How do you protect an earnout after closing?

How do Canadian business owners protect an earnout when selling their company?

If you are selling a Canadian business for $5 million to $50 million, there is a good chance your buyer will propose an earnout: a portion paid at closing, plus additional payments if the business hits EBITDA targets over the next two to three years. The risk is structural — once you sign the share purchase agreement and hand over the keys, you lose control. New owners can implement policies, shift costs, redirect revenues and make decisions that, intentionally or not, make hitting EBITDA targets nearly impossible. Earnout provisions appeared in 33% of Canadian private M&A deals in 2021, and disputes are increasingly common. Protection comes from explicit contractual covenants, not trust.

Why are EBITDA-based earnouts particularly risky?

Revenue is difficult to hide; EBITDA is not. After closing, a buyer can legitimately or questionably reduce EBITDA by: loading the business with acquisition debt and interest, allocating corporate overhead from other divisions, front-loading R&D/marketing/capex, transferring profitable contracts to other units, changing accounting or revenue-recognition policies, or increasing management compensation and consultant fees. Many of these actions can be justified as reasonable business decisions — which is exactly why explicit contractual protections are essential.

What does the Bhasin good-faith duty mean for a Canadian earnout?

In Bhasin v. Hrynew (2014), the Supreme Court of Canada established good faith as an organizing principle of contract law, creating a duty of honest performance that applies to earnout provisions. Practical meaning: a buyer cannot mislead or lie about actions affecting the earnout. What it does NOT mean: buyers have no duty to actively work toward an earnout; they can make legitimate business decisions that happen to reduce it. Quebec's Civil Code expressly recognizes a good-faith duty (Articles 6, 7, 1376); in common-law provinces the strength of such claims is still developing. Do not rely on implied good faith — negotiate explicit protections.

What are the five critical earnout protections every Canadian seller should negotiate?

1. “Ordinary course of business” operating covenants — require the buyer to run the business consistent with past practice during the earnout period; no material changes to model, pricing or marketing without consent; maintenance of adequate working capital; no transfer of contracts, costs or revenues to/from other units; continuation of supplier and customer relationships. Canadian deals are more likely than U.S. deals to include an efforts standard.

2. Detailed EBITDA calculation and expense exclusions — include a model calculation as a schedule. Exclude from EBITDA: integration and one-time costs, interest on acquisition debt, costs allocated from the buyer's other divisions, new-ownership tax effects, extraordinary items, and depreciation/amortization increases from purchase accounting. Specify the accounting hierarchy: agreed adjustments first, then your pre-sale accounting policies, then GAAP/IFRS as fallback.

3. Governance rights and approval mechanisms — retain a board seat, veto/approval rights over major decisions (acquisitions, divestitures, significant capex, product-line changes), information rights (monthly statements, access to books), and management continuity. Consider liquidated damages if the buyer breaches operating covenants.

4. Acceleration triggers — make the full earnout immediately due on: change of control, buyer bankruptcy/insolvency, material breach of covenants, sale of substantial assets (commonly 25%+), termination of you or key management without cause, or failure to maintain working capital. (Acceleration on change of control is not yet standard in Canada — ask for it anyway, especially in a seller's market.)

5. Financial security for payment — an earnout is only worth what the buyer can pay: negotiate escrow of a minimum amount, personal or parent guarantees, a security interest in business assets, interest on late payments, and conduct due diligence on the buyer's creditworthiness.

What additional provisions protect a Canadian seller?

- Indemnity offset limitations — prevent the buyer from withholding earnout payments for disputed indemnity claims; negotiate no offset, offset only for finally determined claims, or a cap (e.g., 50% of the payment)
- Dispute resolution that works — a 30-day objection period, 30-day good-faith negotiation, an independent expert for pure calculation disputes and arbitration for covenant/good-faith questions; avoid blindly delegating all disputes to an accountant
- The effort-standard spectrum — push for seller-favorable language (“best efforts,” “consistent with past practice,” specific operational requirements) over buyer-favorable “sole discretion”; in 2022 only 23% of U.S. deals required running the business per the seller's past practices and just 1% required maximizing the earnout

What practical steps reduce earnout risk in the $5M–$50M market?

1. Minimize earnout exposure — keep it below 20–25% of total consideration
2. Prefer revenue over EBITDA — revenue is harder to manipulate; gross margin is a middle ground
3. Use a sliding scale — reduces all-or-nothing dispute risk
4. Keep the period short — 1–2 years; if longer, insist on annual payments. CRA requires earnouts end within 5 years of the taxation year shares are sold
5. Engage expert advisors early — M&A lawyer (not your corporate lawyer), tax advisor, financial modeller, accountant
6. Document everything outside the agreement — term sheets, LOIs and presentations may be used to interpret ambiguous provisions
7. Mind your post-closing conduct if you stay on — your actions can also be scrutinized in a dispute

What can go wrong? A cautionary example

In Main Market Partners v. Olon Ricerca Bioscience (U.S.), a court allowed a bad-faith claim to proceed where the buyer allegedly steered business to its parent, delayed customer payments, incurred unreasonable strategic costs, and obscured expenses — the EBITDA target was missed and no earnout paid. Even with an agreement in place, sellers may face expensive litigation to collect.

Key facts: protecting your earnout in a Canadian business sale

Prevalence: earnouts in 33% of Canadian private M&A deals (2021)
EBITDA risk: easily reduced post-closing through debt, overhead allocation, front-loaded spend, contract transfers
Bhasin v. Hrynew (2014): duty of honest performance — no deception, but no duty to maximize the earnout
Five core protections: ordinary-course covenants, detailed EBITDA definition, governance rights, acceleration triggers, payment security
Keep earnout: below 20–25% of total consideration; period 1–2 years
CRA rule: earnout must end within 5 years of the taxation year shares are sold
Prefer: revenue-based metrics and sliding scales over all-or-nothing EBITDA targets

About the author

Karl E. Sigerist, Jr., ICD.D is President and CEO of The Shaughnessy Group and the author of Selling Your Canadian Business: A Step-by-Step Guide to Maximizing Value and Securing Your Legacy. Order at Amazon.ca.

Disclaimer: For general informational purposes only; not legal, tax or financial advice. Consult qualified advisors regarding your specific circumstances.