Since my post entitled SaaS Sales Compensation Made Easy, I’ve received a number of inquires about how to adjust SaaS sales commission percentages for very short and very long term subscription contracts, e.g., renewal periods of 1 month vs. 2 years. Clearly a 2 year contract paid in advance is worth more than a monthly renewal and should pay a higher commission. But, how much more?

In the model, I propose as best practice that SaaS sales commissions should be paid 100% up-front in proportion to the lifetime value of the sale (LTV). But to keep things simple, recurring revenue (ARR, QRR, or MRR) is substituted as the everyday measure of LTV, because LTV is always directly proportionate to recurring revenue. Basically, pay on recurring revenue in SaaS just like you would pay on price for any other product. It’s that simple….provided: 1) contract terms don’t vary widely and 2) the churn rate is uniform across customers (no churn cohorts).

However, adjusting your SaaS sales commission plan for these two factors isn’t complicated. You can do the LTV math in the background to produce a simple table of adjustments to the baseline SaaS sales commission for each contract term and/or churn cohort. Then, include this simple table of adjustments in your SaaS sales commission plan. The spreadsheet below does exactly this. (you can “Click to Edit” and play with the numbers or download to Excel. Go ZOHO!).

This enhanced SaaS sales commission model incorporates the effect of payment terms
and churn on lifetime value. The top table adjusts for contract term only,
whereas the bottom table allows for churn cohorts as well.

The lifetime value of a SaaS sale comprised of recurring subscription payments made in advance is given by the following formula:

i = cost of capital; a = churn rate

It is evident from this formula that if either contract term (i) or churn (a) vary across a wide range, then the calculation of the SaaS sales commission based on LTV should be adjusted accordingly (see LTV notes in the spreadsheet for the impact of contract term on i ). Put simply, if your contract terms (renewal periods) vary from monthly to every 2 years, you should consider adding a premium to the SaaS sales commission for 2 year contracts and a discount to the SaaS sales commission for monthly contracts. Or, if monthly customers cancel much more frequently than annual customers, say at a churn rate of 20% for monthly compared to a churn rate of 5% for annual, then you should again discount the SaaS sales commission paid on monthly contracts.

Using the formula above, the spreadsheet calculates a table with the commission percentage for each contract term and churn cohort. This table is created by taking the baseline commission percentage and multiplying it by the ratio of the LTV for each scenario to the baseline LTV. In the spreadsheet, an annual contract is used as the baseline.

To calculate the adjusted SaaS sales commission table that is right for your SaaS business, start by entering the target quota and target commission at quota to generate the baseline commission percentage. Then, you must select a cost of capital that reflects how much your SaaS business values cash up front. The more you value cash up front, the higher the number you put in for cost of capital. For a rapidly growing venture-funded startup, the cost of capital can be well in excess of 25%.

If your SaaS business experiences dramatically different cancellation rates by contract term, then you should adjust the churn rate for each contract term using the second table at the bottom. You can also use the spreadsheet to create adjusted SaaS sales commission tables for two different churn cohorts by entering one churn rate for the top table and a second churn rate that is the same for all contract terms in the bottom table.

It is also instructive to type in a value of 100% churn, implying that contracts are never renewed. In this case the SaaS sales comission payout is 1/12X, 1/4X, 1X, 2X, 3X for monthly, quarterly, annual, 2 year and 3 year contract terms respectively. This is the source of SaaS Sales Compensation Mistake #1 – Paying SaaS Sales Commission on Explicit Total Contract Value. Unless your churn rate is 100% or your cost of capital is infinite, you should not pay SaaS sales commissions based on total contract value. Over time, an automatically renewing annual contract will bring in exactly the same amount of money as a three year contract (provided the churn rate is the same). The only difference is the interest you can earn (or save) on the money up front, which is represented by the cost of capital.

Read the original blog entry...