M&A & exit
Earn-out
Contingent portion of M&A purchase price paid post-close based on achievement of financial or operational targets.
Definition
An earn-out is a contingent portion of M&A purchase price paid to the seller after closing, conditional on the target business achieving specified financial or operational metrics during a defined post-close period. Earn-outs bridge valuation gaps between buyer's lower offer and seller's higher ask, allocating risk based on actual performance. Typical structures pay out over 1-3 years post-close based on revenue, EBITDA, or specific milestones.
Same concept, different references
| Canada (common law) | Earn-out, contractual (governed by SPA) |
|---|---|
| Quebec (Civil Code) | Complément de prix conditionnel |
| US (state law) | Earn-out, governed by state contract law and increasingly by Delaware fiduciary cases |
| Tax | Canadian tax treatment under s. 12, s. 24 ITA depending on form |
Common earn-out structures
Earn-outs can be structured around different metrics, each with different incentives and risks:
- Revenue earn-out: payment based on target's post-close revenue. Simple, but doesn't reward profitability — seller may game with unprofitable revenue
- EBITDA earn-out: payment based on target's EBITDA. Aligns with overall business value but requires careful definition (excludes synergies, acquirer overhead, etc.)
- Milestone earn-out: payment on specific events (product launch, regulatory approval, customer contract). Common in life sciences and technology deals
- Tiered earn-out: full payment at target, partial at threshold, none below. Aligns seller incentives but creates threshold gaming risks
Earn-out drafting challenges
Earn-outs are among the most litigated provisions in M&A. Drafting must address:
- Definition of metric: precise calculation methodology, accounting standards, treatment of one-time items
- Buyer obligations: covenants to operate the business consistent with prior practice; capital allocation; key personnel retention
- Earn-out period: typical 1-3 years; longer periods increase risk of buyer interference
- Dispute mechanism: independent accountant to resolve disputes; arbitration provisions
- Acceleration triggers: change of control, sale of business unit, termination of key contracts — usually accelerate the earn-out
Canadian tax treatment of earn-outs
The Canadian tax treatment depends on the form of the earn-out:
- Capital gains treatment: typical structure — payments treated as additional capital proceeds from share sale, eligible for LCGE on QSBC shares
- Income treatment: if structured as employment or consulting payments, treated as ordinary income at higher tax rates
- Section 248(28) cost amount: complex rules for cost amount of shares received in earn-out, affecting future dispositions
- Quebec parallel rules: substantially similar federal treatment, with separate Quebec tax filing
In Octelligence
Earn-out reporting against the corporate record.
Post-close earn-outs require ongoing reporting of revenue, EBITDA, or milestones. Octelligence supports tracking the underlying records that support earn-out calculations, with audit-ready exports for buyer review.
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