I just have to say it. SaaS sales compensation is not nearly as complex and mysterious as it has been made out to be. I’ve read so many discussions on SaaS sales compensation that claim you should do this in one case and that in another case, such that by the time you finish you can’t see the forest for the trees. Since I’m in the middle of this series on SaaS metrics, it seems high time I got around to addressing this topic (which I’ve been avoiding simply because I did not want to plant yet another tree).
So, here is the scoop….
|The ONLY difference between SaaS sales compensation and sales compensation for software
or other products is that you should pay based on the LIFETIME VALUE of THE DEAL
instead of the unit price of the product
(there being no unit price).
Wait! Relax. Although at first glance, lifetime value may appear to be an overly complex metric to use for sales compensation, it is always proportionate to recurring revenue. So, you simply have to replace “price” with MRR or QRR or ARR in your favorite sales compensation model and you are fine. That’s it! Now you can apply any of the various sales compensation models that you already know and love. Your particular choice should match the specific goals, products, pricing and culture of your specific business, as with any other sales compensation design challenge.
The primary principle of sales compensation is to pay the sales rep in proportion to the value of the deal, usually measured by the price of the product. The value of the deal in turn is wrapped up in the sales commission percentage, which is calculated by dividing the target commission at quota by the sales rep quota:
commission % = target commission at quota / quota
The quota in turn is determined by what is achievable for such a sales rep in terms of number of deals and the average deal value.
quota = target # of deals x average deal value
And, the actual sales compensation is calculated by multiplying the commission percentage by the actual sales.
sales compensation = commission % x actual sales
The target commission is determined by the labor market rate for the type of sales rep you need to fulfill the sales role. This is important, because it is at this point in the sales compensation plan design that we clearly see that sales compensation is NOT about paying the sales rep a percentage of revenue, it is about allocating a target commission payout based on a measure of performance (quota). The measure we use for performance (license revenue, recurring revenue, margin, etc.) is completely arbitrary. We consciously choose a measure that scales with deal value, so that sales compensation aligns sales rep performance with company performance.
You can get really fancy with tiers, spiffs, margin vs. revenue, etc., but these basic formulas are the cornerstone of any sales compensation plan, and this does not change for SaaS. What does change is how you measure deal value, and thus the relevant measure of sales performance.
In a subscription business with a recurring revenue stream, the value of the deal is not as clear cut as the price of a software license. As any MBA or bond trader will gladly tell you, the true value of a subscription deal is the present value of the future cash flows, which amounts to summing up all the recurring revenue over time, taking into account churn, and discounting it by your cost of capital. For a simple subscription with constant recurring revenue, “RR”, this is given by the following formula:
SaaS Subscription LTV = RR + RR (1 – a)/(1 + i) + RR [(1 - a)/(1 + i)]^2 … RR [(1 - a)/(1 + i)]^N
SaaS Subscription LTV = RR ( 1 + i ) / ( i + a )
Where “i” (for interest) is the cost of capital and “a” (for attrition) is the churn rate, and N is the number of payments made over the customer’s lifetime. If the customer follows the normal churn rate, the top LTV formula simplifies to the bottom LTV formula. Again, the MBA’s in the audience will recognize this as the formula for the present value of an annuity.
I say again….do not fear! As previously mentioned, the LTV of the deal is always proportionate to recurring revenue of the deal. The salient word here being “proportionate.” When it comes to designing our SaaS sales compensation plan, we can use ANY measure of recurring revenue (MRR, QRR, ARR) that is proportionate to lifetime deal value. We do not need to calculate the absolute LTV for the deal, because the commission percentage will scale up or down as needed to make sure we payout the target sales compensation. Thus for SaaS, we simply change the calculation to the following:
SaaS commission % = target commission at quota / quota in recurring revenue
SaaS quota = target # of deals x average deal value in recurring revenue
SaaS sales compensation = commission % x actual sales in recurring revenue
Recurring revenue can be measured monthly, quarterly, or annually, because the sales commission percentage scales accordingly. But, once a time-frame for recurring revenue is chosen for calculating the sales commission percentage, it is critical to stick with the same recurring revenue time-frame throughout your SaaS sales compensation plan, i.e., if you calculate average deal value and quota in ARR, then you must measure actual sales in ARR as well to get the correct actual sales commission payout.
Failing to stick with the same recurring revenue time-frame throughout creates an expensive bait-and-switch problem that is the root cause of SaaS Sales Compensation Mistakes 1 & 2 below. Psychologically it is often best to base your SaaS sales compensation plan on a recurring revenue time-frame (monthly, quarterly, or annually) that equals your most common contract renewal term, e.g., if you mostly sign annual renewal contracts, then base your sales compensation plan on ARR, if most renewal contracts are monthly, then use MRR.
To recap…replace unit price with MRR/QRR/ARR…done.
The picture above shows a quick visualization for two sales compensation plans for two sales reps with similar skill sets and market labor rates: one at a software company, and another at a SaaS company. In both cases, the sales rep has a base salary of $50K. On the left, the goal is to motivate the software sales rep to bring in $2M in license revenue. The software sales compensation plan has an accelerator such that payout is $100K at $1.5M and $150K at $2M, and unlimited upside if the sales rep can blow it out of the water.
On the right is a SaaS sales compensation plan where the goal is to motivate the SaaS sales rep to bring in $1M in annual recurring revenue. The plans are IDENTICAL except for the scale of the performance measure on the x-axis (swapping license price with ARR). The SaaS sales compensation plan has a base pay of $50K and an accelerator such that the payout is $100K at $750K ARR and $150K at $1M ARR, and again with unlimited upside to motivate your top sales performers. If we want to recast the SaaS sales compensation plan from ARR to MRR or QRR, we simply change the scale of the x-axis by calculating average deal value, target quota and actual sales in MRR or QRR, 1/12 or 1/4 of ARR respectively.
OK. Visual, but maybe not so easy. Below is a simple numerical example that walks you through the calculation.
SaaS Sales Compensation Plan – Easy Example
Consider a SaaS sales job that requires a skilled sales rep in the $100K range. Say $50K commission + $50K base. What quota can the sales rep carry? Say 5 deals/month at an average deal value of $1000 MRR (equivalent to $12,000 ARR). Using the SaaS sales compensation formulas above with MRR as the measure, the quota in MRR is calculated as follows.
SaaS sales quota = 60K MRR per year = 5 x 12 x $1000 MRR
The SaaS sales commission percentage is then…
SaaS sales commission percentage = 83.33% = $50K ÷ $60K MRR
Now, lets see what happens when our SaaS sales rep closes three deals. A monthly renewal contract with a $1000 recurring payment, an annual renewal contract with a $12,000 recurring payment, and a two year renewal contract with a $24,000 recurring payment. All three deals have an IDENTICAL deal value of $1000 MRR, so our SaaS sales compensation plan will pay them all at an IDENTICAL sales commission.
SaaS sales compensation payout = $833.33 = 83.33% x $1000 MRR
This SaaS sales compensation math is straightforward and really easy for the sales rep to track…no spreadsheet required. For example, here is the list price MRR for all sf.com editions.
For comparison, here is the EXACT same SaaS sales compensation plan and sales commission payout for the deals above recast in ARR.
SaaS sales quota = 720K ARR = 5 x 12 x $12,000 ARR
SaaS sales commission percentage = 6.944% = $50K ÷ $720K ARR
SaaS sales commission payout = $833.33 = 6.944% x $12,000 ARR
This example should make it clear that the choice of MRR, QRR or ARR is completely arbitrary, because the SaaS sales commission percentage scales accordingly to pay the same actual sales commission for the same actual deal value, regardless of which recurring revenue time-frame you choose. The only important rule is that you must use the same recurring revenue time-frame throughout all your SaaS sales compensation plan calculations.
This is where SaaS Sales Compensation Mistakes #1 & #2 below rear their ugly heads. When it comes to payout, there is a tendency to want to swap out the correct recurring revenue measure for the explicit contract renewal payment. For example, in the ARR plan above to plug in $24,000 for the 2 yr deal and pay out $1666.67 instead of $833.33. Don’t do it!
The reason the monthly, annual and 2 year renewal contracts all pay the same commission amount is that they all have roughly the same lifetime values, and are therefore of equal value to the SaaS company. The difference between the three is only the cost of capital. But, the rep and sales manager never see this. That is the point of using MRR/QRR/ARR as surrogates for LTV…to remove all the complexity.
Let’s say we have a churn rate of 10% and a cost of capital of 25% (typical for venture investment). The LTV of the three deals can be calculated using the second LTV formula above.
- 1 mo renewal contract LTV = $37,032
- 1 yr renewal contract LTV = $42,857
- 2 yr renewal contract LTV = $49,834
Sometimes longer term contracts may imply lower churn rates, if we assume 15% churn for the monthly contract and 7.5% churn for the 2 year contract we have the follwoing LTVs:
- 1 mo renewal contract @ 15% churn LTV = $31,618
- 1 yr renewal contract @ 10% churn LTV = $42,857
- 2 yr renewal contract @ 7.5% churn LTV = $53,050
These actual lifetime deal values differ by about +/- 25% (on the order of the cost of capital). They do not differ by 1/12X , 1X and 2X respectively. Hence, if we want to add an incentive to our SaaS sales compensation plan for signing longer renewal term contracts it should be determined by how much we value cash up front, i.e., the cost of capital. In the second example, you might penalize monthly contracts by 25% while placing a 25% premium on longer 2 yr contract, paying $625 for the monthly renewal contract and $1050 for the 2 year renewal contract. You would not pay 1/12X and 2X respectively.
Note: If you have customers with dramatically different churn profiles, you should segment these deals and prorate commission payment relative to the norm as in the second example..
Since this post was published, I created a saas sales commission spreadsheet that demonstrates these calculations.
Basing your SaaS sales compensation plan on MRR/QRR/ARR is not about cutting commissions off at one month/quarter/year. MRR/QRR/ARR are used because they are all equally good, simplified measures of LTV. Paying on MRR/QRR/ARR ensures that the sales rep is paid in-full, up-front for the full lifetime value of the deal that has been closed, regardless of the payment plan chosen by the customer. Not some underpayment or overpayment spuriously based on the contract renewal term, and not in dribbles over the life of the contract to match cash flow. Good for the SaaS sales rep. Good for the SaaS business. Good SaaS sales compensation plan design.
How much easier could it be? Well…here are some very common mistakes to avoid.
SaaS Sales Compensation Mistake #1
Paying SaaS sales compensation on explicit total contract value
Happy customers renew their contracts. Unhappy customers don’t. Unhappy customers cancel early, and ask for refunds. If your customers are happy, then the primary benefit of a long term contract is up-front cash payment, not lock-in. Happiness = Lock in. Your SaaS sales compensation plan should reflect this reality. Consider a service that costs $100/month. A monthly renewal contract appears to be worth $100, while a 1 yr renewal contract appears to be worth $1200, and a 2 yr renewal contract appears to be worth $2400. In reality, all three contracts have the same recurring revenue ($100 MRR or $1200 ARR), and should therefore pay the same baseline commission. This is the essence of Bessemer Law for being SaaS-y #1, which states that “bookings are for suckers.”
Longer term contracts are worth more, but the difference in value is your cost of capital which is typically in the 5-30% range depending on your source of funding. The financially sound SaaS sales compensation approach is to pay a baseline commission on the recurring revenue of the deal, then provide an accelerated payment incentive for longer contracts in the 5-30% range that reflects your own cost of capital. (See the numerical example above for a more detailed explanation). If you base your SaaS sales compensation plan on ARR, then sign a 2 yr contract and foolishly plug the explicit contract value of $2400 into your SaaS sales compensation payout formula because the deal FEELS like it is worth $2400, then you are paying as if the deal was worth twice as much. It isn’t.
SaaS Sales Compensation Mistake #2
Trying to manage cashflow through your SaaS sales compensation plan
This is the reverse bait-and-switch of SaaS Sales Compensation Mistake #1 above, arising when you sign contracts with short subscription terms, e.g., monthly. In this case, there is a tendency to not what to pay out sales compensation in advance of receiving payment. Tough! It isn’t the sales rep’s job to manage cash flow. It’s the sales rep’s job to bring in the deal. If your customers are happy, then a monthly payment plan is just as valuable as an annual plan, minus a small percentage for the time value of the money. The best approach is to pay the sales rep in-full, up-front based on the recurring revenue, then tack on a 5-30% penalty for short term contracts as described in SaaS Sales Compensation Mistake #1 above.
If you are one of those lucky SaaS companies that has high early churn and then things settle down, you might want to break the payment up into two, e.g., 50% now and 50% when things settle down. But, you should NOT leave the sales rep waiting and waiting to get paid over time in an attempt to match cash flow to sales compensation. If your churn rate is very very high, say 50%, then you might ask yourself if you are in a recurring revenue business in the first place and simply revert back to paying on actual contract value.
SaaS Sales Compensation Mistake #3
Not including fully loaded sales compensation in customer acquisition cost
Customer acquisition cost should include all the labor it takes to get a new customer signed, not just out of pocket sales and marketing costs. Generally, adding up all sales and marketing expenses is the best way to calculate your customer acquisition cost. This way you don’t miss anything. When you do this, you will almost certainly find that fully loaded sales compensation costs are a dominant contributor to total customer acquisition cost. As indicated in the SaaS metrics series, controlling acquisition costs is a critical factor in reaching profitability. Therefore, it is important to set a target for the ratio of fully loaded annual sales compensation to new annual recurring revenue that gives a sales contribution sufficient to support overall business profitability (i.e., sales contribution = 1 – sales expense ratio).
SaaS Sales Compensation Mistake #4
Not scaling sales compensation with sales productivity
Some good benchmarks to plug into the commission formula above are $100K in total sales compensation for $1M ARR. On a 50:50 split, this gives a commission percentage of 5%. But, what if you are a start-up and a quota of $1M ARR is just plain unachievable? For example, if your current average deal size is $1000, your sales rep would need to close 1000 deals/year! In this case, you might need to pay 20% on a quota of $250K ARR just to get your business off the ground. However, a sales contribution of 60% is unlikely to be profitable in the long run, because you are paying $100K in sales compensation for a measly $250K ARR (i.e., 60% = 1 – 100K/250K). In this scenario, you should work hard to increase both your average deal value and your achievable quota. As you grow, it is important to scale your commission percentage in lockstep with your increasing achievable quota, otherwise you will get locked into a low sales contribution percentage that will sink your long term profitability.