Sales incetive compensation: practical framework and example
Updated: Oct 18, 2019
I was working on incentive compensation recently and also got several questions from different startups on this topic. While preparing my a long-form blogpost explaining the fundamentals, I realized there is no lack of advice on the topic. The problem with most of this advice, though, is that it is:
Idiosyncratic and not generalizable, e.g.“This worked for [this super successful company] where I led sales/invested/knew someone, so this must work for you”.
Generic, e.g. “Your incentives should be aligned with your goals and priorities”.
One notable exception is this and this posts by Matrix Partners’ David Skok. So instead of writing a long form post, I would like to offer two very practical things: a concrete framework of how to think about sales incentive compensation and elaborate on an example of a sales compensation plan (he one that is mentioned in David's second post).
Framework for thinking about incentive compensation
The fundamentals of incentive compensation design are understanding your business model and resulting revenue equation, the objectives of each element, and who is accountable for them. Once you have it, setting up the incentive plans becomes an easier task. Here is an example of the framework, which is quite typical for a B2B SaaS company, be it a starup or an established company.
Step 1: Define your revenue equation
You start by defining your revenue equation. In the example above, I use a standard B2B SaaS revenue equation, but it may differ for you. Note, the equation will be quite different for other business models, like transitional sales. Look at every element and understand existing performance. Common mistakes I have seen:
Too much focus on new bookings and ignoring expansion bookings and especially churn. I see this a lot with earlier stage Silicon Valley based companies
Too much focus on existing customers and reluctance to go out and hunt for the new ones. I see this a lot with more established companies and less salsey cultures e.g. Europe
Not separating the equation elements and just focusing on the total MRR
Step 2: Define the roles accountable for every element of the equation
Which roles are responsible and accountable for each component of the revenue equation. The common mistakes here:
Having several people responsible for one objective and no one accountable. For example, this often happens with recurring revenue/preventing churn. Companies may have post-sales, customer success, customer service responsible, but no single function accountable. It’s a typical free rider problem when the accountability gets diluted.
Having one sales role (often AE or just a generic “sales executive”) responsible for multiple objectives, e.g. finding new customers, growing existing customers, preventing churn. Most salespeople are good at one element and they will tend to focus on what they are good at.
Step 3: Set incentives that are aligned with key accountabilities of each sales role
Incentives should be aligned with the role’s accountability and areas they have control over.
Incentivizing people on metrics that are outside of their control, e.g., shared with many other people or influenced by outside factors (product launch, partnership deal, etc)
Giving variable pay on a metric (sales, bookings, number of leads) without having a quota, e.g., paying 10% commission on sales. This is a bad practice because incentives are not aligned. A company may miss its sales target, but sales people are still getting paid.
Incentivizing AEs on total revenue, which includes a large recurring component. In a healthy sales organization, revenues are quite sticky and can be managed by after sales functions, whiles AEs should only focus on new revenue (=new and expansion bookings)
Having too many metrics (>2-3 is usually too many) with blurred focus
Having variable component too low. In the USA 50% variable component is typical, while in Europe it may be less culturally accepted. The exact level should depend on the market and company culture, but it has to be perceived as significant (usually at least 30%)
Not incorporating mechanisms for “garbage in”. For example, if SDRs are only incentivized on the number of leads, they will maximize leads and may send bad leads to AEs. In the sale way, if an AE is only incentivized on new bookings, they may to inclined to close customers at all costs, just to see them churn in a few months.
Not communicating the rationale behind the incentives well enough or not generating enough buy-in and trust.
Having too high quotes, such as people find them unachievable
Underestimating the non-financial incentives, like recognition, giving some level of autonomy, team work and healthy competitions
Deep dive on a concrete incentive compensation example
In his Figuring Out Quotas and Commission Rates post, David gives this hypothetical example of incentive compensation. Let’s take it as an example to see when and how it can work.
“Commission Rate = Variable Sales Comp on Target / Quota. For example, if your reps can sell 100 accounts at $10K ARR per account, their quota will be $1M. If your OTE is $150K with 50% base and 50% variable, your commission will be 7.5%. (This would correspond to a quota to OTE of slightly above 6X.)” [if you are new to this, OTE is on target earnings, “quota” is the $ sales plan/target per sales rep]
This example plan is common and is generally recommended for Account Executives (AEs) because the role of AEs is to close new contracts.
The plan would be different for other sales roles like SDRs, technical sales, channel managers, and sales managers because they have different business priorities. For example, SDRs may have incentives linked to the number of qualified leads and revenue from these leads.
$1M quota in this example is based on new recurring revenue, meaning each AE has to close 100 new contracts each worth $10K, be that either from new accounts or cross- and up-sell from existing accounts (expansion revenue).
In most cases, AE quotas should not be assigned on total MRR/ARR/revenue, because these metrics predominantly include recurring revenue. It is the role of AEs to bring new revenue and the role of others in the organization is to retain this revenue by keeping customers happy.
This said, you have to be clear who exactly is accountable for customer retention (=minimizing churn) in your organization. For example, it could be your Customer Success team who are accountable for retention and have NPS and renewal rates as their targets. In some cases, renewals require a significant sales effort, for example, in cases of competitive bids, low switching costs, or even regulation. If significant sales effort is required, renewals can be part of quotas but probably with a lower commission.
To make this plan work, you need to be clear how AEs are supported, especially where AEs are getting their leads from. AE role is typically to close new customers and to proactively up- and cross-sell to existing customers. It should not usually require generating leads at scale or support recurring revenue.
In low ticket sales (usually below $10K in ACV, otherwise known as Rabbits) AEs may not be required or profitable at all as they are usually the most expensive sales people. If you do have them, AEs should receive their leads from marketing (inbound) and potentially SDRs at scale. I have not seen many companies where a skilled AE is able to independently generate 100 new sales $10K worth a year (~8-9 a month) without a strong lead generation support. When it does happen, it is usually very product-driven to a degree that active selling is almost not required.
With larger ticket enterprise sales with relatively short sales cycles, AEs may be responsible for prospecting and closing bigger fish customers. Enterprise sales with longer cycles often requires team selling.
The post talks about typical 7-11% range of commission. If the commissions are set effectively, the range should not be random. Generally speaking, the more sales effort and specialized skill is required, the higher is the commission. Think about the spectrum. One the one extreme, the sales person is almost like an order taker – he or she gets highly warm and qualified leads and all he/she needs to do is a series of standardized closing procedures, e.g., give standard price, send a standard contract, etc. The other extreme is when an AE needs to map a complex enterprise customer organization, deeply understand their each customer’s specific needs, and convince them to replace a legacy competing product they are relatively happy with. In the first case, your commission is likely to be below the range and in the latter it can be as high as 15%.
If you have non-quota bearing sales roles or roles with quota overlays (could be SDRs, technical sales, sales management) contributing to closing and maintaining a customer, you should look beyond cost per AE and assess the total compensation cost of sales (CCOS). In the most simplistic form, CCOS is a percentage of sales costs divided by total revenue. Compensation costs will include fully loaded sales compensation costs (fixed and variable salary + taxes + benefits) of all the salespeople related to generating this revenue. It should also include the growing cost of sales automation tools, travel and meals. You should look at both planned (OTE/sum of quota) and actual (actual paid compensation/actual revenue) CCOS. Benchmarks for CCOS vary and are company and stage specific. It is best to look at them in dynamics for your company. However, if the CCOS in a SaaS/technology company is exceeding 15-20%, it is potentially a red flag and you should probably look deeper in the root causes of it. If marketing costs are significant in your business, CCOS will feed into your core CAC metric.
At System2Labs, we've seen dozens of incentive compensation plans across B2B companies of different stages, industries, check sizes, and cultures. If you have a specific questions about your situation, send contact us.