Article
Strategic Risk Allocation: The Role of Earn‑Outs in M&A
An earn‑out is a contractual mechanism in M&A where a portion of the purchase price is contingent on the acquired business achieving certain post‑closing financial or operational benchmarks within a defined period. If those benchmarks are not achieved, the buyer is not required to pay all or part of the contingent consideration.
Earn‑outs are increasingly common in Canadian private M&A. In 2024, approximately 32% of Canadian private transactions included an earn‑out, reflecting a broader shift in how transaction risk is allocated between buyers and sellers[1]
Current Market Context
Recent macroeconomic uncertainty, including inflation, global trade pressures, and geopolitical volatility, has made historical financial results less reliable indicators of a business’ future performance. As a result, buyers are often reluctant to commit the full purchase price at closing based entirely on forward‑looking assumptions, while sellers may be unwilling to reduce headline price expectations.
Earn‑outs provide a structured way for parties to allocate this uncertainty. By deferring a portion of the purchase price and linking it to post‑closing performance, parties can proceed with transactions while sharing the risk associated with future results.
Key Considerations in Structuring Earn-Outs
While earn‑outs are straightforward in concept, their effectiveness depends on how well key structural risks are addressed at the outset. In practice, most post‑closing issues arise from three areas: (1) the buyer’s control over the business, (2) the accounting framework used to measure performance, and (3) the precision of the agreed metrics. Each of these is discussed in more detail below, but careful, aligned drafting across these areas is critical to minimizing disputes and ensuring the earn‑out operates as intended.
Core Elements of an Earn‑Out
A typical earn‑out is built around two key components: the performance metric and the earn‑out period.
- Performance Metrics. The performance metric determines whether, and to what extent, contingent consideration becomes payable. Common metrics include:
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- Financial Metrics. Revenue, EBITDA, and net profit remain the most frequently used earn‑out benchmarks, accounting for approximately 63% of earn‑outs in 2024 transactions[2]. Revenue is generally easier to measure but may not reflect underlying profitability. EBITDA or profit‑based metrics better capture operating performance but are more sensitive to accounting policies and cost allocations.
- Operational Metrics. Operational milestones may include achieving regulatory approvals, launching products, signing significant contracts, or generating royalty streams. These metrics are more commonly used in early‑stage, technology, or R&D‑focused businesses where financial results alone may not provide a complete picture.
Regardless of the metric selected, the parties should ensure that the metric is clearly defined, objectively measurable, and appropriate to the specific business and industry.
- Earn‑Out Period. The earn‑out period establishes the timeframe over which performance is measured. In Canadian private M&A, earn‑out periods typically range from 12 to 36 months. The period should be long enough to account for seasonality or business cycles, but not so long that performance becomes disconnected from the assumptions underlying the transaction.
Limits of Earn‑Outs
Earn‑outs can be effective in addressing uncertainty, but they are not a substitute for alignment on valuation. Where parties have fundamentally different views on value, deferring part of the purchase price may delay rather than resolve disagreement.
Transactions structured around unresolved valuation differences are more likely to give rise to post‑closing disputes, particularly once control of the business has transferred.
Common Pitfalls
Although earn‑outs are conceptually straightforward, they are a frequent source of post‑closing disagreement and litigation. Common issues include the following.
- Post‑Closing Business Operations. Following closing, the buyer controls the operation of the business. Unless the agreement provides otherwise, there is generally no implied obligation on the buyer to operate the business to maximize the earn‑out. To address this, agreements may include commercially reasonable operating covenants, setting expectations around resourcing, strategy, or continuity of operations during the earn‑out period.
- Accounting Standards and Methodology. Disputes commonly arise where post‑closing accounting practices affect earn‑out calculations. Changes to accounting policies, cost allocations, or reporting practices can materially alter results. Clear provisions specifying the applicable accounting principles and requiring consistent application throughout the earn‑out period can reduce this risk.
- Ambiguity in Metrics and Calculations. High‑level agreement on a metric is often insufficient. Earn‑out provisions should include detailed definitions and calculation mechanics to ensure results are determinable and verifiable. Involving accounting advisors during drafting can help identify gaps or ambiguities before closing.
- Review, Audit, and Dispute Resolution. Because earn‑out calculations are typically prepared by the buyer, agreements often provide:
- Access to financial records,
- Audit rights,
- Defined objection periods, and
- A tailored dispute resolution process, frequently involving an independent accountant.
These mechanisms can help resolve disagreements efficiently and limit recourse to litigation.
Conclusion
Earn‑outs have become a routine feature of Canadian private M&A transactions and are likely to remain so in the current economic environment. When properly structured, they can assist parties in allocating risk and completing transactions where future performance is uncertain.
Clear drafting, carefully chosen metrics, consistent accounting standards, defined operating expectations, and appropriate dispute resolution mechanisms are central to ensuring earn‑outs function as intended. Legal and financial advisors play an important role in assessing whether an earn‑out is appropriate and in structuring provisions that are balanced and workable for both buyers and sellers.
While earn‑outs can be a practical tool where uncertainty exists, their effectiveness depends on thoughtful design and disciplined execution. When approached carefully, they can promote alignment and preserve value well beyond closing. If you would like to discuss how these considerations may apply to your transaction, reach out to any of our team for assistance.
