Current to July 17, 2026
In an Ontario business sale, an earnout makes part of the purchase price contingent on agreed performance metrics.
- The agreement should specify the accounting rules used to calculate the earnout.
- It should address the buyer's post-closing control through operating covenants.
- It should require timely reporting and meaningful audit rights.
- It should provide expert determination, or another clear process, for calculation and payment disputes.
- An earnout makes part of the purchase price contingent on post-closing performance.
- Define accounting policies, permitted adjustments, and the hierarchy among applicable rules.
- Address the buyer's post-closing control over decisions that can affect the earnout.
- Use operating covenants to protect the business and restrict diversion or unusual charges.
- Require timely statements, access to records, and meaningful audit rights.
- Honest performance is mandatory, but it does not replace precise contractual protections.
- Select objective metrics that reflect value and can be measured consistently.
- Refer technical calculation disputes to an independent expert for determination.
- Specify whether a sale, termination, or other event accelerates or ends the earnout.
- Establish clear notice, escalation, and dispute-resolution procedures.
An earnout sounds like a clean solution to a common problem. The buyer and seller disagree about what the business is worth, usually because they disagree about its future. So they agree to let the future decide. Part of the price is paid at closing. The rest is paid later, based on how the business actually performs. But legally, an earnout is not just a forecast. It is a negotiated part of the purchase price. Its exact words, definitions, and context will matter if the parties later disagree (Sattva Capital Corp. v. Creston Moly Corp., 2014).
In practice, earnouts are one of the more disputed pieces of a purchase agreement. That's because the seller no longer controls the business that determines the payout. Canadian common law requires parties to perform contracts honestly. But that duty is not a substitute for detailed drafting, and it does not force either side to give up its negotiated bargain (Bhasin v. Hrynew, 2014). Getting the structure right up front is still the best way to avoid a fight two years later.
Why Earnouts Can Be Beneficial to Both Buyers and Sellers
Sellers may view earnouts as beneficial because they can capture more value if their optimism about the business turns out to be right. Buyers like them because they reduce the cash needed at closing, and shift some risk back onto the seller if the projections do not hold up. Earnouts are common in deals involving founder-run businesses, professional practices, and companies with significant customer concentration or key-person risk.
Before signing, both sides should model the earnout in detail, not just agree on the headline formula. That means testing the maximum possible payment, the timing of each payment, the tax and financing consequences, and the result at different performance levels. The agreement should also explain what happens if performance falls between thresholds, if the business is sold again, if accounting policies change, or if the buyer changes how the business is operated after closing.
Choosing the Metric
The earnout needs to be tied to something measurable: revenue, gross margin, EBITDA, or a specific milestone such as client retention or a contract renewal. Revenue-based earnouts are usually simpler to measure. But they can be affected by pricing, timing, returns, and how revenue gets recognized. Profit-based earnouts may line up more closely with value. They are also more sensitive to decisions the buyer makes after closing, like staffing, overhead, intercompany charges, and investment.
The agreement should define the metric, the measurement period, and the currency. It should set out the accounting policies, consistency principles, permitted add-backs, and exclusions. It should allocate shared costs, and address how acquisitions and discontinued operations get treated.
| Structure | Ease of Measurement | Sensitivity to Buyer Decisions | Accounting Complexity | Dispute Risk | Best Fit |
|---|---|---|---|---|---|
| Revenue-based | High | Moderate: pricing, timing, and recognition can shift it | Low to moderate | Moderate | Stable revenue with consistent recognition |
| EBITDA / profit-based | Moderate to low | High: costs, staffing, and allocations | High | High | Businesses where profitability best reflects value |
| Milestone-based | High, if objectively defined | Low to moderate, depending on buyer support | Low | Low to moderate; higher if subjective | Discrete outcomes such as approvals, renewals, or launches |
A seller in a prior deal, advised by different counsel, agreed to a revenue-based earnout with no protection around how the buyer set prices going forward. After closing, the buyer aggressively discounted the acquired product line to win market share for its broader business, and unit volumes stayed steady while revenue, and therefore the earnout, fell well short of target. A metric tied to gross margin instead of top-line revenue, or a covenant restricting material pricing changes without the seller's input, would have prevented the buyer's broader strategy from silently gutting the seller's payout.
Protecting the Seller After Closing
Once the deal closes, the buyer is usually running the business. The seller's earnout depends on decisions the seller no longer controls. This is where operating covenants matter. Depending on the deal, they may require the buyer to keep separate books, preserve the business or the relevant sales channel, and provide agreed resources. They may stop the buyer from diverting customers or opportunities, or from changing transfer pricing and loading unusual costs into the target.
The drafting should separate firm obligations from targets or aspirations. It should also name the permitted exceptions, such as emergencies, legal compliance, and commercially necessary decisions. If the buyer has contractual discretion that affects the earnout, it must use that discretion for the purpose it was granted, not arbitrarily or in bad faith. The contract can reduce uncertainty here by stating the discretion's purpose, the relevant factors, and any express limits (Wastech Services Ltd. v. Greater Vancouver Sewerage and Drainage District, 2021).
Catching a Shortfall With Negotiated Audit Rights
We negotiated an earnout for a seller that included defined operating covenants preventing the buyer from redirecting the target's customers to an affiliated business, along with contractual audit rights over the relevant financial records during the earnout period. Partway through year one, the seller's accountant used those audit rights and found that several recurring accounts had quietly been rebilled through a related entity, suppressing the earnout metric. Because the covenant and the audit right were both spelled out in the agreement, the seller had a clear basis to demand a recalculation rather than having to prove bad faith in court.
Honest performance is mandatory, but it does not replace precise contractual protections.
Common Disputes
Most earnout disputes come down to one of a few things:
- The buyer changed how the business operates in a way that suppressed the numbers.
- The parties disagree about an accounting term or calculation input.
- Information was withheld.
- The buyer disputes the calculation and refuses to pay.
Canadian contract law requires parties to perform contracts honestly. In practice, that means neither side may lie or knowingly mislead the other about matters directly linked to performance of the agreement. Misleading conduct can include an express false statement, a half-truth, or silence where the party’s words or conduct have created a false impression. But honest performance does not require a party to act as a fiduciary, subordinate its own interests, or voluntarily disclose every fact that might help the other side. See Bhasin v. Hrynew, 2014 SCC 71, [2014] 3 S.C.R. 494 and C.M. Callow Inc. v. Zollinger, 2020 SCC 45, [2020] 3 S.C.R. 908.
A well-drafted process should require a calculation statement with supporting detail. It should give the seller a defined window to review and object. It should require payment of any undisputed amount up front. And it should provide access to the relevant records and personnel, subject to confidentiality protections.
Drafting Around the Risk
Sellers should push for defined operating covenants, meaningful reporting and audit rights, sensible record-retention obligations, and a clear, mechanical formula, rather than one that leaves room for interpretation. Audit access should say who may inspect, what records are covered, when access is available, who pays, and whether a material understatement shifts the audit costs onto the buyer.
For calculation disputes, an independent accountant can act as an expert rather than an arbitrator. But the clause should still define the expert's mandate, the appointment process, what each side may submit, time limits, cost allocation, and the standard of review. It should say whether the decision is final and binding, subject to issues such as fraud or a clear error. Legal, covenant, and bad-faith disputes may need negotiation, mediation, arbitration, or court proceedings instead, since these usually fall outside an accountant's limited mandate.
The agreement should also address acceleration, or deemed achievement of the earnout, if the buyer sells, amalgamates, winds up, or transfers the business. The same goes if the buyer terminates a key seller without cause, or materially breaches an earnout covenant, while still guarding against an unintended windfall for the seller. Buyers, in turn, need enough flexibility to operate and integrate the business without every reasonable decision becoming a claim. Clear remedies, notice requirements, limitation periods, and an express route for urgent injunctive relief help balance those interests.
Five Common Mistakes
- “Choosing a metric that does not match how the business creates value.”
- “Leaving accounting rules undefined invites a fight over the numbers.”
- “Ignoring the buyer's control means ignoring what drives performance.”
- “Weak reporting or audit rights leave the seller in the dark.”
- “An unclear expert or dispute process can prolong every disagreement.”
Frequently Asked Questions
An earnout is deferred purchase price payable only if the business meets agreed post-closing performance targets.
The best metric is objective, consistently measurable, and aligned with how the business creates value, such as revenue, EBITDA, or a defined milestone.
Many earnouts run one to three years, but the right period depends on the business cycle, the metric chosen, and the risks being allocated.
Use precise accounting rules, operating covenants, regular reporting, audit rights, and a clear dispute process.
Calculation disputes often go to an independent accounting expert, while legal or covenant disputes may require mediation, arbitration, or court proceedings.
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This article gives general information about Ontario and Canadian law, current to July 17, 2026. It is not legal, tax, accounting, or investment advice, and it doesn't replace advice about your specific situation. Reading it doesn't create a lawyer-client relationship. Laws and practices change. Get advice from a qualified Ontario lawyer and your accountant before agreeing to an earnout, or before completing a transaction.
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