SaaS Compensation Models Made Easy to Understand
This is not a complex topic. Sales compensation in SaaS companies can be confusing, but it does not have to be.
Now, you don’t have to worry about the complex math of lifetime value and how it relates to your sales compensation model. Just replace “price” with MRR or QRR or ARR in your favorite formula and all will be well.
The primary principle of sales compensation is to pay the sales rep in proportion to the value of their deals. This usually means that they get a percentage commission on what they sell, which can be calculated by dividing the target commission at quota (the amount needed for them make quota) with how much money was made this month.
For salespeople, commissions are usually a percentage of the quota and range from 20% to 60%.
The quota is based on the salesperson’s track record and can be adjusted accordingly.
The quota is the target number of deals multiplied by the average deal value.
To calculate the actual sales compensation, you multiply the commission percentage by your total revenue.
I assumed that commission percentages and actual sales would be enough to motivate my employees. I was wrong.
The target commission is determined by the labor market rate for the type of sales rep you need to fulfill a specific role. This becomes important when we understand that compensation isn’t about paying reps based on revenue, but instead allocating them a fixed percentage (target) in order to incentivize and align their performance with company success.
When it comes to sales compensation, there are many factors that can be tweaked. For example you could have tiers for different levels of commissions or spiffs (special commission bonuses) based on the margin vs revenue of a deal. However these basic formulas are what is important when setting up any plan and SaaS companies should pay attention to measuring performance in this way.
In a subscription business, the value of a deal is not as clear cut. As any MBA or bond trader will tell you, the true value of a recurring revenue stream amounts to summing up all revenues over time and discounting them by your cost of capital.
SaaS companies can estimate their lifetime value of a customer by considering the sum total of future revenues, discounted to present day. This includes revenue from renewals and new sales combined with an appropriate discount rate.
When it comes to calculating the lifetime value of a SaaS subscription, there are three main factors that come into play: 1) the initial investment needed for acquisition; 2) monthly recurring revenue (MRR); and 3) annual churn rate. The equation for LTV is calculated by dividing MRR over 12 months by 12 multiplied with i divided again by total amount invested in number of years minus one.
The top LTV formula is the present value of an annuity, which can be calculated by multiplying “i” (interest) times “a” (attrition rate). The bottom LTV would be found if a customer follows their average churn.
As I mentioned before, the LTV of a deal is always proportionate to recurring revenue. In other words, as long as we measure our SaaS company’s commission percentage against any form of recurring revenue that will be proportional to lifetime value then it doesn’t matter if we calculate the absolute LTV for each individual sale or not.
SaaS commission percentage is the total revenue generated by sales reps divided by their quota. The payout starts at a lower rate and increases as it approaches target.
The quota for a SaaS salesperson is the number of deals multiplied by average deal value in recurring revenue.
With SaaS sales, the commission is based on a percentage of recurring revenue.
Recurring revenue can be measured in different time-frames, but it is important to stick with the same one throughout your sales plan. If you calculate average deal value and quota based on monthly recurring revenue (ARR), then that means actual sales should also be calculated using ARR.
It is important to have a consistent recurring revenue time-frame in order for your sales compensation plan. This way, you can avoid the expensive bait and switch problem that arises when using different types of recurring revenues with various payment periods.
When I first began hiring salespeople, I just assumed pay along with commissions and bonuses would be enough. However, people are not motivated by money alone.
The picture above is a visualization of two sales compensation plans for the same reps. One works at software company, and one sells SaaS (Software as a Service). Both have similar skill sets with market labor rates that are comparable to each other. The goal in both cases is $2M license revenue; however, they differ on their payouts: On the left side plan, there’s an accelerator which increases payout from $100K at 1.5M to 150K at 2M—with unlimited upside if you can blow it out of the water.
Here is a SaaS sales compensation plan that motivates the rep to generate $1M in annual recurring revenue. The plans are identical except for the scale of performance measure on x-axis (swapping license price with ARR). This plan has base pay at 50K and an accelerator such that payout would be 100k at 750k ARR, 150k when 1mARRR reached, unlimited upside for top performers. If we want to recast this from arr or mrr then change by calculating average deal value target quota actual sales respectively.
Below is a simple numerical example of how to calculate the amount.
The best way to make a sales compensation plan is by using the following example: I. Base Pay – $10,000month II. Commission Structure – 10% on gross revenue and 2% of retained accounts (within 12 months)
One of the most common mistakes in sales compensation is to base pay and commission on an assumption that high commissions will be enough motivation. The reality, however, is different.
A SaaS sales quota is $6000 per year, which comes out to be 5 x 12 months multiplied by the MRR.
If you are a SaaS company, then your commission percentage is…
When calculating sales commissions, it is important to know that the commission percentage equals 83.33% of your MRR
Now, lets look at the commission plan for our SaaS salesperson. They closed three deals with identical recurring payments of $1000 each and they all have an IDENTICAL deal value so we will pay them identically according to their commissions.
SaaS sales compensation payout = $833.33= 83.33% x $1000 MRR
To make sure that you are rewarding your sales reps in the right way, try using a straightforward and easy-to-track system. For example, here is the list price for each edition of SF (Salesforce).
A plan with the same terms as above, but in Annual Recurring Revenue (ARR) format can be seen below.
To have a good SaaS sales quota, you need to be able to close 5 x 12 = 60 deals worth $12k each.
A SaaS sales commission percentage is 6.944% which equals $50K ÷ $720K ARR
A SaaS sales commission payout is calculated as 6.944% of annual recurring revenue (ARR).
This example should make it clear that the choice of MRR, QRR or ARR is completely arbitrary because regardless of which recurring revenue time-frame you choose, pay scales accordingly to commission. The only important rule in SaaS sales compensation plans is consistency.
The first two mistakes in SaaS Sales Compensation are when you want to substitute the monthly recurring revenue for an explicit contract renewal payment. For example, if your ARR is $24,000 and a customer renews their service agreement with that plan at 2 years then instead of paying them out on what they should be getting which would be $833.33 pay them out only for the full amount upfront even though it’s less money overall.
With different payment plans, like monthly and annual contracts as well as two-year agreements, the commission is set at a certain amount. This pay varies because they all have roughly equal lifetime values; however it doesn’t matter to reps or sales managers since these details are hidden from them by using MRRQRRARR (Monthly Recurring Revenue Quarterly Recurring Revenue Annual Recurring Revenue) for substitutes of Lifetime Value
If the company has a 10% churn rate and 25% cost of capital, it can be estimated that their LTV is about 2.5 times revenue.
- 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 can be more stable and less likely to churn because we assume that the monthly contract will have a 15% retention rate while the 2 year contract will only experience 7.5%. This means they would last for different amounts of time.
- 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
The difference in lifetime deal values is not as drastic as 112X, so it’s important to take into account the cost of capital when deciding how much an incentive should be. For example, you might penalize monthly contracts by 25% while placing a premium on longer 2 year contract for $625 and $1050 respectively.
The best way to do this is by segmenting the deals and paying commissions relative to each customer’s needs as in the second example.
After publishing this post, I created a spreadsheet to make it easier for salespeople and managers to calculate commission payouts.
In Summary 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.
There are many mistakes that can be made when designing a sales compensation plan. The following list outlines some of the most common errors.
SaaS Sales Compensation Mistake #1: Paying SaaS sales commissions based on the stated total contract value
When people are happy with a product, they usually renew their contract. When customers are unhappy, the primary benefit of long-term contracts is up front cash payment not lock in. Happiness = Lock In; your SaaS sales compensation plan should reflect this reality by giving all three products equal commissions so that you can avoid being seen as predatory.
I have found that there is a time value of money when it comes to contracts. Longer term, more lucrative deals are worth more than short-term ones but they cost you in the form of higher interest rates on your capital investments. A financially sound SaaS sales compensation plan would be something like this: base pay and incentives for longer terms based on 5%-30% extra depending on what’s best for your company (see example), and then an accelerated payment incentive if one signs a 2 year contract which reflects how much their own investment costs them.
SaaS Sales Compensation Mistake #2: Attempting to control cash flow via your SaaS sales compensation plan
The last major mistake I have made is not paying salespeople in advance for their commission. When a contract has shorter terms, such as monthly billing cycles, there is often the temptation to save money by waiting until they are paid before giving them commissions. This isn’t fair because it puts all of the burden on employees and forces them to be responsible for cash flow management instead of bringing deals into your company.
If you are a lucky SaaS company that has high early churn and then things settle down, try breaking the payment up into two parts. However, if your churn rate is very high- say 50% – you might ask yourself whether or not it’s worth continuing to be in this business at all.
SaaS Sales Compensation Mistake #3: Customer acquisition costs do not include fully loaded sales compensation.
The customer acquisition cost should not just be a base pay and commission, but the labor it takes to get new customers. Generally calculating all sales and marketing expenses is the best way to calculate your customer acquisition costs. This way you don’t miss anything like fully loaded annual salary which can also be very costly when adding up with other parts of expense such as commissions or bonuses. As indicated in my SaaS metrics series article, controlling these costs are important for businesses who want to reach profitability because once they do that then they will have enough money coming in from their salaries alone (i.e., if 1-sales contribution = 0).
SaaS Sales Compensation Mistake #4Not scaling sales compensation with sales productivity
The benchmarks for commission percentage are 5% when the total sales compensation is $1M ARR, but in a start-up this might not be enough. For example, if your average deal size is only $1000 and you have an unattainable quota of 1 million dollars annually, then 20% would need to go towards commissions just to get things off the ground.
