What is an earn-out and how does it work in a business purchase?
An earn-out is a contractual provision where a portion of the purchase price is contingent on the business achieving specific performance targets after closing, typically measured by revenue, EBITDA, gross profit, or customer retention metrics over a defined period.
How earn-outs are structured
The contingent portion of the purchase price typically ranges from 10% to 40% of the total deal value, with most middle-market transactions settling at 20–25% contingent. The buyer pays the base purchase price at closing and agrees to pay additional amounts if the business meets predetermined targets during the earn-out period.
Earn-out periods typically range from 1 to 3 years after closing, with 2 years being most common in middle-market transactions.
Common earn-out metrics
The most common earn-out metrics are revenue (45% of deals), EBITDA (35% of deals), and gross profit (15% of deals). Revenue-based earn-outs are easier to measure and generate fewer disputes than EBITDA-based earn-outs, though EBITDA metrics better align seller incentives with profitability.
When buyers use earn-outs
Buyers use earn-outs primarily to bridge valuation gaps when seller expectations exceed buyer willingness to pay upfront, to manage risk when future performance is uncertain, and to retain key seller involvement during transition periods. Earn-outs represented approximately 25–30% of middle-market M&A transactions in North America in 2023.
Tax treatment of earn-outs in Canada
In Canada, earn-out payments received by sellers are generally treated as capital gains if structured as part of the original purchase price for shares, maintaining eligibility for the Lifetime Capital Gains Exemption on qualified small business corporation shares. For asset purchases, earn-out payments may be treated as additional purchase price allocation across asset classes rather than capital gains, potentially resulting in different tax treatment.
Risks and disputes in earn-out arrangements
Earn-out disputes are common, with approximately 20–25% of earn-out arrangements resulting in disagreement or litigation over calculation, performance measurement, or buyer conduct affecting results. According to Norton Rose Fulbright, key sources of earn-out disputes include disagreement over accounting treatment of revenue or expenses, buyer operational changes that negatively affect earn-out metrics, inadequate definition of performance metrics in the purchase agreement, and disputes over whether earnest efforts were made to achieve targets.
According to Osler LLP, sellers should negotiate for earn-out agreements that include specific protections such as maintaining operational autonomy during the earn-out period, requiring buyer best efforts to achieve targets, defining clear GAAP-consistent accounting treatment, and establishing dispute resolution mechanisms.
This article is for informational purposes only and does not constitute financial, legal, or business advice. Every business sale is different. Before making decisions about valuation, pricing, or engaging an advisor, consult a qualified professional familiar with your specific situation.
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