Rethinking Sales Commissions for SaaS

Traditionally, sales representatives are compensated with bonuses for either hitting goals (quota) or as a percentage of revenue generated (commission.) For SaaS companies, business model relies on recurring revenue, this creates a mismatch between the short-term reward of a sales rep and the long-term revenue generation for the business.

Let's look at a hypothetical SaaS product:

  • $200 MRR
  • 1.5% Monthly churn
  • 72 month customer lifetime ((1/Annual churn) * 12)
  • $14,400 LTV (MRR * lifetime)
  • 5% Commission ($720 per deal)

This should give us some basics to work with. For simplicity, we'll assume that, as a small SaaS company, our sales representatives are full-stack. They handle everything from prospecting through closing and account management.

When we close a deal, we give the sales rep a $720 commission based on the expected LTV. For the business, there are three possible retention buckets a customer could end up falling into:

  1. Customer stays for exactly 72 months
  2. Customer stays for < 72 months
  3. Customer stays for > 72 months

The first bucket is perfect. The customer stayed for exactly 72 months and our commission matched our target commission precisely (5%.)

The second bucket is bad for the business. The customer generated less revenue than projected (LTV) so the commission portion of the cost of acquiring that customer (CAC) ended up being higher than 5%.

The third bucket is unfair to the rep. The customer generated more revenue than projected (LTV) so the business paid out less than 5% of revenue to the rep.

Note that the lower our churn rate (and therefore the larger the customer lifetime,) the less likely that a given customer will fall into bucket 1. That customer lifetime number may still be accurate for the business as a whole (i.e. our churn rate is accurate,) but fails to account for the performance of individual employees.

Deals that end up with a lower-than-expected LTV are compensated exactly the same as deals with a higher-than-expected LTV. You could provide some downside protection by, for example, deferring commissions until customers hit six months. But unless you wait for them to hit month 72, which is entirely unreasonable to your employees, you won't know for sure.

In essence, our commission structure is mismatched with the realities of the business. Our incentives very rarely align with value created because our commission structure — up front bonuses — does not align with our revenue structure — recurring monthly payments.

To fix this mismatch, we need to realign incentives with the business. An upfront bonus would make sense if we were selling fixed length contracts, but that isn't the business model of SaaS. We care about both closing new deals and retaining existing clients.

Let's compensate accordingly. Instead of paying 5% upfront, we will instead pay reps 5% of generated revenue every month. What does that look like in practice? Let's look at the first 6 months of a rep who is closing 10 deals per month:

Month Deals Closed Total Deals Closed Commission
1 10 10 $100
2 10 20 $200
3 10 30 $300
4 10 40 $400
5 10 50 $500
6 10 60 $600

For the sales representative this is fantastic. By the end of six months, the rep is making an additional $600 per month in additional income based just on existing customers. A year in, they are making over $14,000/year more than their base salary. They are still directly compensated for their performance and now take part in the major benefits of a recurring revenue stream: stability and stacking revenue.

The business too is better off. From the outset, our sales team is encouraged to find the customers whose needs best fit our product. The less the fit, the higher the likelihood of churn and a lost commission. If a customer is thinking of leaving, our representatives have the same financial incentives — recurring revenue — to encourage them to stay.

Saving the best for last, the final piece in this win-win-win scenario is the customer. Since sales reps are incentivized to reduce churn, they are more likely to engage the product team with customer requests. And not just shiny features that will close the deal because now they care about delivering lasting satisfaction.

In the next post, we'll look at how to scale this beyond just full-stack sales representatives by splitting the roles in two: Account Executives and Account Managers.

We're excited to rethink sales incentives at Seneca Systems to be better for our customers, our employees, and our business. If you share our passion for rethinking what's possible, join us! We're building the foundation of our sales team and would love to hear from you.