Founder Guide: How to Set Sales Quota and Compensation?
Demystifying the challenges to hiring your first sales people
Image: Phillip Lemmons on Shotzr images
Hiring your first salesperson is challenging. A big reason for this is the complexity of sales quota and compensation. Setting compensation for most other roles you hire for tends to be more straightforward — you determine a salary based on market benchmarks, maybe include a smaller annual bonus of some form, and then allocate some vesting options and perks.
When hiring salespeople however, you will typically be looking to structure a performance-based compensation package which brings into play a whole suite of new, and often complicated, questions such as:
What performance metric should I use as a basis for quota? Should it be number of customers acquired, total revenue, net revenue, other? Should it only factor for the first year contract value or ongoing value / renewals? Should quota be net of churn or simply gross? etc
Once I have a metric, how should I set their specific quota target? How long of a ramp up period should I factor for?
How much compensation should I put into the variable versus base salary components?
How should I structure the variable commission payout? How should I pay out commission in relation to that quota? Should I pay out on a percentage of quota basis or based on hard caps? Should I use accelerators?
This chapter in the Founder Guide Series seeks to answer these questions with some basic rules of thumb. There are many factors to consider in setting up your sales compensation scheme and many businesses will pose exceptions to the rules. Ultimately, the structure that is the right fit for you should be determined with the nature of your business, your sales objectives, and the types of behaviors you want to incentivize from the team in mind. That said, hopefully this guide is a good starting point for that process.
General Rules of Thumb
Following are some general rules of thumb for early stage startup founders when approaching the sales compensation process.
It is important to note upfront that you should view your compensation structure as fluid. Things change, teams grow, and go-to-market strategies adapt, so you will likely be constantly reviewing and modifying your compensation structure over time. Making changes in the middle of a quota period is not advisable — always try to be transparent with the team and attempt to communicate any changes as far in advance as possible.
1) What Metric Should I Use as the Basis for Quota?
For most SaaS companies, the quota system is most logically based on achieving monthly revenue goals (MRR or monthly recurring revenue). Each Account Executive has a monthly MRR target that will correlate to the commission they receive for the month. For companies focused on larger and lumpier enterprise sales with longer sales cycles, this quota may be quarterly- or annual-based and set on Annual Recurring Revenue targets (not MRR).
It is important to note that while a revenue-based quota is most common, this is not always the case and in some cases you may deviate from this to incentivize the right behaviors.
For example, when I was with the company OurDeal (a Groupon-type company in Australia), we initially compensated salespeople based on gross revenue (or Gross Merchandise Value — GMV), but then later pivoted to compensating based on net revenue (the total proportion of the GMV that was recognized as revenue to OurDeal). This was because we not only wanted to incentivize our salespeople to go out and bring in deals that secured top line GMV, but also on the commission rates they negotiated for those deals. At the end of the day, a $100,000 GMV deal at a 10% commission rate was a worse financial outcome to OurDeal ($10,000 net) than a $50,000 GMV deal at a 30% commission rate ($15,000 net). So we wanted to incentivize our team to think about the net revenue impact and not simply total GMV.
It is important to note that some companies may prioritize other things above MRR in the earlier days of their evolution, such as acquiring customers or landing key marquee customers, in which case you might elect to structure a compensation scheme based on this objective. For example, in the very early days at my last company Kanopy, when we were focused almost solely on landing customers to get our foot in the door (for later land-and-expand opportunities) and get logos (to build our credibility and reputation in market), we set quota for our team based on number of new customers, not on a revenue target. We classified customers and would give extra points for landing larger, marquee customers than smaller ones.
That said, as mentioned, revenue-based targets are most standard and we will move forward through the rest of this piece on the assumption you are running with that.
In general, shorter term goals are better than longer term (weekly versus monthly versus quarterly versus annual) to stay on top of sales and identify problems early, as well as motivate nearer term, stable performance (and not end of quarter “fluffing”).
2) How Should I set the Quota Amount for Each Salesperson?
In setting quota, there are two major factors you want to keep in mind. The first is that you want to set a MRR quota that is realistic and attainable — something that approximately 60% of your reps should hit.
Use your best rep as an example of what “good” reps can do. Analyze historical sales and pipeline data, conversion rates, and closing percentages to work your way to a sales quota amount that you think makes sense for 60% of reps to hit. You probably won’t get this right at first, but over time and by continuously reviewing the assumptions with more reps, you will get more accurate.
The second key factor to keep in mind is that you want to try to achieve a healthy, balanced relationship between an Account Executive’s On-Target-Earnings (OTE) and their quota targets. OTE is the total compensation that a rep will take home (base salary plus total commissions) should they hit each of their quota targets perfectly.
Old school best practice, you ideally want your reps to be bringing in ARR quota each year at a rate of approximately 6-8x their OTE (i.e. a rep bringing in $1M ARR would be sitting on an OTE of $140-160K). That said market rates fluctuate a lot and have risen particularly of late - so in my experience hitting 5x+ OTE is good at present.
If you are seeing a ARR/OTE ratio that is high, that is a great signal to hire more salespeople. If you are seeing an ARR/OTE ratio that is low - it might be a signal to explore options for improving the sales efficiency of your current model — maybe you need more time to find product market fit, maybe you need to think about whether you can achieve the same sales quota with more junior/lower cost sales reps, maybe you haven’t fully defined your ideal customer profile for your reps properly, maybe you need to rejig pricing, maybe you need to fully rethink the sales model (e.g. switch to more inbound or self-serve sales), etc. At the end of the day, you need to compete for sales reps on the open market and the OTE you will need to offer to get good reps will be ultimately set by the market.
At my last company Kanopy, we were bootstrapping growth and trying to build a sales team in San Francisco competing with the likes of Facebook and Salesforce, who were paying top dollar OTE for sales reps. A healthy ARR/OTE equation would have been difficult to achieve as a result. Our response was to hire much younger sales reps (1–2 years out of college) and invest heavily in a robust training program to get them to fully ramped Account Executive status as fast as possible. Other companies faced with this situation chose to build remote sales teams or set up a secondary office for customer-facing roles in another city.
In sum, the trick here is to understand market OTE rates for reps, think about what a realistic MRR quota is, and hope that the two align to be a healthy OTE/quota ratio. It is a beautiful moment when you find a sweet spot where these factors align!
It is important to note that a quota discount is standard for new sales team members to account for their ramp up period. I tend to see a 3-month ramp up as the most common in the market, but this depends on your business and the time it takes to train your salespeople and them kickstarted with the customer sales cycle. You may for example give a 100% discount on quota for month 1 (so a salesperson is guaranteed to get paid out), a 50% discount for month 2, and a 25% discount for month 3 — as a simple example
3) How Much Compensation Should I Put into the Variable Versus Base Salary Components?
So you now know your rep’s OTE and MRR target. Now the question becomes, how should I split that OTE between base salary and variable commission?
As a general rule, variable compensation (performance based salary pegged to hitting quota targets) is important to ensure you are incentivizing and rewarding sales performance. Much motivation theory will challenge how important it is (versus other factors such as autonomy, mastery and purpose) but let’s move on the assumption that we agree it’s important.
Sales reps at some companies can be purely 100% commission-based (e.g. many real estate agents, recruitment consultants, hair dressers, etc are paid purely on commission), but this is pretty uncommon for tech startups. In general, most companies shoot for a 50/50 split between base compensation and commission — i.e. if you think that a rep should be taking home a OTE of $100,000 if they meet their quotas throughout the year, then you would structure a $50,000 base salary with on-target bonuses that add up to another $50,000 (i.e. if the rep is held to a monthly MRR target, this would meant that the rep would get $4,166 in base pay and $4,166 in added bonus each month if they hit quota).
That said, you may want to over-index more on equity options and/or base compensation in the earlier days if you are expecting your first sales reps to take a leap of faith in joining your company, play a greater role in the broader team and not just be a standard sales rep, and help you to experiment to find product market fit. In this case you might structure compensation to be more 70/30 or 80/20, or keep it at 50/50 but provide a guaranteed base level of bonus each quota period for the near term.
As another general rule, the more the sales role is outbound focused (versus simply fielding inbound leads), the more it makes sense for a higher percentage of total OTE to be variable bonus. This is because all of the sales process is in the sales rep’s control, whereas with an inbound sales model, they are partly beholden to the performance of the marketing operation in delivering quality leads.
The main idea here is that the sales rep must know exactly what their MRR quota is and how much they get paid based for hitting that goal. The next question logically becomes — well what happens if they fall short of or exceed that goal?
4) How Should I Structure the Variable Bonus Payout?
In its most simplistic form, the variable commission payout (or bonus) is paid out as a formula of the percent of the quota the rep hits. Using the example from above, if the rep hit 120% of their quota, they would be paid $4,999 ($4,166 x 1.2). If they hit 80% of their quota, they would be paid $3,332 ($4,166 x 0.8).
There are two ways to make this more complicated. The first way is through “caps”, which put limits on commission payments by either 1) not paying out anything if a rep doesn’t hit a base amount of quota (e.g. if the rep hits <70% of target, they get nothing. The bonus only gets paid out if their hit at least 70% of target); or 2) putting a cap on how much bonus a rep can make in a quota period (e.g. you only get paid a bonus until a max of hitting 200% of quota — i.e. $8,322 or $4,166 x 2.0. Any additional sales beyond this are not paid out). In general, we don’t believe in capping commissions and they can complicate things and create perverse behaviors
The second way to complicate the bonus structure is through “accelerators”. An accelerator increases the bonus that is paid to a rep the more they exceed their quota. For example — you might provide a 1.2x accelerator on sales made in excess of 100% quota and a 1.5x accelerator on sales in excess of 200% quota. So if the rep had a monthly quota target of $5,000 but brought in $12,000 of MRR, they would get $11,665 in total bonus, calculated as:
$4,166 (for hitting the $5,000 quota), plus
$4,999 (for the next $5,000 of sales closed — the 1.2x accelerator applied to the standard bonus rate for the next $5,000 MRR secured), plus
$2,500 (for the additional $2,000 of MRR of sales in excess of $10,000, with a 2x applied to the standard bonus rate)
Some Other Tips and Parting Thoughts
1) Simplicity is key
You want a simple compensation structure that is easy to understand and track in real time. This is most critical. If a sales rep can’t understand the structure and easily ascertain in realtime how they are performing mid period, things will quickly get problematic. There is always a temptation to structure a quota that is based on hitting many metrics — try to focus it on one metric only.
2) Communication with the sales team is important
If you are rolling out a new compensation structure in the early days of your sales motion, it is advisable to communicate to the team that you are still figuring out the optimal sales incentive structure and to manage their expectations that it could change in the future.
Building trust and communicating clearly on this is important with the team. The team needs to trust you — tell them that you are shooting for them to receive a certain OTE that is fair if they perform, but are still figuring out the right quota structure that makes sense. This should be enough.
3) You need to be careful of sales “discounting”
You can try to factor discounting into the compensation scheme to effectively disincentivize it, but we advise against this. Ideally, you put in place processes outside of the compensation system to avoid steep discounting to be given to customers by sales reps (such as manager approval processes for discounts that are more than 10%, or clear set rules).
4) You need to be careful of “bad sales”
Sometimes there is a temptation to account for churn in a sales reps quota through a “claw back”. For example, you might want to calculate MRR quota as new sales made in a month LESS MRR associated with accounts that churned in their first 3 months. The objective here would be to steer your sales reps toward “good sales” and away from “bad sales”. Because if you don’t account for churn, you might have a rep signing up customers based on unrealistic promises for what your product can do and getting paid out bonuses for those sales, while you see many of those customers churn soon after.
Again — we advise against this. At the end of the day, you are trusting your sales reps to do the right thing. Take churn seriously but keep it out of the commission scheme. Churn can ultimately be caused by many things — a reps activities (i.e. “bad sales”), not directing the rep to the right customers, poor handovers to the implementation and customer success teams, poor product execution, etc. If you see an atypical level of churn in the accounts of a particular rep, take them aside and have a conversation about it. Maybe put them on a warning and monitor them more closely in the following months.
Also — you might want to stage your bonus payments if dealing with multi-year contracts where customers are not guaranteed for the whole time. For example, a large, well-known company recently had a big issue with churn. The company rolled out a sales compensation plan where all reps would get 10% of total contract value for deals they sold to customers. The sales reps started selling large multi-year deals and seeing huge bonus payouts upfront. But as customers were onboarded, many were saw the product fall far short of the big promises the sales reps had made, and many customers churned in Year 1 breaking the contract. So customers were frustrated, the company got a bad name in market, and the company didn’t see the revenue materialize; yet the reps were swimming in large bonuses. So for these large contract situations where revenue is not guaranteed, staging bonus payments out per certain milestones can be important.
5) You may consider factoring for cash-based payments in the bonus structure
Paying your reps out only when cash is received from customers, and not when contracts are signed, may help with problems like the one outlined above and also align everyone’s interests to the company’s healthy (prioritizing cashflow, avoiding bad debts). Reps might hate the cash-first approach, but they’ll appreciate why you’re doing it. You should probably only go down this route if you need to — ideally the contracts with customers should be strong, your product delivers, accounts chases down late payments, and you don’t have your reps wasting time chasing payments.
One other alternative is that you may pay out reps based on contract value signed but offer an extra bonus for cash upfront deals. This will make pulling in cashflow upfront from customer top of mind in your reps.
6) You want performance to be transparent and “live”
Sales reps are best motivated when they can get a live update on their progress toward their goal. If they don’t know where they stand mid-period against their quota, they are likely to quickly become frustrated and demotivated.
Being fully transparent on sales can work really well. At my last company Kanopy, we had a big whiteboard in the middle of the main meeting room in the office where we would track the weekly sales progress for each sales rep against their quota. This created a healthy level of pressure, accountability, and competitiveness, and also encouraged all-team celebrations for big sales wins. It made the reps hungry!
“Simple Math to Set Up a Sales Team” (by David Sacks) has some great ideas too (source)
“Compensating the Salesforce” (by David Cichelli) — The book has 40 sample plans in it and is the best I have seen on the topic
HBR “Does Your Company Have the Right Number of Salespeople?” (source)
First Round “A Counterintuitive System for Startup Compensation” (source)
Originally published at https://www.accessvp.com on September 23, 2020.