Anonymised, illustrative composite. The founder had not raised prices since a supplier cost spike seven years earlier. The new owner wanted to fix that in month one — until counsel pointed out who else the pricing decision now belonged to.
At a glance
An independent sponsor bought a specialty distribution business whose founder had built real customer relationships but had left pricing untouched since absorbing a supplier cost increase in 2019. The deal closed on a mixed structure: most of the price paid up front, the balance structured as a two-year earn-out keyed to EBITDA, meant to bridge a valuation gap and keep the founder financially interested in a smooth handover.
Diligence had already identified the underpriced accounts as the single biggest lever available to the new owner — a handful of long-tenured customers on rates that had not moved in years, on a book where competitors were charging materially more for the same service level.
The sponsor wanted the repricing done in the first quarter of ownership, before the founder’s transition involvement wound down and while the sponsor still had the founder’s customer knowledge to draw on. The founder’s counsel objected immediately: the earn-out ran on EBITDA, and a price increase in year one that provoked customer attrition — even a smaller number of large accounts leaving — could depress the very metric the founder’s final payment depended on, in a period where the founder had no operational control at all.
The purchase agreement had no covenant addressing this. It said nothing about pricing, staffing, or how the business had to be run during the earn-out window — the gap treadstonelaw flags directly: “once the deal closes, the buyer runs the business — pricing, staffing, marketing spend, product mix, which customers to prioritize”, and without an express operating covenant a seller is left arguing general good faith, “which is a harder case to make.”
“Harder” is not “impossible” — but it is a good deal harder than the phrase “duty of good faith” suggests, and the sponsor’s counsel said so. In Bhasin v. Hrynew the Supreme Court held that “good faith contractual performance is a general organizing principle of the common law of contract” and recognised a duty of honest performance — while making its limits explicit: it “does not impose a duty of loyalty or of disclosure or require a party to forego advantages flowing from the contract,” and a party may “cause loss to another — even intentionally — in the legitimate pursuit of economic self-interest.” The doctrine that actually reaches a discretionary operating decision is the one settled in Wastech: the duty to exercise contractual discretion in good faith “is breached only where the discretion is exercised unreasonably, in a manner unconnected to the purposes underlying the discretion.” That standard is demanding for the party complaining. Wastech itself lost on facts close to these — its counterparty’s allocation decisions had deprived it of any realistic chance of reaching its target profit, and the Court still found no breach. Treadstonelaw’s own answer on the point runs the same way: “Absent specific protections negotiated into the purchase agreement, a buyer who now legally owns the business generally has the right to run it as it sees fit after closing.” So a price increase does not become a breach because it hurts the earn-out. It becomes a breach only if it cannot be tied back to a purpose the contract itself was serving — which is exactly the fact pattern a sponsor creates when it reprices with no recorded rationale and loses an earn-out-relevant account in the same quarter.
That risk, not any contractual prohibition, is what actually constrained the sponsor’s timing. There was no clause stopping the price increase. There was a real, if unquantified, litigation exposure if the increase and the earn-out shortfall landed in the same conversation.
The sponsor did not shelve the repricing — it documented it. Before touching a single account, the new commercial lead built a written pricing memo: which accounts were below market, by how much, the competitive rate evidence behind each figure, and a phased rollout timed to renewal dates rather than a single blanket increase. The memo was shared with the founder’s counsel before implementation, converting a unilateral decision into a documented, defensible, commercially-rational one — the record a good-faith defence actually needs if the earn-out later comes in under target.
The increase went ahead in a staggered rollout starting in month four rather than month one. Two smaller accounts left; the larger relationships, priced closer to market from the outset by design, stayed. The founder’s earn-out came in near the top of its range in year one. No claim was ever made — but the sponsor built the file as though one might be, from the first pricing memo onward.
One further wrinkle sat underneath the earn-out itself, and it is routinely stated wrongly. ITA s.40(1)(a)(iii) does let a vendor claim a capital-gains reserve, capped by clause (D) at 1/5 of the gain multiplied by the amount by which 4 exceeds the number of preceding taxation years since the disposition — which is why the gain can be spread over at most five taxation years, and why the CRA’s own guidance says “the maximum period over which most reserves can be claimed is four years, resulting in the total capital gain included in income over five years.” But clause (C) limits the reserve to proceeds “that are payable to the taxpayer after the end of the year.” Payable, not contingent. An earn-out amount that has not yet been earned is not payable, so s.40(1)(a)(iii) does not defer tax on the contingent part of the price. Where the earn-out is on shares, the framework that governs instead is the CRA’s cost recovery method in IT-426R: the vendor reduces its adjusted cost base as amounts “become determinable” — meaning “capable of being calculated with certainty” with “an absolute but not necessarily immediate right to be paid” — and only then may a reserve be claimed, on the determined-but-unpaid portion. That method carries six conditions, and one is a hard deadline: “the earnout feature in the sale agreement must end no later than 5 years after the date of the end of the taxation year of the corporation (whose shares are sold) in which the shares are sold.” A two-year EBITDA earn-out sits comfortably inside that. The founder’s advisors therefore had a real and separate interest in the earn-out running to schedule — not because a reserve was quietly deferring the contingent money, but because the timetable is a condition of the only method that makes the tax outcome workable at all.
A 30-minute call is enough to tell you whether a structuring or diligence gap like this one is sitting in your pipeline.
