Earnouts: how they work and when to accept one
An earnout is part of the price, paid later if the business performs. Here are the terms that make one fair, and where it belongs in the deal.
An earnout is part of the price, paid after closing if the business hits agreed targets, usually over one to two years. It bridges two forecasts, the seller’s and the buyer’s. A fair one sits on top of an acceptable cash price and measures revenue, with every term in the letter of intent. One that replaces cash is financing.
What an earnout is
An earnout is part of the price, paid after the sale if the business hits targets the buyer and seller agree in advance. A price of $3 million might be $2.2 million at closing and up to $800,000 more over two years if revenue or earnings reach a stated level.
It exists to bridge a gap. The seller says the business will earn $1 million next year, and the buyer believes $800,000. The two sides set the price on $800,000 and let the extra $200,000 prove itself. Uncertainty from outside the business, such as exposure to US tariffs, is often bridged the same way.
Why buyers ask for one
- The seller’s forecast is above the record, and the buyer wants the seller to stand behind it.
- The business depends on the owner, and the buyer wants them motivated to hand over well.
- Revenue is concentrated, and the buyer wants protection if the big customer leaves.
- The buyer can finance only part of the price today.
The last reason is the one a buyer is least likely to say aloud. An earnout offered in place of cash works as financing, the same job a vendor note does, with payment tied to results.
What makes an earnout fair
The terms decide whether an earnout is a real chance at more money or a way for the buyer to keep it. Six of them matter more than the rest.
| Term | What to ask for |
|---|---|
| The measure | Revenue or gross profit, since the buyer controls net profit through costs |
| The target | Reachable by the business as it runs today, before any changes the buyer plans |
| The period | One to two years, after which the results belong to the buyer’s management |
| Control | Staffing and pricing kept at agreed levels, with a set marketing budget |
| Acceleration | Paid in full if the buyer sells the business or changes it materially |
| The calculation | Defined line by line, with the right to see the books |
The measure decides most disputes. Gross profit is revenue less the direct cost of what was sold. Once a buyer adds a management charge or changes the depreciation policy, net profit becomes a number the seller has little power to influence or check, and revenue is harder to move. In an accounting practice sold on retention the measure is the client fees that stay, and an insurance brokerage may be measured on renewals after closing.
A worked example
Take, as an illustration, a buyer offering $2.4 million cash for a business earning $600,000, with a further $600,000 if earnings reach $750,000 in each of the next two years.
The target sits 25 percent above the record, it is measured on earnings the buyer controls, and both years must hit it. Read plainly, this is a $2.4 million offer with a low probability of $600,000 more, and it belongs beside other offers at $2.4 million when you compare the offers you have.
The same earnout restated as $300,000 for each year revenue holds at the current level, with staffing and pricing kept as they are, is close to a $3 million offer. Both versions carry a $3 million headline, and the second is far more likely to pay it.
| First version | Second version | |
|---|---|---|
| Measure | Earnings, which the buyer controls | Revenue |
| Target | 25 percent above the record | The current level |
| Payment | $600,000 if both years hit the target | $300,000 for each year that holds |
| Read as | Close to a $2.4 million offer | Close to a $3 million offer |
How the CRA treats an earnout on a share sale
For a sale of shares, the CRA’s archived bulletin IT-426R describes a cost recovery method. Each earnout amount first reduces the tax cost of your shares as it becomes calculable, and any amount above that cost is a capital gain in that year.
The method has conditions. The buyer must deal with you at arm’s length, the earnout must relate to goodwill whose value was uncertain at the date of sale, and it must end within five years of the year of sale. The bulletin is archived, so your accountant should confirm how the CRA treats your terms today.
When to accept one
- When it is on top of a cash price you would accept anyway, and the terms are ones you can influence.
- When your own forecast is above the record and you are staying on to deliver it.
- When the buyer is the right buyer at a price that is close, and the earnout is what closes the gap.
When to decline one
- When it takes the place of cash at closing.
- When the measure is a profit figure the buyer controls.
- When you leave at closing and the outcome rests entirely with the buyer.
- When the buyer plans to change the business, because the business chasing the target will then be a different one from the business you sold.
Where it belongs in the process
An earnout belongs in the letter of intent, written out in full. One left as a heading to fill in during the purchase agreement gets negotiated in exclusivity, with this buyer alone at the table.
Every term in the table above belongs in the letter, and a buyer who refuses to put them there is telling you something. Signing a letter with these decisions deferred is one of the mistakes owners make when selling.
This piece describes earnouts in general terms; advice on your own terms comes from your lawyer and accountant. An earnout has tax consequences of its own in Canada, which depend on how it is structured, so your accountant should see the terms before you agree them.
Questions owners ask
- What is a typical earnout?
- A typical earnout is ten to thirty percent of the price, paid over one to two years if revenue or earnings reach an agreed level. A larger or longer one shifts more of the risk to the seller, so value it as an option on future money.
- Should I measure an earnout on revenue or profit?
- From the seller’s side, revenue or gross profit is the better measure, because it is harder to move. Net profit is a figure the buyer shapes once it adds management charges or changes accounting policies, and the seller has little power to influence or check it.
- What happens to an earnout if the buyer sells the business?
- The agreement decides, so it should say the earnout is paid in full, or accelerated, if the buyer sells the business, including by merger, or changes it materially during the earnout period. That clause protects you when the business chasing the target has become a different one from the business you sold.