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Sales Compensation: The Ultimate Guide

Sales compensation is one of the trickiest aspects of the sales organization to get right. Not only are salespeople notoriously good at figuring out and exploiting loopholes in the pay structure, but there are tens of different variables to balance.

How sales compensation should work

A sales compensation plan operates from a basic principle: Money drives behavior.

That is to say, if you want your salespeople to do X, reward them financially for doing X. If you want them to stop Y, penalize them financially for doing Y.

For instance, if you want your reps to prioritize renewals over new business, give them a bigger commission for the former. If you want them to stop selling to poor fit customers, institute a clawback so they lose their commission if the customer churns or returns the product within a set window of time.

The "right" and "wrong" behaviors depend on your high-level company goals.

So before you can craft or adjust your sales compensation plan, you must know your business objectives for the next year.

Here are some common ones:

Primary goals:

  • Grow revenue
  • Increase cash flow
  • Increase average contract length
  • Increase average deal size
  • Increase percentage of repeat customers
  • Increase retention rate
  • Increase upsell/cross-sell rate

Secondary goals:

  • Acquire well-known customers
  • Lower expenses
  • Drive sales for specific product
  • Increase number of specific customer type
  • Reduce discounting frequency
  • Reduce average discount size
  • Acquire “seed” accounts
  • Manage deal flow

Pick one or two goals from the first list and one from the second. Clarifying your priorities will help you decide how to compensate your salespeople.

Keeping sales comp plans effective

The more variables you introduce to a sales comp plan, the likelier you are to unintentionally promote competing behaviors. You also make it harder for your reps to understand how they’ll be paid -- meaning they’re less inclined to go in the direction you’re intending.

With that in mind, use two to three variables. Grasping the fixed, variable, and/or base percentages should be easy. Not sure if your plan fits the bill? Time yourself explaining the plan to a salesperson (or the mirror). If it takes more than one minute, you probably need to simplify. 

And don't worry that cutting out one of your terms will make it harder to hit a specific goal. Sales contests and SPIFs are a great way to drive short-term behavior changes and can be added to the mix at any time. And next year, when your priorities have probably changed, you can create a new sales comp plan.

Sales comp plan types

Salary only

With a salary-only structure, you decide ahead of time how much you’ll pay your salespeople. It doesn’t matter how much (or how little) they sell, their take-home earnings are set.

This structure is relatively rare in selling organizations. On the plus side, it’s simple to calculate sales expenses and predict hiring needs. In addition, reps may be less stressed because they don’t have to worry about the financial consequences of missing their target. You will probably see greater loyalty from your employees.

Yet without commission, reps are usually less motivated to go above and beyond. After they’ve hit quota, they’ll probably relax instead of pushing for the next deal. Many salespeople love the thrill of scoring commission -- that’s why they got into sales in the first place. Watching average performers receive the same pay is typically demotivating. Finally, your best reps will probably leave so they can make more elsewhere.

Commission only

A commission only structure means you pay reps purely based on performance. If they sell nothing in a month, their salary is zero. If they sell $50,000 worth of business in a month, their salary could be anywhere from $15,000 to $22,500, depending on the commission percentage.

This approach has both pros and cons. As the employer, you’re forgoing a lot of risk. When your salespeople succeed, revenue increases. When they fail, you lose nothing.

You’re also giving reps the freedom to earn as much money as they can -- which is highly motivating. And poor performers are unlikely to stick around long.

However, paying commission only makes it challenging to forecast your expenses and stick to a budget. Salespeople are demotivated to do anything but sell, so good luck asking them to attend meetings, log notes, go to training, etc. Finally, you may unintentionally encourage “anything goes” tactics such as lying, manipulating, and other behavior that’ll give your company a bad name.

Wondering what commission percentage to pay? It can range from 5% to 45%. According to RepHunter, 20% to 40% of gross margin (sales minus direct expenses) is standard.

The more support you expect reps to give customers (such as implementation help, account management, etc.), the higher commission should be. Factor in their level of involvement in the sale as well -- if they’re only producing leads, rather than closing them, allocate a smaller commission.

Base salary plus commission

This is the most common pay structure. Reps receive a fixed yearly base salary, as well as commission. They get the security of a steady income with the economic incentive to sell.

You’ll benefit from greater clarity into your expenses (since there’s less variability) and the opportunity to hire highly motivated salespeople. Furthermore, since you’re giving reps a base salary, they’re obligated to fulfill some non-selling tasks, like training a new team member or attending training.

The commission percentage is lower because of the base.

To determine the base-variable comp split, determine:

  • How difficult the sale is
  • How much autonomy is needed (are you providing your reps leads or asking them to generate their own, giving them technical support or requiring they sell a technical product by themselves, etc.?)
  • How much experience is necessary

As the difficulty, autonomy, and expertise grow, so should the base salary.

Variable comp is determined by:

  • How complex the sales cycle is
  • How much influence the rep has over the purchasing decision
  • How many leads they work
  • Selling function (hunting or farming)

Essentially, the shorter and simpler the sale is -- and the less impact the salesperson has over the customer’s behavior -- the smaller the percentage of variable comp should be.

Industry standard is 60:40, meaning 60% fixed to 40% variable. A less aggressive ratio (think 70:30 or 75:25) is common when salespeople are required to teach the prospect because they're selling a highly complex or technical product. 

Account managers may have a similar ratio of fixed to variable pay, driving them to spend more time helping their existing customers than finding new ones.

Base salary plus bonus

A modified version of the base/commission combo, this awards a base salary plus a bonus if the employee hits their pre-set target. For example, you might pay $30,000 base and $15,000 for selling X amount per year.

This approach offers high predictability. If you know eight in 10 employees hit their quota on average, and total earnings are $55,000, you can set aside $440,000 in your annual budget.

But there’s no motivation to overperform.

Absolute commission plan

An absolute commission is paid out on specific activities or milestones. To illustrate, you might pay your salespeople $1,000 for every new customer or 15% of upsell and cross-sell revenue.

These plans are easy for reps to grasp, which always drives good results. In addition, you don’t have to set a quota: You can set benchmarks or recommendations, but ultimately, you’re only compensating salespeople on what they sell. Another benefit: Because output is directly tied to salary, reps are typically highly motivated to perform.

On the other hand, this structure doesn’t take into account market penetration or quantity of opportunities. One salesperson may be getting twice as many leads as her peer, but she’ll be treated equally.

Furthermore, you’ll need to carefully link what’s best for the company with your chosen commission. If you’re trying to drive sales of a certain product line, you’ll need to comp reps accordingly -- they’re always going to do what’s most lucrative regardless of business objectives.

Relative commission plan

Unlike an absolute commission plan, a relative commission plan uses a quota, or predetermined target. This target can be based on revenue (X dollars) or volume (X units).

When a rep hits 100% of quota, they make their on-target earnings (OTE). That either consists of base plus commission or pure commission.

To give you an idea, a salesperson’s yearly quota might be $60,000 in new business. At-plan commission is $50,000, and base is $80,000. Their OTE is $130,000.

Straight-line commission plan

A straight-line commission plan rewards salespeople based on how much or little they sell. If they reach 86% of their quota, they receive 86% of their commission. If they reach 140% of quota, they’re paid 140% of commission.

Although this approach is relatively easy to calculate, it’s not perfect.

What’s the issue? You want to encourage overperformance as much as possible. If you’re already paying base, getting someone to hit 140% of quota from 120% has a greater financial impact than getting an underperformer to hit 100% from 80%.

Plus, someone might be able to get along just fine making 80% of quota. You don’t want to disincentive reps to sell because they’re happy with a lower salary.

That’s where accelerators come in.

Sales accelerators

An accelerator kicks in when a rep is hitting a certain level above quota. Let’s say yours applies after 110% of quota. The salesperson would be paid 1.0x on her performance above 100%. So, if she attains 125%, she’d be compensated like she’d hit 140% (125% + 15%).

This payoff is exponential. You may end up with a huge commission check to hand out if someone has an amazing month or quarter, so be careful.

Decelerators

Decelerators have the opposite effect as accelerators: They penalize underperformers. A decelerator may kick in between 60% and 40% of quota. In other words, if a rep only hits 60%, their performance would be multiplied by a decimal (like 0.5) to calculate compensation.

When to pay commission

There are three standard options for paying out commissions.

You can pay:

  1. when the customer signs the contract
  2. when you receive the customer’s first payment
  3. every time the customer pays

The first option -- paying when the customer signs -- is good motivation for the salesperson because they immediately see the monetary impact of winning the deal.

However, it can lead to cash flow problems for you if there’s a significant delay between the signed agreement and the first payment (especially if you’re an early-stage business and/or it’s a big deal).

The second option -- paying when you’re paid -- can be confusing for salespeople to keep track of. If you’re a subscription business, it can still disrupt your cash flow; after all, if you give a rep commission on the entire contract when you get the first check, you’re paying in advance of the customer’s subsequent payments.

But it’s the most common choice, because there’s less of a lag between commission and revenue. You can also use clawbacks to incentivize salespeople to focus on good fits (rather than anyone who will buy). That usually boosts retention.

The third option -- paying each time you get an invoice -- is the best for your cash flow. Nonetheless, it can be complex to figure out -- especially if you have a large sales team.

Clawbacks

Many subscription companies use clawbacks to keep customer retention high. A clawback “takes back” the rep’s commission and kicks in if a customer churns before a specific benchmark.

At HubSpot, we instituted a four-month clawback. When a customer canceled one to four months after signing up, the salesperson who sold them was forced to give back the commission payment.

This ensured they focused on businesses that could actually benefit from our product.

Paying on gross margin

Some companies pay on profit rather than sales. In other words, a rep would be compensated more for selling a product with a $2,500 gross margin than one with a $1,000 gross margin. There are two advantages to this system.

1) It disincentives discounting

Salespeople can become reliant on discounts to close deals. Obviously, this is bad for business: Not only are your margins eroded, but the perceived value of your product goes down and future customers will come to expect a price slash.

Tying their commission to the product’s final cost encourages them to give fewer and smaller discounts.

2) It encourages sales of certain product lines

Not all of your products are created equal. Maybe you offer professional services, which tend to have low margins. Or some of your solutions require lots of maintenance from your team.

Whatever the case, paying on gross margin motivates your salespeople to sell more of your most profitable products.

Three things to keep in mind:

  • If revenue isn’t your priority, don’t use this strategy. Perhaps you’re trying to build market share or attract the top 20 logos in your industry. You want salespeople to focus on those goals -- compensating them on profit will distract them at best and cause them to pursue the wrong customers at worst.
  • If reps don’t have control over price, don’t use this strategy. They must either be selling multiple products at different price points or have discounting power.
  • If it’s too difficult to keep track of gross margins, don’t use this strategy. Shifting product and/or distribution costs, rebates, and territory changes can make calculating this extremely hard. There are other, simpler options for discouraging discounts and/or driving specific product sales.

Quotas and OTE

How do you know what OTE should be? One-fifth of quota is a good rule of thumb. That means if a rep’s annual quota is $700,000, their OTE would be $140,000.

The “ideal” ratio is considered six to eight times quota. In that world, the rep’s yearly target is $700K and their OTE is $87,500.

A word of warning: These are suggestions, not guidelines. Ideal salaries vary based on how competitive your industry is, required expertise and/or technical knowledge, complexity of sale, your company’s maturity and revenue, and so on.

Setting quotas

Of course, that begs the question: How do you decide what quota should be? There are two main approaches to setting quotas.

The more data you have, the easier it is. A “bottoms up” approach starts with your team’s capabilities and the perceived market opportunity and figures out what each territory or salesperson quota should be.

Your inputs will vary depending on your product and type of sale, but generally you’ll want to factor in:

  • Average contract value (ACV) or average deal size
  • Average revenue per salesperson
  • Number of salespeople
  • Number of qualified leads (per month or quarter)
  • Percentage of qualified leads that close

That tells you how many deals a rep should be working and thus what a reasonable quota should be.

Alternatively, you can simply multiply the typical number of closed deals by the average deal size. This should give you a baseline number, but beware — the more successful and experienced your salespeople become, the more deals they’ll be able to work and the bigger their contracts should be. That means this quota may quickly become inaccurate.

The second approach is “tops down.” You combine market data with your revenue targets to figure out what your team needs to bring in. So, if most companies in your space pay salespeople in the X to Y range, and your salespeople need to close Y amount in total for the business to hit its objectives, you can figure out both a reasonable OTE and an optimal team size.

Sales contests and SPIFs

To temporarily change behavior, use one-time rewards. These can either be monetary -- such as a $500 cash prize to the first rep who closes 10 deals of a certain product -- or non-monetary, like a fancy dinner for every district that increases their retention rate by the benchmark percentage.

Sales contests should run for a relatively short time. One to four weeks is a good range; any longer and your reps will lose urgency. In addition, you only want to run one contest at a time. Remember, the more behaviors you're rewarding, the likelier it is your team will be pulled in conflicting directions and the harder it'll be to drive specific outcomes.

No sales comp plan is perfect. Your priorities are constantly shifting, your reps are always looking for new loopholes, and your prospects are periodically changing their preferences. But follow these tips, and you'll craft a comp plan that drives bottom-line success ... for now.

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