This sales compensation model is the key to unlock product-led growth
Sales compensation is arguably one of the most critical parts of a company's strategy. From HR to finance, sales leadership, and operations, designing and managing compensation plans is one of the few components of go-to-market strategy for which every key stakeholder needs to be involved.
One lesser known impact of sales compensation strategies is how they actually inhibit companies from implementing the right go-to market strategy and pricing models.
For example, if you are currently working on revamping your pricing, you might not realize it now, but how sales teams are going to be compensated under that new pricing is going to be a major topic, potentially preventing you from implementing the best pricing model for your business.
For companies looking to introduce product-led growth (PLG) principles to their go-to-market strategy, or to completely transition to PLG, revamping sales compensation structures is essential in order to be successful.
“One of the thorniest topics that can slow down a company’s ability to launch and succeed with UBP (usage-based pricing) is how to effectively revamp and align sales compensation plans to this more flexible and customer-friendly pricing approach.” Ben Chambers - Senior Director, Sales Compensation @NewRelic
Though sales compensation strategies vary by vertical, company culture, and other factors, the most common methods are subscription based models, which include the following mechanics:
- Measuring quota against bookings and committed contracts.
- Paying sales commissions on bookings, generally the following month or at the end of the quarter.
For example, if a customer signs a contract in November for an annual contract value of $30,000, the rep receives a $3,000 commission paid out in December.
With today’s shift towards PLG and UBP, however, many companies are shifting their compensation models to align with their new go-to-market strategies and paying commissions on consumption, product usage, invoicing, or collection.
Changing an incentive structure is like changing a company's pricing. Everyone would like to update it, but few dare to. It’s very risky, and probably one of the reasons why paying commissions on bookings is still so widespread. Companies have stuck with it for so long and everyone is used to it, including sales teams. It isn’t a coincidence that the companies which took these risks and adopted new ways of compensating their sales teams are also the companies leading the shift to new go-to-market and pricing strategies.
Let’s pause and recap:
- The software industry is poised to adopt product-led growth and usage-based pricing;
- Changing the pricing strategy or adopting product-led growth won’t be successful without revamping sales compensation plans;
- There are success stories where companies with large sales teams have adapted to these changes and thrived
It’s crucial then to consider what is happening. What are these companies seeing that others don’t?
We'll present the "Vested Commission Model" and “Consumption-based Sales Performance Management”, which, in a nutshell, focuses on vesting commissions over time so that the sales team is incentivized on long term relationships instead of focusing on rewards happening immediately after a transaction. We'll consider the reasons why companies with UBP or PLG go-to market strategies have evolved towards incentive structures that follow the vesting model. We’ll also explain that a vested commission structure can, and perhaps should, be adopted by any company. In our opinion, it’s worth considering if one of the following is true:
- Your go-to-market strategy includes product-led growth.
- You have a usage based pricing model.
- Customers purchase more of your product after the initial sale is done - in other words you have a Net Revenue Retention (NRR) above 110%.
- Conversely, you have a high churn rate because new deals coming in are of low quality.
- Your customers are showing signs of discontent in the months following the contract or purchase order signature.
- The current sales culture at your company gives incentives to short-term goals instead of prioritizing customer relationships and long term success.
- You would like to reduce the cost of growth, be more disciplined and have strong financial oversight on sales compensation.
Why do most companies pay commissions on bookings?
Paying commissions on bookings or purchase orders has been the traditional method used by sales teams. Much has been written about it so we won’t dwell too much into details. Let’s however share a couple of examples showcasing why this method has been so popular:
- It is commonly believed that rewarding sales reps right after they make a sale is a powerful motivator because it provides immediate positive reinforcement.
- Bookings or purchase orders are the first tangible evidence of a commitment from the customer. Sales reps know it well; no gong before a signature.
- It is simple. The purchase order provides a single source of truth with commissionable metrics (products sold, deal amount, commitment, etc..) that everyone can agree on, the customer, the sales reps, the sales leadership and the finance team paying commissions.
- Signing purchase orders & contracts with yearly commitments allows companies to recognize revenue upfront, providing an effective way to tell if a sales team hit the quota.
That being said, paying commissions so early also has multiple drawbacks. A contract is merely a plan and a promise. Many things can happen: the customer doesn’t pay the invoice, asks to churn shortly after the contract is signed, or realizes they were oversold and consequently ask for a refund on what wasn’t consumed.
Nobody would reward a general for presenting a game plan. You need to win the battle, capture the ship, and find the treasure before sharing the gold. What really matters is the execution of the contract.
This leads to more headaches for the finance and sales teams, complex compensation plans, and horrible clawback rules for reps.
Traditional sales compensation plans are hurting companies with modern go-to-market strategies.
Let’s say it again: you need to capture the ship, not simply sink it, and take down the treasure first. Then you can compensate the team for the win. The key components here are execution, delivery, and the long term satisfaction of the customer.
Companies that have adopted PLG or UBP have embraced this reality. A product-led motion makes product usage the core mechanism for growth. It usually means that anyone can go and try the product, with little or no entry cost, but the deal only becomes valuable to everyone if usage increases while the product delivers more value.
Consumption based pricing provides significant benefits to both vendors and customers but the model also comes with an important dynamic: predicting revenue is hard. Case in point; Snowflake and New Relic.
Companies and markets like predictability. But consumption based pricing makes it hard to predict revenue. So what did everyone do? Well, instead of embracing the power of consumption based pricing, companies tried to shoehorn this model into subscription selling. How? By selling a yearly subscription with an upfront committed purchase of a minimum volume. Inertia was strong, companies already had huge sales teams with reps used to earning commissions on subscriptions models. Engineering teams built complex billing systems, finance teams had commission plans and budgets in place.. At the end of the day, everyone is just really used to subscription based models.
Restaurants are the perfect analogy to illustrate consumption-based pricing. You go to a restaurant and pay for the food you ordered. It’s so simple. Isn’t it just the perfect way of consuming? Go to the restaurant whenever you want to, and only pay what you ordered.
Imagine now: you go to a restaurant, but the waiter tells you they only sell “Yearly pre-committed plans”... In other words, they want you to commit to an annual minimum amount of times you’ll go to their restaurant, with a minimum bill for each meal, and pay the yearly bill upfront, including tips.
You ask why and the waiter explains that they have ambitious quarterly goals, communicated to investors, and they need to recognize the revenue as soon as possible. Additionally, all the waiters are used to earning commissions calculated on annual estimated consumption, and they don’t know how to pay their team differently.
Can you imagine the problems this system generates?
- Hurting revenue: "If I’m going to commit to a full year eating at the very same restaurant, and pay all the bills in one lump annual upfront payment, I might as well ask for a 50% discount. Perfectly reasonable.”
- Longer sales cycle: “Choosing the restaurant I’m going to eat at for the next 12 months is for sure not an easy decision. Let’s have a look at 10 other restaurants and do a three-month proof of concept with each one before deciding. That’s a big distraction from my other current projects but I don’t want to mess up this decision or I could get fired.”
- Smaller renewals: “The first year, the sales reps were really damn good. They sold me on a three-course meal with a bottle of wine each day for the whole year. But I know better this time, so I’ll cancel the wine and the starters for my next 12 month contract”.
- Increased complexity: “How am I supposed to estimate how much food I’m going to eat this whole year? I’m going to need an army of solutions engineers to quickly help me scope the project. I had a look at the restaurant’s pricing page but I don’t understand a thing about their internal jargon. Can somebody please explain what the “glycemic index” is and why it impacts the price?”
- Putting pressure on customer success: “I’m a CSM and I’m pretty angry at the AE who sold a deal including five stars meals every day. I’m now responsible for delivering the value, while the AEs are moving on to the next sale because their manager says that their time is best used doing what they do best, selling…”
- More bureaucracy: “CSMs aren’t happy about the deals closed. From now on, CSMs and 5 other teams need to sign off on the terms before the deal can be signed.”
- Board meetings now spent tracking consumption: “We sold this massive deal of 1,000,000 burgers but the client has only consumed 92 burgers in the first three months. What’s going on? From now on, I want their consumption and usage reviewed at every board meeting so we can take actionable decisions to increase consumption and usage” - The CEO
These negative sales dynamics have led many companies to shift their sales organization towards modern go-to-market and pricing strategies. And one of the most important transformations was to go from a bookings approach to a consumption based approach to sales incentives In order words, to implement the vested commission model and consumption-based sales performance management.
The new era for vested commission models and consumption-based sales performance metrics
The idea of the vested commission model, as its name indicates, is to vest incentives over a longer period of time. The goals are to create a culture that promotes long term successful relationships, while also aligning short term business goals.
In his book “Build: An Unorthodox Guide to Making Things Worth Making”, Tony Fadell mentions different ways to implement a vested commission model. One method is to offer stocks instead of monthly cash commissions, because “stocks provides a built-in incentive to stick around and invest in long-term customers who are good for the business”.
To us, though, replacing commissions with stock options seems too far removed from the standards of compensation for sales teams. Instead, we prefer another approach: using consumption-based sales performance metrics, like usage or invoice collection.
Below, we describe three methods (from simpler to most advanced) to implement the vested commission model using consumption-based sales performance metrics:
- Calculate commissions on the committed contract value, but vest commission payments on invoice collection.
- Use invoice collection as the first metric to implement a compensation strategy that focuses on consumption.
- Rely entirely on consumption-based metrics to calculate and pay commissions.
Method 1: Calculate commissions on the committed contract value, but vest commission payments on invoice collection.
Calculating sales commissions on committed contract values is what most sales teams are already used to. Here commission payments are vested over time instead, which means that the salesperson will not receive the full amount of their commission all at once. The commission will be paid out in installments as the payments for the contract are received.
Though, in our opinion, sales people shouldn’t be responsible for the payment of the invoices, this method still has many benefits:
- The best of both worlds: Commissions are still calculated on committed contracts, ensuring the company keeps its focus on upfront cash flow and future revenues under contract. Commission payments however, are triggered when the money is in the bank.
- Increased quality of new deals: it prevents sales reps from closing customers that aren’t a good fit for the company, and at risk of churning in the short term;
- Improved quality of pipeline and better focus for the reps: Reps have an incentive to filter out prospects that could close with a lot of work, but wouldn’t be a good fit for the company. Killing these deals early on allows them to focus elsewhere.
- Fostering long term relationships: it incentivizes the reps to keep and nurture their relationships with customers. It’s always easier to go back to the customer that isn’t paying if you keep them close to you after the sale is done, instead of transitioning the account to CSMs and moving far away.
- It drastically reduces the cost of growth: Working capital is negative because you pay commissions at the same time as you receive the cash. This is huge for companies since sales commissions are a big chunk of monthly burn. It also increases productivity at every level. For example, CSMs don’t have to spend countless hours with customers that are a bad fit and are going to churn eventually, no matter how good the onboarding.
- After a few months, it’s all the same for the AEs: This be counterintuitive but, if reps close deals consistently, after a few months they’ll earn the same monthly amount of commissions, no matter if commissions are paid upfront or vested over time (see the example below)
In this example, every month the AE closes a $12,000 ARR deal, and earns a $1,200 commission for it. In the first table, the AE is paid 100% of the commission one month after the deal is closed. In the second table, the company pays monthly installments so that 100% of the commission is paid only after 6 invoices are fully paid by the customers. After 6 months, the monthly payslips are the same in both scenarios.
Method 2: Use invoice collection to implement a compensation strategy that focuses on consumption.
In this second method, the total amount of the commission is calculated on the invoices themselves, instead of the committed contract. Therefore, there is a double vesting mechanism:
- Commissions are fully paid until all invoices are paid, for a given period of time (example: during the first 6 months or the first year);
- Quota attainment is known after a few months. There are several ways to calculate quota attainment under this method:
- Example 1: wait until invoices are paid to calculate the total quota attainment;
- Example 2: wait for a few months of consumption data to calculate a run rate and estimate the quota attainment based on a few months of data.
This approach is often used in industries where customers are billed for the goods or services that they consume on a regular basis, such as the telecommunications industry.
This strategy isn’t new at all, but when it comes to the software industry for example, we are very much in the early stages and not many companies have adopted this approach.
Method 3: Build sales compensation plans around consumption based metrics like usage and consumption
Implementing this strategy isn’t easy and there are many implications to it. This article from Ben Chambers provides an interesting list of possible decisions you’d need to figure out in order to implement it. For example, which “consumption metric” should be taken into account:
- Total consumption: the sum of all consumption metrics rewarded;
- Incremental consumption: consumption above a certain threshold;
- Billed consumption: usage that brings revenue;
- Consumption run rate: using a defined period of time (which one?) to calculate an estimated consumption run rate and pay commissions on that amount.
If you add the extra complexity of gathering all the data needed to track all these data points and metrics, you understand why not every company is ready to switch to these methods, despite all the proven benefits it brings, on top of allowing the company to transition to PLG.
Reading the above, you might think “But isn’t it way simpler for everyone to just pay 10% on the total amount of the committed contract?” And you’re right, it is simpler! Just like jumping on a horse was the simplest method to go from one place to another, while some people were working on the first internal combustion engines. It’s difficult at first, but a few years later a single machine can build 500,000 cars per year… In the SaaS industry, the “automobile” is already live: there are teams out there that are getting better and better at gathering, manipulating and using data, allowing them to build innovative compensation plans and implement modern go-to-market strategies. There’s a reason why usage-based companies have better financial performance than their peers!
You might not be fully ready, but start poking around to understand what is going on. There are simple ways to get started and learn your way up to advanced strategies. It is worth it.
All of the above might sound intimidating. But everything in life that has the potential to yield huge benefits is difficult, daunting and takes a while to master. Otherwise, well…everyone would already be doing it.
Here’s our recommendation:
- Start poking around and learn about vested commission models and consumption-based sales performance management.
- Implement a simpler version of a vested commission models, like calculating commissions and quota on contracts and subscriptions, but paying commissions after invoices are paid (method 1 described above).
- Reach out to companies like Palette, who are specialized in sales compensation models built for modern go-to-market and usage based pricing.
Finally, consider all the benefits that it could bring to your organization, for example:
- Reduce the cost of growth with lower working capital and better unit economics of each new customer.
- Improve the fit of new customers brought in each month.
- Increase your net retention rate by bringing in customers that grow usage and consumption over time.
- Reduced bureaucracy.
- Enable your company to start a product-led sales motion.
- Building a sales culture that prioritizes customer relationships and long term success, with AEs that care about your mission, and want to do right by the customers by truly solving their problems instead of joining your company to make a quick buck.
We’d love to hear about your experience, and which compensation plans you’ve put in place at your organization. Don’t hesitate to reach out (email@example.com) or join the Sales Compensation Hub (Sales Compensation Hub) community to share ideas and learnings with other leaders.
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