An earnout defers part of the price until the business performs. It is among the most litigated clauses in a private company sale, and almost always for one reason: the parties agreed on a number and never agreed on how to count it. The counting is the work.
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A seller prices the business on where it is going. A buyer prices it on what it has already done. An earnout resolves that argument by paying the difference only if the future arrives — a further amount payable after closing if the business hits agreed targets over an agreed period. It is a bridge across a valuation gap, not a discount and not a financing tool.
Earnouts turn up most often where recent results are unusual. A single large contract that may or may not renew. A launch year with growth the buyer will not pay for in advance. A professional or service business where the clients may be loyal to the departing owner rather than to the business. In each case the buyer is refusing to pay today for something only the seller believes in.
They come at a price for the seller. You are accepting part of your money later, without control, calculated by the person who owes it, out of a business you no longer run. That is a genuinely worse position than cash on closing, and the earnout amount should reflect it. A seller unwilling to accept those conditions should negotiate a lower fixed price instead.
There is a middle option people forget. A <a href="/escrow-holdback-lawyer-ontario">holdback</a> keeps money that is already agreed to be the seller's, subject to claims. An earnout creates money that does not exist yet. If the real concern is undisclosed liabilities rather than future performance, a holdback is the honest instrument and it is far easier to administer.
Revenue is easy to measure and easy to game. Profit is harder to game and much easier to depress. EBITDA sits between them and is the usual compromise, but only if the agreement defines it — which items are added back, how management fees and owner compensation are treated, how the buyer's own overhead allocations are excluded, and which accounting policies apply. Attach that definition as a schedule with a worked example.
Whoever runs the business after closing controls the number. That is why earnout agreements need operating covenants: run the business in the ordinary course, keep it as a separate cost centre, do not merge the customer base into another division, do not reallocate the sales team, do not change credit terms or pricing in a way that shifts revenue outside the measurement period. Silence on these points favours the buyer entirely.
The seller needs access and audit rights, not just a promise. Set out what statements the buyer must deliver, on what timetable, in what format, and how long the seller has to object. Then set out what happens on objection — the parties negotiate for a fixed period, and failing that an independent accountant decides, on defined terms, with the costs allocated by outcome so nobody benefits from stalling.
Say expressly whether the buyer may set off indemnity claims against earnout payments. Buyers want that right; sellers should resist an unlimited version of it, because it turns every warranty argument into a reason to stop paying. A workable compromise is set-off only for claims that have been agreed or determined, with disputed amounts held aside instead of simply retained.
A working-capital adjustment is not contingent on performance. It exists because the price assumed the business would be handed over with a normal level of receivables, inventory, payables and cash, and the actual level on the closing date will not match. The price moves up or down accordingly. This is arithmetic, not risk-sharing, and every asset or share deal of any size should have one.
The mechanics are standard and the disputes are always the same. Agree the target amount before signing, using a stated historical average rather than a figure conjured on the day. Agree the definition of each component. Agree who prepares the closing statement, within how many days, and how long the other side has to object. Agree the accounting policies, and state that they override general accounting principles if the two conflict.
Do not let a working-capital adjustment and an earnout use different accounting rules, or the same receivable will be counted twice or not at all. Do not let either overlap with the indemnity. If a bad debt has already been deducted from the price through the adjustment, the buyer should not also claim it as a breach of the accounts receivable warranty. Say so in the agreement.
Tax treatment of earnout payments is not automatic and depends on how the payments are characterized. Sellers hoping to treat the whole amount as a capital gain should confirm the position with their accountant before signing, because the drafting can affect the answer. We work alongside your accountant on that point. See <a href="/pricing">our published fees</a> and how we handle <a href="/buying-selling-a-business">business sales</a>.
It is part of the purchase price that becomes payable only if the business hits agreed targets after closing, measured over an agreed period. It bridges the gap between what a seller thinks the business will do and what a buyer will pay for today. The targets, the measurement rules and the dispute process all have to be written down in detail.
Revenue is simpler to verify but easy for a buyer to manipulate through pricing or credit terms. Profit measures the thing that actually matters but can be reduced by allocated overhead and management fees. EBITDA with a written definition, agreed add-backs and a worked example is the common compromise. Whatever you choose, define it in a schedule rather than a sentence.
Operating covenants. The agreement should require the business to be run in the ordinary course during the earnout period, kept separately measurable, not merged into another division, and not stripped of its sales staff or customers. Add reporting obligations, audit access, and a clause stating that acts done for the purpose of reducing the earnout are a breach.
That is what the dispute clause is for. A standard mechanism gives the seller a fixed window to object in writing with reasons, a short negotiation period, and then referral of the remaining items to an independent accountant acting as expert rather than arbitrator. The determination is final, and costs are usually split according to how close each side's position was.
No. A holdback is money already agreed to be the seller's, retained temporarily to secure warranty and indemnity claims, and released if no claim is made. An earnout is additional money that only becomes payable if performance targets are met. If your real worry is undisclosed liabilities rather than future results, a holdback is the right instrument.
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