David Randell and David Slipp

With a number of economic indicators showing headwinds ahead, purchasers and vendors are likely to have a more challenging time agreeing on a target company’s valuation. In these cases, parties will often turn to earn-out provisions in order to bridge the valuation “gap”.

For a detailed review of the law of earn-outs in the United States, see this article contributed to the Harvard Law School Forum on Corporate Governance and Financial Regulation by Gail Weinstein et al. Inspired by that piece, this article focuses on the Canadian perspectives of earn-outs and reviews some of the Canadian jurisprudence. Unlike the Unites States, there is no seminal or leading case on earn-outs in Canada. In fact, it appears that the Supreme Court of Canada has never heard a dispute related to an earn-out provision.

What is an earn-out?

An earn-out provision is a tool that can be used by vendors and purchasers in an agreement of purchase and sale to bridge a gap between the parties as to the value of the target business. Earn-outs provide for subsequent payment(s) by the purchaser to the vendor post-closing over a set period of time, if the target business achieves certain defined thresholds (usually financial) or through the calculation of defined metrics. Commonly, earn-out mechanisms in Canada have been based on:

• Gross revenue;
• Earnings before interest, taxes, depreciation and amortization (“EBITDA”)/profit;
• Royalties earned; or
• Achievement of milestones such as the granting of a licence or listing on a stock exchange.[1]

An earn-out can be drafted as an all-or-nothing payment: if the company has gross revenue of $2.5 million in 2020, then the vendor will receive an additional payment of $250,000.

Alternatively, they can be dependent on the operation of a formula: the vendor will receive 15% of all royalties paid to the company in excess of $1.5 million.

If the vendor is key to the business and will be staying on as an employee, an earn-out can be used as an incentive to continue building the business. They can also be used to defer or amortize payment of the closing price over a longer period of time, which can help alleviate liquidity concerns for the purchaser and have potential tax benefits.

An earn-out is one way to include flexibility into an agreement of purchase and sale, but unfortunately, this flexibility comes at the cost of certainty and can often lead to conflict between the vendor and the purchaser.

What are the potential tax consequences for using an earn-out mechanism?

The tax treatment of the income generated by the earn-out payments will be categorized in one of two ways: as capital income benefiting from the capital gains exemption, or as income dependent on the use or production from property taxed at the full marginal rate. The Canadian Revenue Agency (“CRA”) will weigh a number of factors in deciding how much of the income is taxed, including whether the sale was of the assets or shares of the target company. Unfortunately, the CRA has a history of inconsistent treatment of earn-out income.[2]

In Smith v The Queen, the vendor in an asset transaction sold the clientele list of their business to the purchaser.[3] It was established law that a sale of a clientele list was a business transaction subject to the capital gains exemption, however, Justice Favreau of the Tax Court of Canada stated that payments contingent on the amount of money generated by a sold asset may bring the income under paragraph 12(1)(g) of the Income Tax Act and was therefore taxable at the full rate.[4]

Further, the tax treatment for earn-outs in share transactions is not so clear-cut. The CRA has developed a mechanism to reduce the tax liability for vendors when the earn-out was used to bridge a disagreement on the valuation of the target company’s goodwill, however, the criteria that must be met to use this mechanism are narrow and will not always apply.[5] In other cases, the income may fall under paragraph 12(1)(g), or the fair market value of the right could be included in the proceeds of disposition and claimed in the year of sale.

The tax implications for the purchaser under an earn-out are much simpler. Any portion of the purchase price that is subject to a contingency cannot be added to the purchaser’s cost until it occurs. As time passes, and the contingencies become certain, the cost of the property will go up. Occasionally, a complication can arise regarding eligible capital expenditures if the target company ceases to exist before the end of the earn-out period (wind-up, amalgamation, etc.) but the increase to cost over time remains constant.[6]

How will the Court approach a dispute about whether the earn-out is owed?

The parties in Whiteside v Celestica International Inc. found themselves at odds in front of the Ontario Court of Appeal when the vendors claimed they were owed a full earn-out payment of $1,750,000 and the purchaser claimed that no payment was due because the target had not been met. [7]

In that case, the earn-out payment for each period was calculated using a formula based on the earnings before interest after taxes (“EBIAT”) of contracts that met specified criteria. During the last earn-out period, the company landed a very lucrative contract that, if included, would result in an earn-out payment being owed, but if excluded, would result in no payment being owed. The contract did not fit squarely within the specified criteria, but the company had included similar contracts of lesser value in earlier earn-out calculations.

Justice Paul Lalonde of the Ontario Superior Court of Justice found that the company was justified in excluding the contract from the calculation based on his strict interpretation of the clause containing the specified criteria. On appeal, the Ontario Court of Appeal overturned Justice Lalonde’s decision on the grounds that he failed to properly interpret both the contract and the testimony.

The Court of Appeal stated plainly that earn-outs, like other contractual provisions, cannot be read in isolation from the rest of the contract and must be considered in the specific circumstances of the contract’s creation and purpose. Justice Lalonde’s interpretation of the earn-out provisions was not consistent with the rest of the contract or the manner in which other calculations were made by the parties.

Further, the Court is free to interpret contracts in light of how the parties acted after the agreement was made but before the disagreement. The Court of Appeal put great reliance on the fact that the purchaser had included similar contracts in the calculations in previous years, but neglected to include the one that would have impacted the earn-out. The Court of Appeal also found based on the evidence presented at trial that the company had deferred some of the revenue from the contract into the next fiscal quarter, which fell outside of the earn-out period.

Do purchasers have a duty to work towards meeting the earn-out criteria?

In Bhasin v Hrynew, the Supreme Court of Canada imposed an implied duty of good faith performance in all commercial contract relationships.[8] However, in doing so, the Court is clear to state that this duty does not prevent parties from obtaining an economic benefit to the detriment of another party. There does not appear to be any Canadian case law considering whether actively working against an earn-out formula to minimize obligations thereunder constitutes bad faith. The lack of Court consideration in this area is likely due to the prevalence of dispute resolution clauses in purchase and sale agreements.[9] The contract in Whiteside explicitly required the parties to act in good faith in relation to the earn-out calculation, but the Court did not consider whether the (assumedly) purposeful decision to exclude the contract constituted bad faith and determined the issue on other grounds.

The Courts in Delaware have addressed the issue of good faith in the earn-out context and generally determined that although the American duty of good faith performance requires parties to not work actively against the achievement of an earn-out, if a legitimate business decision undermines the achievement of targets, then that will not constitute bad faith.[10] However, some States, including California and Massachusetts have imposed a “reasonable efforts” burden on purchasers to achieve earn-outs.[11] In light of the Bhasin decision, the intention of the purchaser while making business decisions would likely be a determining factor if a claim of bad faith made it to the courts in Canada.

What if the purchaser and the vendor have a conflict unrelated to the earn-out?

In Coolbreeze Ranch Ltd. v Morgan Creek Tropicals Ltd., the purchaser in a share transaction made a claim against the vendor, claiming that the vendor had misrepresented the financial outlook of the company and its relationship with a number of distributors. [12] The purchaser did not dispute that it owed the vendor $650,000 in accordance with the earn-out formula, but it sought a set-off against any potential damages stemming from the misrepresentations and a stay of execution of the debt until the misrepresentation claim could be determined.

The Supreme Court of British Columbia declined to allow the set-off because there was not a sufficient nexus between the two claims. The Court interpreted the contract as having two parts: the payment of the closing price upon closing for the acquisition of the shares, and the payment of the earn-out according to the formula. As the misrepresentation potentially devalued the shares, it related to the first part of the contract and had no impact on what should be paid under the earn-out.

Even though the parties to this agreement included a dispute resolution mechanism, which was properly followed, the contract did not address whether funds owing under the earn-out could be reduced to satisfy claims under the indemnity clause or be used as a way of set-off for any future disagreements.

Key take aways

1. Earn-outs can be used in a variety of contexts and are a valuable tool in negotiating an agreement, but their inherent flexibility may cause problems post-closing. In addition, the income from earn-out payments may not be treated as a capital gain, and should be negotiated with this in mind.
2. In interpreting an earn-out, the Court will interpret the contract as a whole and will consider the past conduct of the impugned party to determine if a payment must be made. Purchasers have no duty to work towards an earn-out after taking over the business in Canada, but are likely bound by the implied duty of good faith performance not to actively frustrate them except as a consequence of a legitimate business decision. The temptation for purchasers to undermine payments will be lessened if earn-out payments are not wholly contingent on the achievement of one target, but include a sliding scale of compensation.
3. Parties should prepare for the worst and include a robust outline for dispute resolution and turn their minds to how, if at all, amounts owed under an earn-out can be used to satisfy claims brought by the purchaser during the earn-out period.

This article is provided for general information only. If you have any questions about the above, please contact a member of our Mergers & Acquisitions Group.

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[1] Practical Law Canada Corporate & Securities, “What’s Market: Earn-Outs” (August 28, 2019) [What’s Market].
[2] Warren Pashkowich and Daniel Bellefontaine, “Participation-Based Payments: What Are They and How Are They Taxed?” (Canadian Tax Foundation, 2017 Conference Report, 9:1-25) [Pashkowich and Bellefontaine].
[3] Smith v The Queen, 2011 TCC 461.
[4] Income Tax Act, RSC 1985 c 1 (5th Supp).
[5] Interpretation Bulletin IT-426R, “Shares Sold Subject to an Earnout Agreement,” September 28, 2004.
[6] Pashkowich and Bellefontaine, supra note 2
[7] Whiteside v Celestica International Inc., 2014 ONCA 420.
[8] Bhasin v Hrynew, 2014 SCC 71.
[9] What’s Market, supra note 1.
[10] For example: Winshall v Viacom (2013) (Del. Sup. Ct.) and American Capital Acquisition v LPL Holdings (2014) (Del. Sup. Ct.).
[11] Gail Weinstein et al., “The Enduring Allure and Perennial Pitfalls of Earnouts” (Harvard Law School Forum on Corporate Governance and Financial Regulation).
[12] Coolbreeze Ranch Ltd. v Morgan Creek Tropicals Ltd., 2009 BCSC 151 [Coolbreeze Ranch].