I routinely field requests from founders, CEOs, and Heads of Sales on setting up the proper compensation plans for their sales teams. They know that I have a strong opinion on this topic. Back at band camp (which is what will now forever be my reference to my work at salesforce.com), I was intimately involved with the design, administration, and automation of our sales compensation plans. I had the pleasure of working with Steve Cakebread, Loretta Clarke, and Sam Chung to not only define and refine the first SAAS compensation plans but to also successfully implement a very tricky SAAS commissions automation project somehow in time to pass Sarbanes Oxley.
I also had the less distinct pleasure of informing the always over-achieving sales executive Joe Williams (who had clearly understood his comp plan well) that his payout on the company’s first huge TCV transaction was going to be capped. These plans and approaches served us well from our first ten reps to the several thousand in place by the time I departed. I would argue that if these concepts and constructs discussed below worked for “that place”, they could easily work well for your software company, regardless of its size.
I will try once again to oversimplify a somewhat complicated concept. I will break this down into only two pieces this time — the first (this one) will focus on the importance of ratability and my ten guiding principles of proper SAAS compensation plans. In part two, I will share compensation modeling templates as well as step by step instructions on using them to set up plans for your company and sales reps.
Before I proceed to espouse how simple it is to set up compensation plans that will work wonders for your company, there is one key accounting principle on SAAS compensation to understand. This one principle is what allowed SAAS companies in the ’00s (when the blackberry was cool) to hire the best reps from on-premise software companies and pay them just as much if not more for the sales of new software.
This accounting principle is called ratability — because SAAS contracts are ratable (i.e. over a contracted period of time), the revenue associated with those contracts are recognized ratably over the length of an agreement. Similarly, the commission paid out to salespeople for these contracts are amortized over the length of that agreement.
For example, on a two year, 100K ACV a year deal with a comp plan that only pays on ACV with a 15% payout rate:
- Revenue: You would recognize $8,333,33 each month for 24 months ($100,000/12 months)
- Payout: You would write a check for $15,000 to the rep.
- Commission Expense: You would recognize $625 in expense each month for 24 months ($15,000/24 months)
From a cash accounting perspective, the pay-out the rep for on-premise and on-demand software is not that different if at all. In fact, it’s often the same, and as such, you do need to have effective cash collection and management principles in place. From a ratable expense accounting perspective, it makes a world of difference. Be sure when you calculate your CAC and months to payback and magic number, you have accounted for your commissions ratably, so you are comparing your performance appropriately to industry benchmarks. It’s not going to help you benchmark much if you are treating your revenue in a ratable manner but not your commission expense.
One last poorly kept secret of the magic of SAAS versus on-premise software sales economics (especially if you follow Golden Rule #8 as described later in this piece) — your good to great account executives cost far less as a percentage of revenue over the long haul in SAAS assuming you have a respectable renewal rate.
In fact, those reps become cash printing machines.
- For example, if a rep is paid $45K for a one year, $300K ACV SAAS deal, that 15% payout rate could be considered high or low depending on your perspective.
- However, if your renewal rate is 90 %, then over 5 years, that one deal has a Total Value of $1,228K ACV or ($300K + .9*300 K+ .9*270K + .9*243K + .9*218.7K), yielding an effective payout rate of 3.7% on that deal for the AE.
- Even when you apply some fancy net present value calculations, that one deal (assuming a 5% interest rate) is worth $1,074$ in today dollars, yielding an effective payout rate of 4.2% on that deal for the AE.
Note: I am not an accountant, nor do I play one on TV and thank goodness, I did not stay at a Holiday Express last night. There are new rules around commissions accounting, but the ratable principles more or less hold. I simply do not understand why many SAAS companies don’t start commissions expense amortization until much later in their lives. It not only reinforces heavily early the importance of directing the majority of your compensation on true annuity components of your business but also allows you to benchmark your CAAC and operating expenses vis a vis relevant peer companies.
With that almost rapturous deep dive into the wonders of SAAS commissions accounting behind us, lets get to the business of how best to design the appropriate SAAS sales compensations for your organizations. To do so, you should understand and digest my ten golden rules/design principles for great compensation plans. Before everyone starts getting excited because their special way worked better for them, just remember — these are my ten golden rules and this advice is free. These rules will apply for most SAAS companies who have reps that sell subscriptions to customers, hopefully for a minimum of a year at a time.
Rule # 1 — Make Your Plans Easy to Understand
You want your salespeople to easily understand how they will make money and you want their behavior to over-optimize for what’s in their compensation plan. My personal belief is that your compensation plans be no more than 2–3 pages (with a signature block) and you try like hell to not change them mid-year once they are handed out. For your account executives, leaving a cushy sales job at a large company to sell at a start-up because they want to make an impact and have more stock is hard enough — please don’t make the critical error of changing their compensation plans regularly within a quota year. That is the easiest way to demotivate them and destroy trust. Rather, keep the plan consistent and ensure the plan allows a rep to easily predict what they will make on any sales transaction.
Rule # 2 — Use the Rule of Four to Set Your Compensation
For most SAAS accounting to work and to ensure a moderately respectful level of sales efficiency, you should avoid going below 4 for this calculation: (annualized quota) / (annualized on target earnings) where on target earnings is defined as base salary plus variable compensation. For example, for a rep who makes $150K OTE ($100K base, $50K variable), their quota needs to be approximately $600K (in annuities) to make the math work. For highly efficient businesses, especially for their lower end market segments (with a high degree of inbound demand), you may see ratios closer to 6. This 4–6 multiple also allows you to quickly understand if you are over or underpaying for performance and as a result, perhaps running out of cash too early or not providing your sales teams with a fair shake.
Rule # 3 — Ensure your Quota Periods & Sales Cycle Lengths are Sympatico
Everyone understands the construct of an annual plan: you have one quota number that you are expected to achieve within the defined year. Where I see companies, especially in their earlier stages, get too cute is when they try to hand out monthly or quarterly quotas to their sales teams without having the relevant business dynamic to support it. In my view, monthly plans only make sense when your business is relatively transactional, and sales cycles are less than 45 days, and quarterly plans only make sense when your sales cycles are less than 90 days. More specifically, make sure that the ability to close within a certain quota period is within the sales rep’s control; it is clearly not if the sales cycles of deals are considerably longer than the calculation periods. These types of plans also bring in a level of weird incentive for under-performers within a period: if a rep is not doing well within a month or quarter on these plans, they would be smart to push any deals they were going to close into the next period to maximize their compensation (especially true for compensation plans that are “not fill the bucket” and pay all dollars out at the highest tier of performance within a period). Therefore, in my view — monthly plans and annual plans are easy to understand if relevant for your business, and quarterly plans are often more trouble than they are worth.
Rule # 4 — Focus your Comp Plans on Annualized Recurring Revenue
Remember that whole lovely preamble on the magic of ratability. As such, when deciding on what components you are paying your reps on, remember that the value of your company is most tied to the total amount and growth rate of the committed recurring revenue of your business (“tell me, what’s your ARR”). As such, the king component for a standard SAAS compensation plan is the annual contract value or ACV of your software license subscription. Many people try and define this differently and they need to just STOP. ACV = the net new annualized committed annuity (ie, a contract length of a minimum of one year) a customer has signed an order form for with your company. This should be calculated and the focus of compensation for all net new license annuity events — whether that is a first-time sale to a new client (i.e., new business), or additional seats (i.e., growth) or additional products (i.e. expansion) to an existing client. For compensation plans that are focused on ACV as the primary component, it does keep things simple when reps are negotiating contracts with clients. Because, if the contract language a customer is requesting has any details that make the ACV undefinable (termination for convenience, an X month out, etc.), then the rep won’t be paid either because we won’t know over what period to spread that commission across.
Rule # 5 — Your Plans Should Incorporate Cash and Multi-year Agreements
In addition to ACV, the other biggest deal components that truly impact your business and financial performance are your Cash Billing Terms (annual upfront, quarterly, or monthly) and Multi-Year commitment (i.e., the number of years beyond one that a customer agrees to in an order form/contract). The former is all about cash burn, and the latter is all about bumping up your net retention rate or at a minimum buying you time with a client to ensure they are successful. That being said, do not chase these components for the sake of chasing them — there are businesses/industries whereby customers are not going to sign a multi-year commitment with cash up-front (i.e., very small businesses email marketing segment). In emphasizing these components appropriately for your business, I very much like seeing them in your compensation plans because then, your reps will always push their prospects for as much cash and as long a deal as possible without jeopardizing their deal. The other added bonus is you can soon kiss goodbye the litany of “end of the quarter” approval requests you receive today on horrible payment terms and contract lengths. I will explain how to do this, but I like to set up actual cash and multi-year quotas that reps can overachieve on similarly to ACV and hit accelerators. Start first with asking yourself for a given market segment of reps (i.e. enterprise) at your company the following 2 questions: 1) How important is annual cash up-front and multi-year agreements to me? 2) How hard is it to actually get those terms from customers? In the enterprise segment, the answer to those questions is usually very important and not so hard.
Rule #6 — Use Aggressive Accelerators to Attract the Best Sales People
IMHO, your top reps should always be your highest paid cash-based employees across your entire company. In fact, the amount of money a good/great rep earns (as long as they are not psychotic narcissists or their quotas ridiculously low) should be celebrated. To that end, do not be shy in the use of your accelerators for overachievement on quota. A general rule of thumb that I like to use is that if a rep achieves 2 x their quota, they should be paid 3x their variable. So for example: if a rep is on a $150K Base / $150K Variable plan with a $1.2M quota and they closed $2.4M in business, then everyone should be thrilled if that rep made a minimum of $600K. Similarly, and I know there are dissenters on this opinion out there, I am not a big fan unless the business is super cash constrained of paying negative accelerators for the first chunk of a sales reps performance. As an example, on that same plan as outlined above, the nominal payout rate up to 100% is 12.5% or $150K Variable / $1.2M quota. A plan with a negative accelerator would actually pay less than that (and as low as 0%) for some minimum threshold of performance over which the rate would be higher than 12.5% to get the reps who do 100% back to that rate of 12.5% on average for the first $1.2M in ACV closed. For me, life is hard enough and unless your business is highly transactional and requires very little sales excellence to close, avoid these types of plans.
Rule # 7 — Resist Adding/Hiring “Farmer” Reps for as Long as Possible
I often have strange discussions with founders and heads of sales at companies with less than 25 account execs who want to start splitting up their ACV targets and quota credit between new business “hunter” reps and existing customer focused “farmer” account managers. My immediate response (except if the company is a very SMB transactional business where the AE’s have no relationship with clients and selling product 2 into that install base is mission critical) is STOP. DO NOT PASS GO. I hate the use of farmer reps and arbitrarily deciding what quota credit a hunter account exec receives (ie credit for first 14 months of sales) for the following three reasons:
- Salespeople are salespeople and customer success people are customer success people. I like the purity of their roles and skill sets. Trying to make a success person (whose variable is usually tied to renewals & retention) also a great salesperson (who variable is tied to net new ACV) at the same time is fool’s gold. Have success people do what they do great but the quota credit for net new ACV should flow to the AE. The account exec will engage as needed to close the deal.
- For an account executive, it is hard enough to join a company and close brand-new accounts from scratch after they ramp up. The reward for that new business traction over time is that they should be able to more easily hit their quota in their future with the add-on potential within the clients they have closed. If it becomes too easy, don’t worry — companies can always each year add more reps, reduce accounts per rep, and raise quotas.
- Your account executives, assuming they aren’t brain dead automatons, will always take the largest deal off the table that makes sense at the time. Often that may mean selling a low discounted good-sized seed into an account initially with a plan to expand dramatically over time. However, this type of behavior would disappear immediately in a company with silly hunter/farmer compensation rules (whereby an AE is a hunter AE and only gets credit for what’s sold as new business for some defined period) as the new business reps would wait as long as possible to create the biggest possible deal.
Rule # 8 — Never Pay AE’s for Renewals
The converse to rule #7 is that account executives are paid only for net new ARR license revenue. They may receive credit for a multi-year commitment at the time of sale but will never receive credit for the renewal of contracts they initially sold. Otherwise, your sales teams become insurance agents who can over time make most of their number from previously sold annuities. Avoid this at all costs. Aside from the fact that this goes against all that is true in my ratable accounting preamble, the reality is that 1) we want reps focused on selling net new business and 2) reps aren’t the people who primarily drive renewal success. Rather, it’s the customer success team (usually a CSM) that drives retention and as such has their goals and compensations primarily tied to renewal success.
Rule # 9 — If Possible, Do Not Make Your Account Execs Collections Agents
I like my account executives focused 100% on breaking into new accounts and closing business and not on contacting the accounting department to get the check that’s past due on your invoice. I understand the construct that many companies adopt which is “I don’t pay the reps until we get paid” but I just do not roll like that. It’s the reps job IMHO to sell deals (and on you to incentivize them appropriately for requiring annual billing terms) and your finance department’s job to collect cash appropriately. I recommend that account executives are paid what they have earned no later than at the end of each month for what was closed in the prior month. That being said, if an account becomes dramatically overdue and thus at risk of being written off to bad debt and thereby de-booked (and commissions clawed back), get those reps engaged to get that cash!
Rule #10 — Thou Shall Pay Appropriately for Services
Most start-ups need a few years before finding a perfect product-market fit and hitting their stride in regards to delivering the product their target customer wants. As such, in the early days, it’s critical to ensure your customers are successful and that you provide them the level of assistance they need to be successful. This often requires the attachment of paid professional services. These services are not annuities and not high margin businesses ( you are world-class if you run >20% margin PS businesses) and, as such, I recommend paying account execs 3–5% of the value of the services up until the time you start to have a vibrant 3rd party services ecosystem. You can then consider if it makes sense to pay your reps anything on the sales of your professional services as you don’t want to create an incentive for them to not recommend your 3rd party system integrators. Side note: if you are clever, you will try and package as many success offerings as high margin annuities (i.e. premium support, training credits that expire after a year, etc) in order for them to count towards ACV quota credit as reps will obviously look to promote those much more aggressively.
