Selling A Business: Earn-Out Clauses To Bridge A Valuation Gap

Key Takeaways

• Earn-out clauses help bridge valuation gaps between buyers and sellers.
• A portion of the purchase price is paid after closing based on predetermined criteria.
• The metrics used can be financial or non-financial.
• The earn-out structure directly affects the parties’ behaviour after the transaction.
• Vague wording is one of the main sources of dispute.
• The more objective and measurable the criteria are, the lower the risk of conflict.

In the context of a merger or acquisition, buyers and sellers often struggle to agree on the targeted company's value. The seller may believe their company is worth significantly more than what the buyer is willing to pay, mainly due to differing assumptions about the company's future performance, and vice versa.

To bridge this gap, parties sometimes resort to a contractual arrangement known as an earn-out clause.

An earn-out clause provides that a portion of the purchase price is withheld and will be paid by the buyer to the seller based on target post-closing results or upon the fulfillment of predetermined conditions (for example, over a 24-month period following the closing of the transaction).

While earn-outs are not used in every transaction, their popularity tends to rise during periods of economic uncertainty: according to a study by SRS Acquiom published in 2026, a quarter of the private transactions recorded in 2025 included such a clause, thus confirming a marked upward trend over the past decade.

Why Resort to An Earn-Out Clause?

Earn-out clauses are highly adaptable to the specific circumstances of each transaction and involve a series of trade-offs. Choosing the right arrangement will always depend on the issue the parties are seeking to resolve (whether it involves a company without a sufficient track record, a promising technology not yet commercialized, or an unstable economy making valuation challenging, for example).

Economically speaking, by agreeing to an earn-out, the seller bears at least part of the risk that the company will not perform as well as expected after closing, thereby reassuring the buyer, who in turn exposes themselves to a potentially higher total price than they were willing to pay at closing if post-closing results prove favourable.

This sends a clear signal to the buyer regarding the seller’s own convictions about the company’s value and future potential. In other cases, earn-outs simply serve to align assumptions that both parties share amid uncertainty, without either party having an informational advantage over the other. Consider, for example, risks related to trade policy between two countries, the outcome of which is unpredictable for all parties.

How to Choose the Right Performance Metric?

Earn-outs can be based on financial or non-financial metrics. Outside the life sciences sector, financial metrics are the most common.

Metrics Based on EBITDA or EBIT

Earn-outs based on EBITDA or EBIT paint a clear picture of the company’s operating profitability after closing and, between 2023 and 2025, accounted for between 13% and 23% of transactions, according to the Acquiom study.

While they provide clarity on operating performance, they remain complex to compute and verify and create room for manipulation due to the many discretionary decisions involved in their calculation.

Revenue-Based Metrics

Revenue-based earn-outs are by far the most common (accounting for between 65% and 69% of transactions, according to the same study) and are particularly prevalent for high-growth companies.

They are simpler and more transparent but remain poorly aligned with the company’s financial performance. Furthermore, if the seller remains in management, they may have an incentive to artificially inflate revenue through rebates, discounts, or premature revenue recognition practices, to the buyer’s detriment.

Non-Financial Metrics

Non-financial metrics (such as obtaining a patent, securing regulatory approval, or reaching a customer threshold) are easier to design and generally give rise to fewer disputes, as they cannot be easily manipulated through accounting practices.

The Main Earn-Out Structures

Beyond selecting the appropriate metric, earn-outs can be structured in different ways: on a linear basis (where the amount paid is proportional to the degree to which the target is achieved), as a cliff earnout (where the seller receives everything or nothing), or as a steps earnout (where achieving successive performance thresholds unlocks increasing payments). 

Cliff Earnout 

Cliff earnout involves significant behavioural risks: if the seller realizes they will not reach the target, they may lose all motivation to put in the necessary effort. 

Practitioners tend to advise against using this structure unless the cliff is set at a level that is very easily attainable. 

Steps Earnout 

Steps earnout are preferable as it partially rewards the seller at various points during the earn-out period, thereby keeping them motivated to work toward the company’s success. 

Linear Structure

Linear structure, on the other hand, acts as a performance-based royalty and helps avoid the “all-or-nothing” mindset associated with the other two structures.

Key Risks Linked to Earn-Out Clauses 

Earn-outs are widely recognized as sources of post-transaction litigation.

According to the American Bar Association, they give rise to litigation so often that some practitioners advise buyers to set aside a provision equivalent to 20% of the purchase price to cover lawsuits filed by sellers.

The most frequently cited pitfalls are:

• misalignment of the parties’ interests after closing;
• morale issues among management teams if targets are not met;
• difficulties in interpreting clauses, as the parties tend to exploit even the slightest drafting ambiguity;
• the risk that agreed-upon milestones will become obsolete over time.

Although protective measures can be negotiated (such as acceleration clauses if control changes hands or commitments to manage the company in accordance with the seller’s historical practices), they remain fairly rare in practice and are themselves a potential source of litigation when the parties disagree on what constitutes “reasonable” management.

Drafting an Earn-Out Clause Effectively to Minimize Litigation Risks

An earn-out clause is a powerful but demanding tool. How it is drafted depends heavily on each transaction’s specific facts and how far apart the parties’ positions are.

To minimize the risk of disputes, the parties should ensure that their earn-out is clearly defined, as objective as possible, easy to measure, and consistent with the nature of the target company’s business.

It is therefore strongly recommended to seek legal counsel early on in any transaction that may include an earn-out, to choose the metrics and structure best suited to your situation and to set contractual guidelines for behaviours that could lead to disputes once the champagne has been popped.

Earn-out Clause: Tailored Support for Your Transaction

Considering a transaction where an earn-out clause might be included? Contact Marianne Richer-Laflèche to assess available options and determine the best structure for your situation. You can also explore our services in mergers, acquisitions, and business transfers and business law to learn more about the support offered by our teams.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.