By Rebecca Cochrane and Kyra Flomen
The evolving trade relations between Canada and the United States since the start of President Trump's second term have created considerable uncertainty in the capital markets. From the threat of tariff application to proposed regulatory changes, this new uncertainty has fostered a "wait and see" mentality among many market participants in the mergers and acquisitions (M&A) space. One possible solution for those looking to make deals while shielding themselves from potential risk presented by these new market conditions is the reliance on earnouts as a flexible structuring mechanism in M&A transactions.
An earnout is a deferred financing mechanism; a portion of the purchase price is made contingent on the target company achieving certain post-closing performance milestones. In the last decade, the use of earnouts has increased, especially in mid-market transactions. A 2024 study conducted by SRS Acquiom Inc. found that one in five private target M&A transactions with which it was involved that year (predominately in the U.S.) utilized earnouts.1
Despite volatility in the capital markets, the deep historical and commercial relations between the Canadian and U.S. economies, along with the general alignment between the two legal systems, make cross-border M&A attractive. Buyers and sellers can utilize creative deal structures – including earnouts – to navigate this changing economic landscape.
Considerations for Earnout Provisions
Earnouts help the parties to M&A transactions distribute risks; however, this tool should not be used to merely kick risk exposure down the road. Earnouts should be carefully crafted to outline how the earnout will be calculated and how the parties will evaluate whether the target company has reached the earnout thresholds.
Earnouts based on financial metrics must be carefully drafted to avoid ambiguity and potential disputes. Measuring performance using EBITDA, for example, is inherently more complex and subjective than using top-line revenue, as EBITDA can be influenced by accounting choices, discretionary adjustments, and the treatment of expenses or non-recurring items. In cross-border transactions, that complexity is magnified when the buyer and seller rely on different accounting standards – such as U.S. GAAP and IFRS – making it essential to align on definitions and methodologies at the outset.
Post-closing, the seller typically has less control, if any, over the target business, including its ability to reach the earnout thresholds. As such, it is useful to consider including buyer covenants in the purchase agreement about how the business will be run. For example, sellers may seek the inclusion of a covenant that the buyer will use their best efforts to maximize the earnout payment, will commit to a certain level of investment in specific segments of the business or will conduct the operations of the target company consistently with past practices.
Cross-border earnouts also raise additional challenges, such as differing tax treatments, accounting standards and dispute resolution mechanisms – all of which require careful planning on both sides of the border.
Earnouts in Economic Uncertainty
With the current economic upheaval between Canada and the U.S., buyers and sellers often struggle to agree on future events that could materially impact the value of the target company. Earnouts assist by enabling market participants to enter into M&A transactions while maintaining a "wait and see" mentality regarding the final purchase price.
Benefits for Buyers:
- The use of earnouts helps ensure the buyer is not overpaying for the target company, especially in an economic environment where valuation is difficult. Additionally, with the Canadian dollar recently weakening against the U.S. dollar, potential Canadian targets may be on the market for a more attractive price.
- Maintaining deal activity may give buyers an edge in downturns. Bain & Company, in their Global M&A Report 2023, found that buyers who were active before the 2007-2009 global economic recession performed better by staying active, with their average annual total share returns reaching 6.1%, compared to 3.8% returns for buyers who reduced their activity in response to the recession.2
Benefits for Sellers:
- Earnouts can assist sellers by enabling them to receive greater value for their businesses than the market conditions might otherwise facilitate, particularly if the target company continues to perform post-closing. An earnout can be the bridge between what a seller believes their business is worth and what a buyer is willing to pay today.
Key Takeaways
- Despite economic instability and changing trade relations between Canada and the U.S., employing creative M&A deal structures, including the use of earnout mechanisms, can assist market participants in bringing deals across the finish line.
- Earnouts can reduce risk and unlock deal value in uncertain times.
- The use of earnouts in M&A transactions has increased over the past decade, and the current economic climate could encourage further use of this financing mechanism.
- Purchasers benefit from the use of earnouts by helping ensure they do not overpay for a target company, particularly when market unpredictability further complicates the valuation process.
- Earnouts are useful to sellers facing a buyer's market by giving sellers the opportunity to earn a higher purchase price post-closing.
Footnotes
1. SRS Acquiom, "M&A Deal Terms: Three Trends to Watch in 2025" (2025) online: M&A Deal Terms: The Key Trends for 2025
2. Bain & Company, "Global M&A Report 2023" (January 2024) online: bain_report_global_m_and_a_report_2023.pdf.
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.
