The Golden Rules of Sales Compensation

These 5 key concepts can build a successful incentive plan.

If a company were an engine, the sales function would be its fuel. It is the function that is responsible for generating all, or most, of a company’s revenue. One of the differences in the ways sales professionals are compensated is the inclusion of a sales commission plan. Sales professionals only make part of their total earnings via salary. The rest is made via the rules dictated by a sales incentive plan, which in many cases includes commissions.

Sales incentive plans are delicate things. This stems from the fact that the best sales professionals intuitively do whatever puts the most money in their pocket, within legal and ethical boundaries. They do so assuming the company has put a lot of thought into how they are incentivized, and therefore, whatever pays them the most surely is good for the company, too. 

Adhering to the following rules is critical when setting commission plans for your sales team.

1. 1. Business Strategy Alignment.

      Don’t expect a sales professional to read your mind to determine what is good versus bad business. Instead, make sure the sales compensation plan fosters behavior that is consistent with your business strategy.

      Charlie Munger, longtime vice chairman of Berkshire Hathaway, is often quoted as saying, “Show me the incentive, and I will show you the outcome.” Remember that the best sales professionals do whatever puts the most money in their pocket. That means it is your duty to make sure that behavior is consistent with your business strategy. This requires some advanced thinking and scenario planning to identify loosely defined rules or gray areas that can be exploited, either intentionally or accidentally. 

      For example, imagine that a company is just getting started and the most important thing to the owner is establishing a base of customers. This might result in sales representatives being paid a certain amount for each new account they acquire. Perfect, right? Well, if the definition of “new account” just means that a new customer bought anything, a savvy sales rep looking to maximize their earnings will sell the easiest offering just to get the compensation associated with acquiring a new account. If the easiest thing to sell is of such minimal value that simply paying the sales commission crushes profit margins, then there is a problem. For example, the plan could require a minimum amount of revenue from a new account in order to qualify for a sales commission.

   2. Never Change the Rules in the Middle of the Game.

      Before officially announcing compensation plan details, try to identify accidental loopholes or opportunities for bad behavior that maximize earnings. Then, stress-test your compensation plan by modeling various simulated results, especially ones that simulate a sales representative far exceeding their targets.

      Most compensation plans are established to cover a year at a time. If you absolutely have no choice but to make a change mid-cycle, come clean with your sales team by explaining the rationale and thinking about how to handle in-flight sales opportunities that are about to close. Those that would have paid more commission before the change will certainly be top-of-mind. Some concessions and grandfathering of prior rules might be justified.

      If your exposure isn’t significant, you might be better off looking the other way and biting your lip until you approach your next plan cycle and then modifying the commission plan. In other words, think about the risk-reward trade-off, and understand that changing the rules in the middle of the game might cause you to lose some of your best sales representatives. But even if you decide to delay the change, you might let the sales team know that you realize a mistake was made and that you’re going to stick with the plan through the end of the period. That way, they understand things won’t be that way for the next period.

      In the very early days after hiring your first couple of sales representatives, you might not know what a reasonable sales quota or target looks like. In this case, don’t lock things in for a full year because it leaves you with too much risk of being way off on either the high side or the low side. Instead, set quotas for only three to four months or one to two quarters at a time until you gain some maturity. This will minimize the need to change the elements of the commission plan in the middle of a shorter cycle.

      Think about the risk-reward trade-off, and understand that changing the rules in the middle of the game might cause you to lose some of your best sales representatives.

   3. Keep It Simple.

      If the plan requires the sales representatives to have a magic decoder ring to figure out if, when, or how they will get compensated, you’re in trouble. Minimize the number of things the sales team gets paid for by prioritizing what’s important and using simple language to communicate the commission plan.

      If you have a sales representative you can really trust, get their opinion ahead of time, and ask them if the plan is simple to understand. After they read the draft plan, have them explain back to you how they will get paid. Then ask them how they would go about maximizing their earnings on the plan. If you don’t want to do this ahead of time, do it immediately after announcing the sales compensation plan. If you have a sales manager who manages the sales team, he or she can be an ideal proxy for preview.

   4. Be Very Clear.

      This can sometimes be at odds with keeping things simple, but it is important to minimize accidental misunderstandings. One way to do this is to include some definitions and examples in the official documented compensation plan. Going back to the example of the business strategy misalignment, the new account criteria should be clearly defined in the plan.

      Other items that might be documented for extra clarity include metrics like revenue or contract value, exceptions for things like purchase orders with contingencies or adverse terms, and pre-approval requirements for things like needed discounts. The document should also include some specific examples and associated commission calculations, as well as describe when the commissions for a sales period will actually be paid.

      One of the best ways to determine if your plan is clear is to test-drive it with a trusted sales representative before announcing it to the sales team. 

      If, after announcing the plan, you discover misunderstandings or different interpretations, you have a short window in which you can add clarification. Clarification is different from changing the rules, especially if done early in the sales plan period.

      Similar to the keep-it-simple objective, one of the best ways to determine if your plan is clear is to test-drive it with a trusted sales representative before announcing it to the sales team. Ask him or her to explain the plan back to you, and ask a few what-if questions to test his or her understanding.

   5. Avoid Earning Caps.

      Even if you think it’s extremely unlikely that a sales representative could make $500,000 or more using the commission plan, if they did the things necessary to achieve that, would it harm the business to pay it? You’d probably rather not pay it if you don’t have to, but would it harm the business? If you follow the first rule, business strategy alignment, this hopefully will not be an issue.

      In most cases when this happens, it means the sales representative sold a significant amount of product that brought in significant revenue and profit to the company. Companies that sell to large organizations and have more than 10 enterprise sales representatives will often discover they pay the highest performer more than the CEO. Such a sales representative often achieves 150 percent of their quota, or more. This is hopefully something to celebrate and can be used not only to energize the rest of the sales team but also to attract additional high-achieving sales representatives. The top handful of sales representatives at Fortune 500 software companies often make $1.5 million or more.

      The only exception to this rule comes in the very early days with your first sales employees and very limited maturity in setting quotas. If during that period you decide to implement some sort of cap to commission earnings potential, have a discussion with the sales team to make sure they understand why it’s in place and let them know you plan to remove it as soon as the company is more mature with measurements and forecasting capabilities.

      An alternative to setting a hard cap is to convey the message that management judgment may be imposed for commission calculations that exceed a certain amount. With this approach, don’t get greedy with the number, but instead, let the sales representatives see their way to very nice earnings if they greatly exceed their target.

Ultimate Objective

Done correctly, sales compensation plans will serve as a valuable recruiting tool and motivation for the sales team to reach their full potential. Combine that with world-class forecasting and the resulting predictability it provides for the organization, and you’ll be able to direct your attention to other facets of the business.