Where Owners Go Wrong With Commission Structures

+ How to Get Them Right

As both a Fractional CFO and an owner myself, I’ve seen and tested out my fair share of commission structures.

While they tend to vary a bit by industry, they usually share a common attribute.

And that’s not being incentivized properly.

Here’s what I mean.

You’re Driving the Wrong Behavior

Before putting any kind of commission structure into place, you’ll need to articulate the results that you want to see more of. Then you’ll have to start thinking about the unintended consequences that your new policies may be ushering in.

For example, let’s say you want to grow ARR. If you fail to incentivize anything other than Revenue, this could lead to heavy discounting. That discounting, in turn, directly hits your gross margin.

While a 5% discount may seem immaterial on a 20% net margin business, this is actually a 25% hit to Net Margin. Think about that.

In perpetuity agreements have their flaws too. While they may reduce churn, you don’t want your Ops team doing all the work to keep those longer-term clients happy while the Sales team reaps all the benefits.

Another big pitfall I see is in timing. Instead of paying out commissions as you recognize Revenue, you should match those outflows to when you actually receive payment.

Setting the Right Structure for Your Team

As an owner, you have a number of options here. The challenge is to match the structure with your goals, sales cycle, and the behavior it’ll in turn drive among your employees.

In my business, I like to offer higher splits to keep my team motivated. While this lowers profitability for me personally, it helps me stay alive longer from a cash flow perspective.

If you want to focus on booking more multi-year contracts, then your commission structure should reflect that clearly. Perhaps the best way to do this is by allowing your reps to earn more on these longer-term deals.

Regardless of your business’s specific goals, they should be easily discernible and directly supported by the structure you choose.

And to help with that, here’s a quick rundown of the most common structures you might want to choose from.

Straight Commission

Also called “100% commission,” this structure pays based on sales made only. In other words, there’s no base salary component. While straight commission may incentivize shortsightedness among your salesforce, it does make sense if you’re a scrappy startup needing to sell without a lot of cash on hand to pay employees upfront.

Tiered Commission

Tiered commission structures typically mean paying out progressively bigger commissions as contract values increase. However, there are no shortage of variations on this theme. For example, you might want to pay reps more once they exceed quotas or close more of the deal types you’re looking to push that year. While this approach effectively compensates your top performers, it only works if you have the infrastructure in place to accurately track performance.

Single-Rate Commission

Single-rate pays out a fixed commission for each sale, regardless of deal size. The main upsides to a single-rate structure are that it’s easy to track and conserves cash. A major drawback to this approach, though, is that it rewards all types of deals at the same rate. So if you’re trying to push a specific offering or contract type, you might want to stick with tiered commissions.

Gross Margin Commission

Gross margin structures are similar enough to single-rate structures, but the main differentiator is that they pay commissions based on the gross revenue made by the company rather than on the value of the contract. As a CFO, I tend to prefer this structure since it solves the discounting problem rather effectively.

Residual Commission

Residual structures reward reps for securing long-term clients and upselling them by offering recurring commissions until that customer churns. However, you’ll want to be cautious before implementing this structure if another team is doing the majority of the retention work.

Putting It All Together

Here are your top takeaways from this week’s post.

  1. Picking the right commission structure for your team means articulating your goals and protecting against the unintended consequences.

  2. Pay special attention to how your commission structure affects both Gross Margins and cash flow. Do this by keeping a close eye on discounting and timing payouts with their associated inflows.

  3. Straight, tiered, single-rate, gross margin, and residual are the main types of commission structures. Each have their own benefits and drawbacks. What works best for your business will depend on the behavior you’re trying to drive among other factors.

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‘Til Next Time,