- How it works In a vendor-financed deal, the seller agrees to receive part of the purchase price over time — typically over two to five years — as a loan from seller to buyer.
- How an earn-out works An earn-out is a mechanism where the buyer pays an additional amount to the seller — after closing — if the business meets defined performance targets during a…
- In some deals, a buyer proposes both: a portion of the price on vendor financing and another portion as an earn-out.
Not every Ontario business sale closes with a cheque for the full price handed over on day one. Often the buyer cannot — or will not — pay entirely in cash at closing. Two common mechanisms bridge the gap between what a seller wants and what a buyer can pay up front: earn-outs and vendor financing (also called a vendor take-back or VTB). Both shift some financial risk onto the seller after the deal closes, and both require careful legal documentation to protect against disputes down the road.
Vendor Financing: The Seller Becomes the Lender
How it works
In a vendor-financed deal, the seller agrees to receive part of the purchase price over time — typically over two to five years — as a loan from seller to buyer. The buyer pays an agreed principal amount at closing and then makes regular payments (with interest) on the balance.
Example: A business sells for $1,000,000. The buyer pays $700,000 at closing and gives the seller a promissory note for $300,000 payable over three years at an agreed interest rate.
Why sellers agree to it
- It can make the deal happen when the buyer cannot fully finance the purchase price through a bank.
- It may be structured to provide the seller with regular income over several years.
- In some circumstances, spreading receipt of proceeds over multiple years may have tax benefits — this is a question for your accountant, not a general article.
The seller's risks
The fundamental risk is that the buyer defaults on the note. Once you close the deal and hand over the shares or assets, you are a creditor — not an owner. If the business fails under the new ownership, you may not be paid in full.
How sellers protect themselves
- Security: Require the buyer to grant a security interest over the shares or assets of the business as collateral for the loan. Register the security under Ontario's Personal Property Security Act (PPSA). If the buyer defaults, you have priority over unsecured creditors.
- Personal guarantee: Require the individual principal of the corporate buyer to personally guarantee the note.
- Subordination: Know whether bank lenders will insist the vendor note be subordinated (ranked behind the bank's debt). This is common and limits your protection.
- Events of default: Define carefully what triggers default — not just missed payments, but material adverse changes in the business, breach of the purchase agreement, or failure to carry insurance.
- Acceleration: On default, the entire balance becomes due immediately.
Earn-Outs: Tying Part of the Price to Future Performance
How an earn-out works
An earn-out is a mechanism where the buyer pays an additional amount to the seller — after closing — if the business meets defined performance targets during a future period. The earn-out bridges a valuation gap: the seller believes the business will perform strongly; the buyer is uncertain. Instead of arguing over price, they agree on a baseline and let future results determine the rest.
Example: Purchase price is $800,000 at closing plus up to $200,000 in earn-out payments over two years if annual EBITDA (earnings before interest, taxes, depreciation, and amortization) exceeds $300,000.
Common earn-out metrics
- EBITDA or net income — common, but can be manipulated by the buyer through management decisions.
- Revenue — simpler to measure, harder to game, but does not reflect profitability.
- Gross profit — a middle ground.
- Customer retention or specific contract milestones — useful for service businesses.
Why earn-outs create disputes
Earn-outs are the most frequently litigated element of business purchase agreements. The core tension: after closing, the buyer controls the business. A buyer who wants to minimize earn-out payments can make operating decisions — increasing expenses, shifting revenue recognition, absorbing overhead from other parts of their business — that reduce the metric on which the earn-out is based.
Protecting the seller in an earn-out
The seller's protections must be negotiated into the purchase agreement:
- Definition of the metric: Be precise. Define every term used in the earn-out calculation. "EBITDA" means different things in different contexts.
- Operating covenants: Require the buyer to operate the business in a manner consistent with maximizing the earn-out metric — or at minimum, in the ordinary course, without material changes.
- No artificial manipulation: Expressly prohibit the buyer from taking steps designed to depress the metric.
- Accounting standards: Specify which accounting principles apply and who prepares the earn-out calculation.
- Dispute resolution: Build in a mechanism for the seller to dispute the earn-out calculation — typically an independent accountant as a neutral arbitrator.
- Acceleration on sale: If the buyer sells the business during the earn-out period, the remaining earn-out should be paid out in full (or on an agreed basis).
Combining Earn-Outs and Vendor Financing
In some deals, a buyer proposes both: a portion of the price on vendor financing and another portion as an earn-out. From the seller's perspective, this means a significant part of the purchase price depends on the buyer's performance and good faith. Before accepting this structure, assess carefully:
- How much of the total price are you actually receiving at closing?
- Is the business's post-closing performance truly within the buyer's control, or subject to market forces?
- Is the buyer creditworthy enough to honour both the note and the earn-out?
Frequently asked questions
Should I insist on a bank letter of credit for the earn-out?
Some sellers do. A standby letter of credit from the buyer's bank guarantees payment of the earn-out up to a set amount regardless of what the buyer does. Buyers resist this because it costs them money and ties up credit. It is a worthwhile negotiating point if the earn-out is significant.
Does vendor financing affect the purchase price for tax purposes?
Generally, the full purchase price — including the vendor note amount — is recognized for tax purposes at closing, even though you receive the cash over time. This can create a timing mismatch. Discuss the tax treatment of vendor financing with your accountant before agreeing to the structure.
How do I register my security interest in Ontario?
Security interests in personal property (which includes shares and most business assets) are registered on Ontario's Personal Property Security Registration system. Your lawyer handles this registration as part of the closing process.
What happens to the earn-out if the buyer breaches the purchase agreement?
A material breach by the buyer typically entitles the seller to terminate the agreement and pursue damages. In the earn-out context, damages can include the lost earn-out payments the seller would have received but for the breach. Documenting the earn-out calculation methodology carefully supports a damages claim.
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