A well-written sales compensation plan document clearly defines when the commission* is officially “earned,” and this may or may not be at the same time that it is paid. Many companies will pay some or all of the commission for a sale following the booking of the order, but reserve the right to reverse sales credit and payment if the order is cancelled, the product is returned, or the sales value is not collected from the customer within a certain timeframe.

Typical “triggers” for payment include:

• Booking/Order: The customer has agreed to purchase a specific product or service at a specific time for a specific price with specific terms, all documented in writing (e.g., booking)
• Shipment/Work completed: The product is shipped from the warehouse, or the service is delivered and accepted by the customer
• Revenue: Revenue for the sale is recognized in the company’s account in system (which may be triggered by shipment or service delivery as well)
• Cash: Some or all of the payment for the sale is received.

In the case where some or all of the commission is withheld until the company receives payment from the customer, some states (Illinois and Maryland) are beginning to adopt what is called “substantial procurement” doctrine, recognizing the right of sales people to be paid commission for booking a sale, even if their plan document states that payment is not earned or made until cash is received.

Despite this clearly defined “trigger” for earning and payment in the plan document, former employees in Illinois and Maryland can now argue otherwise. Their argument is rooted in the significant investment of time and effort on their part culminating in the successful close of the sale. They argue that a booked order “substantially procured” the commission because they (1) were able to convince the customer to agree to the sale, (2) processed the order, and (3) knew the company was prepared to ship or deliver the product or service to the customer.

In today’s economy, with companies struggling to maintain their cash flow, sales reps are not typically in the business of securing payment, leaving this task to their friends in accounts receivable.

Bottom line: In at least two states in the US, your sales people have the right to their commission payment if they obtained the order, regardless of the wording of your sales compensation plan document. Thus far, the practical implications have extended only to terminated employees. Watch for similar actions in other states, and for sales people making the claim that payments may not be withheld until cash is received if their job is done once the order is obtained.

For more details see the article on the SHRM web site by Joan Deschenaux (SHRM Senior Legal Editor), visible only to SHRM members.

*To date, this issue has arisen only with true commission plans (communicating compensation as a percent of the value of what is sold). However, the principles apply and the issue may shortly arise with other forms of sales compensation including quota-based incentives or bonus-type plans.

For example, in large ticket software sales a comp plan may stipulate that

Credit trigger: Sales credit is given when the order is booked (deal is signed), relieving quota and moving the sales person up in the tiers towards a higher payout rate

Payment trigger: 50% of the compensation value of the deal is paid following signing, and 50% is paid following payment of the first invoice

Earnings trigger: Compensation is earned only when cash is collected and all payments in advance of this are draws against these future earnings (which gives the company certain rights to reverse payment/sales credit in case of cancellation or non-payment by the customer)

For the purposes of this discussion, we’ll assume that the most typical arrangement is in place regarding the three triggers above, which is that sales credit and payment are triggered together at the same time, and that earnings are always triggered at cash collection to allow for charge-backs as needed.

The four most usual crediting and payment triggers are:

Order intake (/booking)

Sales job: Obtain new customer acquisition, new business

Typical in: Larger companies with dedicated new business roles, stable processes, robust deal review; long term contract sales

Product shipped / service delivered

Sales job: Book orders from new or existing customers that result in delivered value

Typical in: Many businesses – this is the most typical sales credit/payment trigger

Revenue recognized

Sales job: Book orders that result in recognized revenue in the measurement period (e.g., year)

Typical in: Many businesses since it’s the same as the prior category in most cases; for software, revenue recognition rules can make the timing of this a bit tricky, and recognized revenue is a common measure/distinction for services sales and account management roles

Cash received

Sales job: Sell, and ensure fulfillment and collection

Typical in: Earlier stage businesses where funding the commission requires the cash; businesses selling to markets with colleciton issues; long term contract sales with a preference for up-front payment

The principle is that you should pay the sales person soon after two conditions are met:

1. Their job is substantially “done” and you’d like them to move their focus off of the old sale and put most of their energy into new opportunities, and
2. You know what the sales is worth, within about 10% (this may mean you can’t fully pay for rate-table sales, like a rate for hourly work with no commitment to a specific number of hours, until a usage rate is established or the invoices are generated).

Relevant to this discussion, but a subject worthy of separate treatment is the issue of the “annuity tail” that may grow and attach itself to your comp plans if you pay based on invoice for long-term contracts. For several posts addressing different aspects of this problem, see this link.

• The sales job isn’t really done until the cash is collected – this is true when collection is often the responsibility of the sales person
• The company is earlier stage with limited cash reserves and needs the cash in the bank in order to pay the sale people
• Sales people are selling contracts for a rate ($/hour, $/square foot) rather than a fixed price contract, so the real value is not known until the product or service is used and billed.

Others who credit and pay when an order is booked do so because acquiring new business is the primary sales accountability, and there are others in place to deliver and collect, and the situations listed above are not top priorities for these businesses as compared to focusing their sales talent on new business acquisition.

And sometimes it becomes necessary to move from paying at booking to paying when cash is collected. In this case, the business may have to eventually deal with the problem that the lag created by the new sales crediting policy will mean a permanent loss of income for the sales people. (This might be recouped at the very end of their employment IF they continue to be paid them after they have terminated for deals sold while they were employed. But many companies would not plan to continue the payments after termination. And either way, that’s a potentially long time from now.)

Some companies making such a transition will offer a bridge payment to cover the transition; others may expect the sales person to absorb the loss; and of courser there’s the third option of sharing it. If we look at it purely from the company’s point of view, the current year cash outlay to offer the bridge (maybe 80% of expected commissions for the average lag time between booking and cash, paid out during the transition months) would not add any cost vs. the expected cost of the old (pay at bookings) plan. And if the comp plan doesn’t pay after people leave, then it all comes out even in the end, roughly. That’s probably the humane approach, and most likely to keep the sales people focused and productive during this transition (which they will not like, however you do it).

Question

Our sales people sell long-term deals, most of which span several years. When should they be paid for these – upon signing, as invoiced, when revenue is recognized, at completion, or a combination of these?

Answer

We have seen several different compensation arrangements for long-term deals, which are often found in subscription businesses (e.g., SaaS, phone/internet service, online test delivery), and complex multi-year implementations requiring installation/configuration (e.g., enterprise software, utility infrastructure). Some businesses pay the sales people who sell these long-term deals all at once, and others stage the payment over time. The most common arrangements we have seen are listed below, along with some idea of when they are most valuable:

Pay upon contract execution

This is most common when the sales person is a pure “hunter” and there are project management or account management people in place to take the hand off after the contract is signed. The sales person has “done their job” when the contract is signed. And the value of the contract to the company is very likely to be exactly as expected at the time of signing.

Pay as invoiced

In this case, the customer may pay a portion of the agreed price at signing, then pay over the course of the contract, perhaps as milestones are attained, or perhaps on a regularly monthly schedule. Often the sales person will receive payment after each invoice is created. In many types of business this will also align with revenue recognition (when goods are shipped), but may not (especially in the case of software sales or professional services for installation). This type of payment policy will keep the sales person focused on ensuring the contract is executed as planned, and invoices are generated. It will also allow the company to better align the cost of the sales compensation with the income received. And in cases in which the contract is for a rate (e.g., for bandwidth used, hours of professional services, or tests delivered), it will ensure that the sales people is paid fairly for actual realized sales.

Pay when cash is received

If collection is often an issue, or if sales compensation cost must be funded directly out of cash receipts, a cash-based payment policy may be used. This will have the effect of focusing the sales person on seeing the transaction all the way through to collection. This is most commonly used in cash-flow-constrained early-stage businesses. Most more mature businesses find that well-written contracts and careful negotiation of terms, combined with customer-pleasing delivery and a capable accounts receivable function ensure the cash comes in; and they would rather have their sales people focused on selling than on collections.

Pay when revenue is recognized

Especially in the sales of licensed software, software as a service, and professional services associated with software implementations, revenue recognition rules come into play. It is possible for contract to be signed, and even for substantial cash to be received, and yet for the company to not be able to recognize significant revenue until a later quarter or year. When revenue recognition that is potentially out of alignment with order acceptance, invoice generation, and cash receipt is an important business goal, sales people may be paid based on recognized revenue.

Pay portions of the compensation on a deal based on a combination of the above “triggers”

In some cases, several of the objectives cited above may be in play. For example, there are new business “hunter” sales roles for which the “handoff” to the project management team happens over a six month period while implementation is under way. In such a case, 50% 0f the payment for the deal may be made following contract signing, and 50% following completion of implementation.

Key principles

1. Finish paying the sales person at the point at which you would like them to disengage and focus on the next deal for the typical deal.
2. It’s reasonable and appropriate to include charge-back provisions so that sales credit and payment will be reversed if deals fail to materialize as anticipated. This should only be used as a fail-safe when such reversals are rare (well under10% of deals).
3. The payout arrangement has to work for the sales person and the company – so if the company is cash-strapped, payment aligned with cash collection may need to be considered.
4. Beware annuity “tails” – they create plan administration complexity, encumber the company years from now based on a plan designed today, and, over time, may create a situation in which current year pay is not tied to current year success for sales people.

Question

We sell long term, high volume contracts. Should our sales people be compensated through the entire term of the contract, or should they receive an initial commission which diminishes over the term of the contract?

Answer

The applicable principle here has to do with the definition of the sales job for those long-term contracts. If the sales person is expected to “account-manage” the account and ensure satisfaction throughout delivery (perhaps while also looking for opportunities to expand the business in the account), then payment over the life of the contract would be appropriate. If, however, the sales person hands off the signed contract to a delivery team and is expected to then begin to focus on the next opportunity, then completing payout closer to contract execution would be in order. And in between these two would be the situation in which the sales person’s role is expected to diminish over time, in which case a commission rate which decreases each year over the life of the contract would be appropriate.

The rule of thumb is that you finish paying the sales person for the deal at the point at which you would typically expect them to disengage and move on. That said, the company may also reserve the right to reverse sales credit if the contract is cancelled, or if the eventual contract value is materially less than the value at signing.

One major exception to all this is in the case of contracts for rates as opposed to fixed price contracts. If the contract is for a rate and the total volume is not known or committed to at the time of signing, it may be necessary to pay out as the business is invoiced over time.

A significant disadvantage to paying out over time on long-term contracts is that it will tend to create a long annuity “tail” of payments which can serve to make sales people far more focused on managing those existing already-sold deals than on landing new ones. While some will argue that the annuity tail serves as a retention tool, consider who you are retaining with it. Those who expect to sell significant deals in the future would prefer the more substantial up-front payment and a “tail-less” plan. Those who prefer the plan with a tail would be those who prefer to create a comfortable cushion to mitigate their future risk.

1. Is the pay mix changing at all? Often more frequent payments can be a way to alleviate some of the sting of a change to a more variable pay mix (if you have had to make reductions in base salary, increasing the frequency of incentive payments can help your reps meet their regular financial obligations).
2. If the pay mix is not changing, what impact will smaller more frequent payments have on your reps’ perception of the incentive program? Will the amount paid still be meaningful or will it get sucked into their regular expense budget and not be as noticeable as a larger lump payment would be?
3. Can your company handle the increased administrative burden of more frequent payments, and what are the limits? Most companies would not find it cost-effective to make daily incentive payments, although I have known some to make weekly payments (against my advice).
4. How will more frequent payments change the reps’ behavior – are there any unintended consequences and can these be alleviated through selection of the appropriate design option?

On point 4, there are typically two choices for performance period when switching to payments that are anything other than annual in frequency: discrete and year-to-date (YTD). In all our examples below we will assume the change is from annual payments to quarterly payments, as per the initial question. However, the same logic could work for monthly payments that are on an annual, semi-annual, or quarterly performance period.

We’ll start with discrete periods first. In this method each incentive payment corresponds with the end of a performance period, and the next payment starts fresh with the next period. There is no carry-over of performance from one period to the next. This type of plan is common in highly transactional, high frequency selling environments where sales are made regularly and there is little ability for the rep to game the timing of sales crediting. If the rep can control when sales are credited, you will likely see peaks and valleys in performance from one period to the next, where reps are pulling or pushing sales to maximize earnings. If your plan has thresholds (that require a minimum performance before payment is earned) and escalators (where payment increases for increased performance) and you are using discrete periods, you are very likely to experience some of this “porpoising” as reps figure out how to get the most bang for each sale. The end result of this behavior is an overall annual performance that may be below target, while the rep has been able to earn above target pay by using the escalators to his/her advantage in high volume periods. If there is little possibility of this behavior, using discrete periods is the most straightforward mathematically and often the most motivating in the short term for the reps.

The most common solution for this problem is to use a YTD mechanic instead. This requires that performance be tracked against a longer performance period and that each payment is calculated against an annual YTD target incentive amount as well. While the mathematics on this can be a bit daunting at first, once reps and managers understand that pay is not “lost” in a bad period, but may be earned back, they quickly see the advantages. In a typical YTD approach, an annual quota is divided into four even amounts as is the annual target incentive. We’ll use $1,000,000 as the annual quota and $10,000 as the annual incentive. A quarterly YTD approach would work as follows:

Q1 Quota: $250,000
Q1 Target Incentive: $2,500

Q2 Quota: $500,000 (Q1 + Q2)
Q2 Target Incentive: $5,000 (Q1 + Q2)

Q3 Quota: $750,000 (Q1, Q2 + Q3)
Q3 Target Incentive: $7,500 (Q1, Q2 + Q3)

Q4 Quota: $1,000,000 (full year)
Q4 Target Incentive: $10,000 (full year incentive)

While there are many ways to arrive at the amount earned as a percentage of target, the common mathematical element critical to the success of a YTD plan is to calculate the percentage of the YTD target incentive earned and then subtract any prior payments already made. This creates the “true-up” which ensures that sales which may fall later in the year still “count” toward the reps overall annual payment. Those who are mathematically astute will quickly see there is a potential for ending the year in arrears using this method. Therefore we recommend capping Q1-Q3 payments at 100% of target, and saving any payments for performance above 100% until the full-year results are in. That way a strong start to the year and weak finish will be less likely to create the need for a rep to “pay back” money already paid.

There are some variations on this approach, which combine different aspects of a discrete plan and a YTD plan. Here are two:

1. Use discrete quarterly periods for payments up to 100% with a year-end bonus that rewards for any full-year performance above 100%. This avoids the need to do the true-up calculation which causes some organizations communication difficulty. It does not, however, eliminate the potential for reps to play with the timing of sales to increasing their earnings, but it reduces it by keeping all the “upside” until the end of the year. As with the traditional YTD approach this also acts as a retention tool for anyone running above 100%. Should they leave prior to year-end they will be walking away from any upside the plan may provide.
2. Software companies sometimes use YTD quotas while paying using a discrete quarterly target incentive. This encourages more balanced performance throughout the year, but puts a pretty high premium on the accuracy of quarterly quotas. If business is steady and/or seasonality is highly predicable, this may be an effective way to get even performance throughout the year (as there is no true-up opportunity, it really does matter more WHEN the sale happens, not just that it happened sometime during the year). There is another advantage to this method in that it puts more emphasis on sales that happen earlier in the year. If a rep can “fill the bucket” as quickly as possible in the year, he/she will have the best chance of being in the “sweet spot” of the plan design (where the escalators are the steepest) for each quarterly payment period. As there is no true-up, there is also no chance of ending the year in arrears. There is, however, the possibility that a rep who starts out slow but ends strong will make less money than a rep who had a very strong start but ended weak. Consider which outcome is better for your business when selecting between the traditional YTD approach and this variation.

Words of caution:
It is common for incentive plans to include hurdles and modifiers. These can become especially challenging when dealing with the traditional YTD plan (using a true up calculation). You must be very cautious to do any modifier calculation AFTER the YTD calculation has been completed and you have the final quarterly payout calculated. Whether the modifier increases or decreases the quarterly payout, you must include the ORIGINAL quarterly amount (prior to modifier) when calculating your next quarter’s YTD payout. If your plan has complex calculations including modifiers, hurdles, and any other type of linkage between elements (especially if they are using different performance periods), you should make the choice to use a YTD calculation very cautiously. If it is important to your business to go this direction, you may need to change some of the other elements of your plan design to ease the calculation complexity and ensure your reps have a clear understanding of how they will get paid.