties must not lie to each other or knowingly mislead each other about matters directly linked to performing the contract. That helps if a buyer misreports results to you.
The same principle has limits. There is no general duty of disclosure and no general duty to give up contractual advantages, so you cannot count on the law to force the buyer to run the business to maximize your payment. If you want specific protections, they need to be in the agreement.
Where the agreement hands the buyer a discretion, such as over costs, pricing or operations, the Supreme Court of Canada has said that discretion must be exercised honestly and reasonably, in light of the purposes for which it was granted. A seller can point to that principle when the buyer's choices undercut the earn-out. How far it goes in your situation depends on the exact wording and the facts, so it is worth asking a lawyer before you rely on it.
Terms sellers commonly negotiate
Because the law does not fill in the gaps for you, the written terms matter. The table below lists protections that are usually negotiated. These are drafting choices, not legal rights, and what a buyer will accept varies.
| Term | What it tries to address |
|---|---|
| Clear definition of the target | Avoids arguments over what revenue or profit means and which costs count |
| Accounting standards | Fixes how results are calculated, so the buyer cannot change methods |
| Operating covenants | Limits actions that would deliberately reduce the earn-out |
| Information and review rights | Lets you see the numbers and have them checked |
| Acceleration on a later sale | Addresses the buyer selling or merging the business before the period ends |
| Limits on set-off | Stops the buyer from deducting unrelated claims from earn-out payments |
| Security or guarantees | Helps if the buyer is a new company with few assets |
Not every item will suit every deal. A very restrictive operating covenant may be hard to get, and a buyer may ask for the freedom to run the business as it sees fit. A lawyer can help you decide which protections matter most for your numbers.
Tax and timing points
If part of the price is paid after the year of sale, you may be able to claim a capital gains reserve for proceeds that are not yet due. Generally the gain must be brought into income over no more than five years, with at least one-fifth included each year. When qualifying small business corporation shares are sold to a child who is resident in Canada, the reserve period can extend to ten years.
How an earn-out fits those rules depends on how the deal is structured and what is being sold. In a share sale by an individual, the gain is a capital gain, and the lifetime capital gains exemption may be available if the shares qualify. In an asset sale by a corporation, the corporation realizes the gain and the exemption is not available to it. Ask your accountant to model the earn-out under each structure before you sign.
Practical steps before you sign
- Ask for the earn-out formula in a worked example using real numbers from your business.
- List every post-closing decision the buyer could make that would change the result, and see how the draft handles each one.
- Confirm what information you will receive, how often, and whether you can have the figures reviewed.
- Find out who is actually responsible for payment, and whether anything backs that promise.
- Ask your accountant how the deferred payments will be taxed, including any reserve.
- Note the dispute process and the dates, since the basic limitation period is two years from discovery.
If the earn-out is a large part of your price, have a lawyer review the agreement before you accept the offer, not after. The wording that defines the target and the buyer's freedom to act is usually where the money is won or lost.
Frequently asked questions
Can a buyer run the business however it wants during the earn-out?
Only to the extent the agreement allows. The law does not require a buyer to give up its own advantages, so limits need to be written in. Where the buyer has a discretion, it must be exercised honestly and reasonably in light of its purpose.
Does the buyer have to tell me how the business is doing?
There is no general duty of disclosure in Canadian contract law, though a party must not knowingly mislead the other about matters tied to performing the contract. If you want regular reports or the right to review the numbers, ask for it in the agreement.
How long do I have to sue if the earn-out is underpaid?
The basic limitation period in Ontario is two years from discovery. A business agreement made on or after October 19, 2006 can vary or exclude a limitation period other than the 15-year ultimate period, so check the wording of your agreement.
Can I spread the tax on a deferred payment?
You may be able to claim a reserve for proceeds not yet due, but generally the gain must be included in income over no more than five years. Your accountant can tell you how it applies to your deal.
Sources
- Income Tax Act, s. 40 (Justice Laws) — Justice Laws (federal)
- Income Tax Act, s. 110.6 (Justice Laws) — Justice Laws (federal)
- CanLII – Bhasin v. Hrynew, 2014 SCC 71 — canlii.org
- CanLII – Wastech, 2021 SCC 7 — canlii.org
- CanLII – Limitations Act, 2002, S.O. 2002, c. 24, Sch. B — canlii.org
Links go to official government, court and regulator pages. The law changes — confirm you are reading the current version.
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