SALES COMPENSATION PLANS — IN-DEPTH GUIDE

If you’re a young company building a sales team and struggling to figure out the right sales incentive plan, you’re not alone. We get this question a lot as investors advising founders. Compensation is an important factor in attracting and retaining employees, especially for sales teams. Sales commission is a key aspect of sales compensation — It’s the amount of money a salesperson earns based on the number of sales they generate.

A FEW BASIC TIPS WHEN DESIGNING A SALES COMPENSATION PLAN

1. Don’t cap compensation — Capping the earning potential decreases motivation of your salespeople. Management should be supportive of their sales team and want them to make as much as possible in return for meeting and exceeding targets.

2. Do it right the first time — Unexpectedly changing a compensation plan moves your sales team’s goals and targets, diminishing your reps’ morale and motivation.

3. Keep it simple — Make your compensation and commission plan clear. Not only will this make the commission structure easier to manage, but it will also ensure there aren’t any loopholes in the plan.

4. Provide a head start — Depending on the business, it can sometimes take time for a new sales rep to hit their stride. Consider giving them a grace period before they must meet their minimum quota (ex: 1–2 months).

DETERMINE SALES COMPENSATION PLAN GOALS

The first part of developing a sales compensation plan strategy includes setting your goals and laying out your business objectives. In addition, the overall business sales forecast should align with the sales quotas. Below are some common examples of primary and secondary goals of sales compensation plans for consideration.

TYPES OF COMPENSATION STRUCTURES

The structure of a sales compensation plan varies by business and is typically based on team structure, resources and goals. For example, one sales organization might offer a higher base salary, while another might prioritize a higher commission ratio based on their budget, product, business development priorities, employee needs and targets.

1. Base Salary + Commission

Under this plan, salespeople are provided a base salary with commission. The standard salary to commission ratio is 60:40, where 60% is fixed and 40% is variable. This structure is ideal for companies where sales rep retention is critical to the success of the sales organization. The company is actively investing in the success of the rep while incentivizing their performance.

2. Straight Commission Plan

With this plan, a sales reps’ income comes directly from the sales they generate with no guaranteed base salary. This structure is ideal for companies with not a lot of capital because the sales rep assumes the risk by forfeiting the security of a steady salary. High-performance sales reps can thrive in these environments, but the downside is sales rep quality and stability in roles solely based on commission. In most cases these reps are referred to as sales agents.

3. Relative Commission Plan

The relative commission plan is when a sales target is set. Let’s say a salesperson has a quarterly quota of $80,000 and a quarterly commission of $10,000. If they meet 85% of the quota, they’ll receive 85% of the $10,000 commission. And if they exceed their quota (ex: $88,000 or 110%), they receive an increased commission equal to the percentage they exceeded it by (ex: $11,000 or 110%). This is in addition to their base salary, which can help incentivize underperformers without causing the turnover that often happens with roles under commission-only plans.

4. Absolute Commission Plan

This is when a commission is paid as a result of engaging in specific activities or meeting specific goals. For example, a salesperson might be paid $1,000 for each new customer and $500 for renewing a customer contract. Like the relative commission plan, it can help incentivize underperformers, but the emphasis is less on revenue and more on activity.

5. Tiered Commission Plan

A tiered structure encourages reps to put in extra effort by providing higher commission as they hit higher sales milestones. Under this plan salespeople are paid increasing commissions as they meet their quota, exceed their quota, and continue to close more deals than they’re expected to. On the flip-side they may receive less commission if they miss their target. This helps ensure a company recuperates the minimum required revenue per salesperson to cover their base salary. This structure is ideal for organizations with salespeople who need to consistently try to exceed their goals while having a little more control on commission rates than the relative or straight-line commission plan. This is my preferred structure as many investor backed companies (including public companies) are adored for beating targets and can be highly discounted for not meeting them.

Example:

SALES COMPENSATION TERMS TO KNOW

Depending on how you structure your sales compensation plan, the following terms and concepts may come up as you start documenting the compensation plan process.

Sales Quota

A sales quota is a target set by the company or sales manager for sales reps to hit in a given period — either individually or as a group. The most common time constraints for quotas are monthly, quarterly, and annually. This ensures meeting targets throughout the year and rewards short-term and longer-term results. Various quotas can co-exist such as topline revenue, account growth, margins, retention, sales by product, geography and activity. Topline revenue quotas can include these other more granular targets, but it will be more complex to manage.

On-Target Earnings

On-target earnings (OTE) provide salespeople with a realistic view into what their total compensation for a position would be when their expected and reasonable goals and quotas have been reached.

Sales Accelerators

A sales accelerator kicks in when one of your reps hits a specific amount over their quota. This type of payoff is exponential for your reps — they may end up with a large commission check if they have a highly successful month or quarter (so be aware of your resources and budget). For example, if a rep hits 110% of their quota by the end of the month, you’d pay them 130% of their commission depending on whether you want to highly incentivize them to exceed their targets. The tiered commission plan, described above, is an example of sales accelerators at work.

Example:

*This is the year bonus however the same format can be used for monthly and quarterly sales targets.

Sales Decelerators

Sales decelerators have the opposite effect as accelerators — they penalize underperforming reps (see red font above). A decelerator may kick in between 50–95% of their quota. In other words, if a rep only hits 70% of their quota, they may get no commission in order to absorb their fixed salary component. This is referred to as their minimum quota.

Clawbacks or Delayed Commission

A clawback kicks in when a customer churns prior to hitting a specific benchmark. The customer churn results in a sales rep not receiving their commission and is common among subscription companies in an effort to keep customer retention rates high. Some SaaS companies institute a four-month clawback or delay for commission payout. This ensures reps focus their time and attention on businesses that can really benefit from the product. If your company has a customer success team, you may also want to consider upside for their efforts in retention.

Sales Performance Incentive Fund or Sales Contests

Sales performance incentive funds (SPIFs) or sales contests are ways to incentivize high performance among your salespeople. These tactics are often used to change behavior and include a bonus (such as a $500 cash prize to the first rep who closes 10 deals this month) or non-monetary (a trip for every team that increases their retention rate by the benchmark percentage). These sales incentives and contests should run for short periods of time — about one to four weeks total. If they run longer, reps will lose the necessary sense of urgency for this tactic to work.

DECIDING ON BASE SALARY VS. COMMISSION

Pay mix — the ratio of fixed pay (base salary) to variable pay (incentive or at-risk pay) is commonly used to gauge the extent to which a sales compensation plan motivates salespeople to drive results. As mentioned earlier, a 60:40 pay mix is the average sales teams, but the mix varies across industries and sales roles. A very aggressive mix (ex: 0:100) is common in industries (ex: insurance) that use independent contractors as sales agents. A less aggressive mix (say 75:25) is typical in industries such as pharmaceuticals that want salespeople to focus on customer education, and for technical sales jobs that have a large problem-solving or consultative sales process component. Depending on the sales roles, a company might offer a 50:50 pay mix for salespeople in new customer acquisition (CA) roles, but a 70:30 mix for salespeople in account management (AM) roles. This encouraged the CAs to “hunt,” while the AMs focused on cultivating relationships with existing customers. Example of a 50:50 mix is below:

To determine your base-variable (or fixed) compensation split, think about the following factors:

• How difficult is the sale to make? The more difficult the sales, the more likely a sales rep will need a higher base to cover their cost of living before receiving commission. Sales to large enterprises take longer than individual consumers — craft your split to match your unique business.
• How much autonomy is needed (for example, are you providing your reps with leads or are you asking them to generate their own? Are you giving them technical support or are they completely alone?). These factors can help them achieve their targets and earn commissions relying less on base salary to live.
• How much experience is required to achieve on target earnings?

To determine the variable compensation, think about the following factors:

• How long and complex is your sales cycle?
• How much influence the rep has over the purchasing decision?
• How many leads reps work with at a given time?
• Your team’s selling function (such as hunting or farming)

Essentially, the simpler a sale is and the less impact a rep has over the customer’s behavior, the smaller the percentage of variable compensation should be.

How to calculate a realistic sales quota

Generally speaking, 80% of your sales team should be able to meet their quota most of the time. If that’s not the case, your sales quota might not be realistic. Below are examples of how a realistic sales quota can be set for your sales reps.

#1 Bottoms-Up Approach

Starting with the company’s top line sales objectives, the bottoms-up approach requires you to consider your team’s capabilities as well as the market opportunity to determine what each territory’s and/ or salesperson’s quota should be. The more historical sales rep achievement data you have here, the easier this will be. Your inputs will vary depending on your product and type of sale, but generally, you’ll want to consider the following when using the bottoms-up approach to establish quota:

• Average contract value (ACV) or average deal size
• Average revenue expected per salesperson to meet the company’s objectives
• Number of salespeople needed
• Number of qualified leads (per month or quarter)
• Percentage of qualified leads that close

These considerations will tell you how many deals a rep should be working and thus what a reasonable quota should be based on forecasted conversion. Alternatively, you can simply multiply the typical number of expected closed deals by the average deal size. This will give you a baseline number to use for your quota. Caution though because the more successful and experienced your salespeople become, the more deals they’ll be able to work and the bigger their contracts will be. This means their quota may quickly become inaccurate, so you’ll want to have an agreed mechanism to re-evaluate it if you go with this approach. I usually ensure everyone knows that the quota can be revisited at set intervals (example yearly) and this is mentioned in the signed compensation plan attached to their employment agreement.

#2 Top-Down Approach

With a top-down approach, you combine market data with your revenue targets to figure out what your team needs to bring in. This is especially important to ensure you can cover the fixed cost of a salesperson. So, if most companies in your space pay their salespeople in the X to Y range, and your reps need to close Y amount in total for your business to hit the established goal, you can determine a reasonable OTE as well as your optimal team size.

ENEMIES OF A HEALTHY SALES QUOTA

1. Unrealistic quotas

If you set your monthly quota without considering seasonality or historical rep performance, you’re setting your team up for failure. Similarly, don’t adjust quota based on an unexpected renewal or larger than average deal. Raising rep quotas because of a great month can demoralize high-performing reps and stall growth. Before raising quotas (for new reps or at renewal), make sure you have three to six months of data to support the decision — and that it’s not just coming from one rep. With more than one sales rep it is obviously easier to identify an overachiever. If you have one rep or territory consistently beating their number, identify what their success is due to and consider adjusting their quota (at renewal) instead of everyone’s quota.

2. Stress due to unrealistic quota

The fastest way to demotivate or even burnout your sales team is to set unrealistic quotas. Your job is to know your team’s limits and set a more top-down approach to quotas. The average tenure of sales reps has seen a 50% decline from an average of 2.5 to 1.5 years in the last 10 years. Sales is already a volatile profession. Retain top-tier employees by ensuring their quotas are realistic and they have the support to meet and exceed their goals regularly otherwise they will leave for a more realistic earning opportunity.

3. Commission caps

Commission caps limit the amount of commission a salesperson can earn. When a rep has hit their commission cap, they are not financially rewarded for closing more business. This de-incentivizes reps to push the limits and close more business. This is why I like an unlimited upside for out-performers that beat the average of their group.

A word on Stock Options

Sales reps are continuously motivated by hitting short term-results and being compensated for measurable results. In your company you can expect the highest employee churn to be in the sales department. Sales reps often come and go due to being let go for underperformance or because they leave in hopes of an easier commission win. For this reason, many sales reps do not get motivated by stock options which they might not be around to fully collect if there is a vesting schedule (ex 4-years). Another thing to consider is how your cap table might look down the road with this kind of turnover. For a Vice-President of Sales, you may want to consider stock options for them. However, make it directly correlated to achieving the company’s top line revenue projections. As is the case with setting the right salary to commission mix, you want to consider this third incentive in the overall compensation for on-target earnings.