It's the time of year when sales leaders, sales ops, and finance leaders get ready to launch their new sales compensation plans. While most of the compensation construct is standard across sales teams, it can be confusing for those without sales backgrounds. In order to give Founders, CEOs, and executives a background on sales compensation, we created this blog to review how sales compensation plans are developed and how the different designs drive differentiated behavior. As a continuation to this blog, we will be publishing another with our new Insight Comp and Quota report that offers insights on compensation, quota, and span of control across our portfolio companies.
Let’s start with the basic structure of compensation in sales. There are two components that make up an individual’s On-Target-Earnings (OTE) – Base Salary and Variable Compensation.
Base Salary is the regular bi-weekly or monthly payment that is made to an individual for working for the company. In non-sales roles, base salary represents between 75-100% of the person's overall take home pay. In sales, however, represents a smaller amount (50-60%) of the overall compensation to give the sales rep greater upside potential if they outperform their quota.
Variable compensation represents between 40-50% of the OTE, but can be considerably more based on the sales rep’s performance against their quota. In a standard compensation plan, the variable comp element will often be quoted assuming 100% attainment of quota. A sales rep with a 200k OTE on a 50/50 plan will have a base salary of $100k and variable compensation of $100k at target.
The variable compensation may be impacted by decelerators or accelerators. These are elements that slow down the rate of earning for those reps that are below quota and increase the rate of earning for sales reps achieving or exceeding their quota. We’ll cover examples of this in the commission section.
The primary reason to use a sales compensation plan is to drive sales people to sell more of a given product, solution, or commercial structure. Properly designed sales compensation plans can push all of the sales people to keep their foot on the gas through the entire year regardless of how they are performing. That said, sales plans are not a replacement for good management; Sales leaders should ensure that their teams are performing and hold them accountable when they are not, but sales plans can help to encourage the desired behavior.
There are three main compensation constructs – Management by Objective (MBO), Commission Plans or Quota Plans. One of the most important tenets of sales comp design is to keep things simple and tie the behavior as closely to the compensation as possible. While each of these constructs has can be used to compensate sales people, commission plans are the most straightforward. That leads most companies (including the majority of our portfolio companies) to use a commission plan.
MBOs are similar to the bonuses that non-sales teams earn. Individuals have specific goals that they must achieve in order to qualify for bonuses and accelerated bonuses. Most MBO plans have between 2-3 goals, but there can be up to 5. In sales organizations that use MBOs, one of the main goals will be the team achieving their overall target. Payouts for MBO plans are typically in step function format with reps receiving 0, 75%, 100%, 125%, and 150% based upon achieving and exceeding their goals. These types of plans are typically used in companies with highly technical sales and non-traditional sales people because they are easy to administer and the overall cost can be contained.
Commission plans are the most common plan for sales. In a commission-based plan, a sales rep will earn a percentage for every dollar of the solution that they sell. Assuming a commission rate of 10% on $800k of software sales, the sales person will earn $80k in commissions. This structure directly ties the sales to the amount earned. It is fairly easy for a sales rep to project the payout for their upcoming deals and that may motivate them to get the deals closed as quickly as possible. In its simplest form, a straight commission plan will offer a set commission rate regardless of the performance of the sales rep. By incorporating accelerators, we are able to drive greater sales from high performing reps. For example, a commission rate might be 10% for ≤100% of the plan but increase to 12% once the rep starts to exceed plan. In the same situation as above, the $800k deal generates $96k in commission if the rep is performing above their quota. To cover the increased cost of accelerators, companies often put in place a decelerator which may penalize significant underperformance. For example, a rep who is finishing the year at 50% of quota might only earn a commission rate of 70% of the target commission rate (in the above case, 7%).
Companies can use standard commission rates where everyone in the same role earns the same rate or they can create individual commission rates that are based on each rep’s variable compensation target and their quota. While individual rates are more complex to manage, they allow you to differentiate compensation based on the rep’s specific opportunity – similar to a quota plan.
Quota plans are the last major plan construct. This plan type typically exists in Enterprise sales organizations where territory balancing isn’t quite as easy as it is in mid-market and SMB segments. This plan allows the assignment of individual targets that can vary greatly based on the opportunity that each sales rep has; compensation is tied to performance against the quota plan but shifts from being a % of dollars sold to a % of variable compensation.
Let’s look at an example – you have two reps selling your product (which appeals to financial services companies) with one rep in NYC and the other rep in Vermont. The rep in NYC has significantly more opportunity, so she has a quota of $3M, while the Vermont rep has a quota of only $800k. If both reps hit their quota, they should both earn their variable incentive of $150k since they’re both selling their full potential. The way this would work in a compensation plan is that for performance from 75-100%, they would receive the performance percentage in their variable (81% performance pays out 81% of variable). Once they pass 100%, you may want to include accelerators ie. 2% for every 1% above 100% – 101% might pay our 102% of variable.
Those are the basics – two main components make up every compensation plan – Base Salary and Variable, and there are 3 constructs that are typical in sales organizations. In our next blog, we’ll get into more of how a compensation plan gets designed to drive specific behavior, we’ll highlight some unique structures that companies use. In our final blog, we’ll share highlights from our Comp and Quota report. Hopefully, this overview helps you feel more informed when engaging with the sales leadership on sales comp plans.