What are earnouts in M&A deals and why are they important?

An earnout is an agreed-upon payment to management for achieving a certain goal as part of an M&A deal, which is outlined as part of the M&A agreement. For example, an earnout could stipulate that management needs to achieve a 10% growth in gross profit in the next year in order to receive an earnout payment. This incentives management to grow the business and aligns interests, while also motivating management to stay with the company before the earnout is paid.

Earnouts are structured to be a deferred portion of the purchase price and are therefore non-taxable. In order for the earnout to not be considered management compensation and therefore remain non-taxable, the earnout must not be contingent on management staying in their roles after the earnout is paid. In other words, management must be allowed to leave their roles if they wish after the earnout is paid.