Earnouts in Business Sales: When They Make Sense (and When They Don’t)
When a buyer and seller cannot agree on price, the earnout is often offered as a bridge. The seller receives part of the purchase price up front and earns the remainder if the business performs to certain metrics post-closing. In theory, this aligns both sides. In practice, earnouts are among the most disputed structures in private company M&A.
For owner-managed businesses in Vancouver and across Canada, earnouts have become common enough that any owner contemplating a sale should understand how they work, when they help, and when they hide risk.
What an Earnout Is
An earnout is contingent consideration. A portion of the purchase price is held back at closing and paid only if the business meets agreed performance targets over a defined period after closing.
The size of the earnout varies, but ranges of 10 to 30 percent of total consideration are common. The performance period is typically one to three years.
The structure has two main components:
• the metric being measured (revenue, EBITDA, gross margin, customer retention, or others)
• the payout formula, which translates performance against the metric into actual dollars
Why Earnouts Are Used
Earnouts are most often used when:
• the buyer and seller cannot reconcile their views on future performance
• the business has recently grown quickly and the buyer is uncertain about sustainability
• a key customer, contract, or product launch is pending
• the buyer wants the seller to remain involved during a transition period
• financing or risk considerations limit how much the buyer will pay at closing
They are also used as a negotiating tool when one side is closer to walking away than the other. An earnout can save a deal that would not otherwise close, but it can also become a way to defer hard conversations to a later, more contentious time.
Common Earnout Metrics
Common earnout metrics include:
• revenue
• EBITDA or adjusted EBITDA
• gross margin
• customer retention or renewal rates
• specific contract or product milestones
Each metric has trade-offs. Revenue is easier to measure but does not reflect profitability. EBITDA reflects profitability but is open to dispute on cost allocation. Customer-based metrics work well in some industries and not in others.
Why EBITDA-Based Earnouts Are Difficult
EBITDA earnouts seem attractive because they align with valuation. They are also the most prone to disputes.
Sources of dispute include:
• allocation of corporate overhead from the acquirer
• charges for shared services, IT, or management time
• changes in accounting policies after closing
• reclassification of costs between operating and non-operating
• integration costs that may or may not be excluded
• investments in growth that depress short-term earnings
Many of these issues are foreseeable. They should be addressed in the purchase agreement, not left to interpretation later.
Revenue-Based Earnouts and Their Trade-Offs
Revenue earnouts are simpler to administer. They are also less aligned with value, since revenue can be grown unprofitably.
Trade-offs include:
• easier to verify than EBITDA
• less prone to accounting disputes
• but capable of incentivising unprofitable behaviour
• potentially harmful to longer-term value if pursued aggressively
In some industries, revenue earnouts work well, particularly where margin structures are stable and the buyer is confident that growth will be profitable.
Earnout Period and Caps
Two structural points matter for any earnout:
• the length of the earnout period
• whether the earnout is capped
Shorter earnouts (one year) reduce dispute risk but may not produce enough payout to bridge meaningful gaps. Longer earnouts (three years) increase total payout potential but extend the seller’s exposure to the buyer’s decisions.
Caps are common. They protect the buyer from outsized payouts, but they also limit the upside the seller is being asked to wait for. Floors and tiered payouts can soften the all-or-nothing risk of a binary target.
Who Controls the Business During the Earnout
This is the central tension. Once the deal closes, the buyer owns the business. The seller is being asked to rely on the buyer’s decisions to determine post-closing performance.
Common protective provisions include:
• an obligation to operate the business in the ordinary course
• restrictions on changes that would depress the earnout metric
• a requirement to use reasonable efforts to grow the business
• reporting and audit rights during the earnout period
• the seller’s continued involvement in management for a defined period
No language can fully replicate ownership. The further the buyer moves from the way the seller ran the business, the more likely disputes become.
Tax Treatment of Earnouts in Canada
Tax treatment depends on the structure of the earnout, the nature of the consideration, and applicable rules at the federal and provincial level.
Common considerations include:
• whether the earnout qualifies for capital gains treatment
• how the cost base reserve mechanism applies
• the impact of the reverse earnout structure
• cross-border tax implications where the buyer is foreign
• the interaction with the lifetime capital gains exemption for qualifying small business shares
Tax structuring should be addressed early. The wrong structure can significantly reduce after-tax proceeds even when the gross deal value looks attractive.
The Risk of Disputes
A meaningful percentage of earnouts in private company M&A end in dispute. Common patterns include:
• disagreements over what is included or excluded from the metric
• disagreements over whether the buyer operated the business consistent with prior practice
• disagreements over allocations of cost or revenue between divisions
• disagreements over the impact of post-closing investments or strategic shifts
Once the dispute is in motion, the leverage shifts to the party with more time, more capital, and less to lose. That is often the buyer.
When Earnouts Make Sense
Earnouts can make sense when:
• the buyer and seller have a genuine, specific disagreement about near-term performance
• that disagreement can be objectively tested in a short period
• the metric chosen is straightforward and within the seller’s influence
• the seller will remain involved enough to affect the outcome
• the structure is documented in detail, not in principle
In those circumstances, an earnout can produce a fair outcome that neither party would have accepted as a fixed-price deal.
When Earnouts Should Be Avoided
Earnouts should generally be avoided when:
• the gap in price reflects different views on a multiple, not on performance
• the seller is exiting completely at closing
• the metric depends heavily on decisions the buyer will control
• the buyer plans to integrate the business immediately
• the period is too long to measure consistently
In those cases, the better path is usually to negotiate the fixed price harder, accept a deal that is below the asking price, or consider a recapitalization that allows the seller to retain equity rather than rely on a contingent payment.
How KitsWest Capital Helps
KitsWest Capital advises on private company sales where earnouts and other contingent structures are often part of the negotiation. Our role includes assessing whether an earnout is appropriate, structuring it to minimize dispute risk, and integrating tax and valuation considerations into the broader deal.
Typical involvement includes:
• framing the earnout discussion within the overall negotiation
• selecting and defining the appropriate metric
• drafting protective provisions in coordination with legal counsel
• coordinating with tax advisors on after-tax outcomes
• preserving the seller’s position through closing and the earnout period
Final Thoughts
Earnouts can save deals. They can also defer disputes that should have been resolved at the negotiating table. The difference usually comes down to preparation, clarity, and the discipline to draft the structure with specificity rather than goodwill.
For owners contemplating a sale, an earnout proposal is not in itself good or bad news. It is a signal that the price gap or the risk profile is greater than the buyer is willing to absorb at closing. Whether to accept it depends on the alternatives, the structure, and the level of trust between the parties.
Speak with an Advisor
If you are evaluating a business sale, acquisition, unsolicited offer, or valuation matter, KitsWest Capital welcomes confidential discussions.
