What do earnout provisions in Ontario business sales actually do? An earnout defers part of the purchase price and ties payment to the business's future performance.
This guide explains when earnouts get used and why they do not eliminate disagreement so much as postpone it. It also covers how the earnout's structure shapes how that disagreement eventually gets resolved.
Key Takeaways
- An earnout defers part of the purchase price, with payment depending on the business's performance after closing.
- Earnouts are typically used where valuation is uncertain, or where buyer and seller see the business's future differently.
- Earnouts do not eliminate the disagreement between buyer and seller. They move it into the future.
- The earnout's structure, including its metrics, duration, and control terms, determines how disagreement actually gets resolved.
- Poorly structured earnouts are a common source of post-closing disputes between buyers and sellers.
This guide draws on more than ten years of experience structuring and negotiating earnout provisions for Ontario business sales.
What Earnout Provisions Do in Ontario Business Sales
An earnout splits the purchase price into two parts. The buyer pays a portion at closing. It pays the remaining portion later, contingent on the business hitting agreed-upon performance targets.
This structure shifts part of the payment risk onto the seller. If the business performs as expected, the seller receives the full agreed price over time. If it does not, the seller receives less than the total headline number that appeared in the letter of intent.
For the buyer, an earnout reduces the amount of capital committed upfront. It also ties part of the price to results the buyer can actually observe after taking over the business.
When Earnouts Are Used in Ontario Business Sales
Earnouts are not the default structure for a business sale. They tend to appear in specific situations.
Valuation Uncertainty
An earnout is common where the buyer and seller cannot agree on what the business is actually worth. This often happens with businesses that have unpredictable revenue or a limited operating history. It also comes up where performance depends heavily on factors that are difficult to verify during due diligence.
Rather than resolving this uncertainty through a single negotiated price, an earnout lets the parties defer part of the decision. Actual performance settles the question that negotiation could not.
Differing Expectations Between Buyer and Seller
An earnout also gets used where the buyer and seller simply see the business differently. A seller may believe the business is about to grow significantly, perhaps due to a new contract or product launch. A buyer may be more skeptical of that projection.
The buyer avoids paying full price for growth that has not yet happened. The seller avoids accepting a discount for growth it fully expects. Instead, an earnout pays the seller for that growth only if it actually occurs.
Earnouts Don't Eliminate Disagreement - They Postpone It
It is tempting to think of an earnout as a solution to a valuation disagreement. It is more accurate to think of it as a postponement.
The underlying disagreement, over what the business is really worth, does not disappear when an earnout gets signed. It simply moves from the negotiating table to the earnout period itself. There it resurfaces in a different form. Disputes arise over whether performance targets were actually met. They also arise over whether the business was run fairly enough to let the earnout succeed.
This is why an earnout that looks like a clean compromise on paper can become the most contentious part of a deal after closing.
How to Structure Earnout Provisions in Ontario Business Sales
The underlying disagreement does not go away. How the earnout is structured determines whether it gets resolved smoothly or becomes a dispute.
Performance Metrics: Revenue vs. EBITDA
The metric an earnout is tied to matters enormously. Revenue-based earnouts are simpler to measure but can reward growth that comes at the expense of profitability. Earnings-based earnouts, such as those tied to EBITDA, better reflect real business performance. They are also more easily influenced by accounting decisions made after closing.
Whatever metric is chosen, it needs a clear, specific definition in the agreement. It also needs an agreed method for calculating it, to reduce the chance of a dispute over how the number was reached.
Control and Operating Covenants During the Earnout Period
Control is often the single biggest source of earnout disputes. After closing, the buyer typically runs the business. This means the buyer also controls many of the decisions that affect whether earnout targets get met.
A seller who no longer controls hiring, spending, or strategy has limited ability to influence the earnout's outcome. Well-drafted earnouts often include specific operating covenants. These restrict the buyer from taking actions that would unreasonably undermine the seller's ability to earn the full payment.
Duration and Payment Schedule
Earnout periods commonly run from one to three years. The right length varies significantly by industry and by how much uncertainty the earnout is meant to resolve. Longer periods can better reflect a business's true trajectory. They also extend the period during which disputes can arise, and delay when the seller actually receives full payment.
Common Sources of Earnout Disputes
A handful of issues account for most earnout disputes in practice.
Disagreements often arise over how a metric was calculated. This is especially common with EBITDA-based earnouts, where accounting judgment calls can shift the number significantly.
Disputes also arise when a buyer's business decisions affect the metric without being clearly prohibited by the agreement. Cutting a product line or changing pricing are common examples of this.
A well-drafted earnout anticipates these issues in advance, rather than leaving them to be resolved through a dispute later.
How Earnouts Connect to Representations and Warranties
Earnouts rarely stand alone. They typically emerge from gaps identified elsewhere in the transaction.
Sometimes representations and warranties cannot fully bridge a disagreement about the business's condition or prospects. An earnout is sometimes used instead, shifting part of the resolution from legal promises to actual future results.
Sellers considering this structure should also understand how it fits into broader deal readiness. Our guide on what needs to be ready when selling your business in Ontario covers this in more detail.
For a broader look at how earnouts fit into the full transaction, see our guide on buying or selling a business in Ontario.
Planning for Earnout Disputes Before They Happen
Because earnout disputes are common, well-drafted agreements typically address how disputes get resolved. This is better than leaving that question open.
Many earnout provisions include a specific dispute resolution mechanism. This is separate from the general dispute process in the rest of the purchase agreement.
This might involve an independent accountant reviewing the disputed calculation. It might also involve a defined escalation process before either party can pursue formal legal action.
Agreements also commonly require the buyer to provide regular financial reports to the seller. Access to relevant records during the earnout period is often included too. Without this kind of transparency built in, a seller has little practical ability to verify whether targets are being met fairly. This makes disputes more likely rather than less.
Building these mechanisms into the earnout from the start tends to produce a smoother outcome for both sides. Relying on the general terms of the purchase agreement alone tends not to.
The Bottom Line on Earnout Provisions in Ontario Business Sales
An earnout defers part of the purchase price, tying payment to the business's performance after closing. It typically gets used where valuation is uncertain or where buyer and seller have genuinely different expectations.
An earnout does not eliminate the underlying disagreement. It postpones it, and how the earnout is structured determines whether it resolves smoothly or turns into a dispute.
If you are negotiating an earnout in an Ontario business sale, our team at Levine Law can help. We can structure metrics, control provisions, and payment terms that actually hold up once the business changes hands.
Frequently Asked Questions
What is an earnout in a business sale?
An earnout defers part of the purchase price, with payment depending on the business's performance after closing.
When is an earnout typically used?
Earnouts are commonly used where valuation is uncertain. They also come up where buyer and seller have different expectations about future performance.
Does an earnout resolve a valuation disagreement?
Not entirely. It postpones the disagreement, letting future performance settle the question instead of resolving it through negotiation alone.
What is the most common source of earnout disputes?
Control during the earnout period is a frequent source of disputes. The buyer typically runs the business and makes decisions that affect whether targets get met.
Should an earnout be based on revenue or profit?
Both approaches have trade-offs. Revenue is simpler to measure, while profit-based metrics like EBITDA better reflect performance but are easier to influence.
How long do earnout periods typically last?
Earnout periods commonly run from one to three years, depending on the industry and how much uncertainty needs resolving.
Can a buyer make decisions that hurt an earnout's outcome?
Yes, unless the agreement includes operating covenants. These would restrict the buyer from taking actions that unreasonably undermine the seller's ability to earn full payment.
How do earnouts relate to representations and warranties?
Earnouts sometimes get used where representations and warranties cannot fully bridge a gap, shifting resolution to future results.