How much should you pay for free MRR months?
Aligning your sales commissions payouts with recognized revenue earned on a deal.
When you are designing comp plans – one of the things you want to account for is making sure that you’re aligning your sales commissions payouts as closely as you can with the actual deal revenue that the company is receiving.
One of the options that many companies use when offering a subscription is to give free months at the beginning or end of a deal in order to secure the business (this happens a lot in the telco and contact center industries). Let’s say that you have a customer that you are looking to secure a 36 month (3 year) deal – and in order to do it you have to give 3 months free. Let’s say that the order is for $10K/month during the life of the deal.
Many people will look at the deal like this. The total revenue you are going to collect is 33 months x $10K = $330,000 and you have 3 months at $0K. In a scenario like this – your effective MRR across the 36 months (life of the deal) is $330,000 / 36 = $9,167 (or 92% of the monthly price). It’s important to understand revenue recognition here. On a 36-month deal, the company will recognize 1/36th of the revenue every month (the $9,167). Some companies design their comp plan to pay on the gross MRR amount ($10K) – and don’t account for the free months that are being given. Not optimal.
This is not a great way to structure a comp plan because the incentives you’re giving the salesperson (get a deal done and get it off the street) – and the company (maximize revenue) don’t align. If the salesperson didn’t give away any months and the company achieved maximum revenue – the salesperson would get paid on the full MRR. But if there are free months – those need to be accounted for in the bookings measure for compensation.
An extreme example of this makes this problem obvious. Let’s say that the salesperson had the ability to give away 35 months for free on the 36-month deal. If you were paying them on the gross MRR amount – they would get compensated on a $10K/month deal – but the company is only effectively realizing $10K total over 36 months – or on a revenue recognition basis – only $10,000/36 = $277/month. Massive mismatch.
Something most people don’t think about when giving free months away though – is actually extending the term of the contract. If you’re going to do a 36 month deal with 3 months free – turn it into a 39 month contract. 36 months at full MRR and then 3 months free tagged on to the end. This changes the economics a bit – and the deal now looks like this:
Total revenue = 36 x $10,000 = $360,000 (+9% over the other approach). Effective MRR = $360,000 / 39 = $9,230. This is better for the company and it’s (slightly) better for the salesperson. Historically I’ve found many customers are open to doing a structure like this when you start to think about things a little bit differently. While this is slightly better for the salesperson – it’s not really going to motivate them to push for a 39 month deal versus a 36 month deal – so what do you do?
The easiest answer is pay them as if it was a full MRR deal (@ $10K/month) since you are getting a full 36 months of revenue. What you’re trying to do is drive the right sales behavior. Close the deal – and if you have to give away free months – maximize the company revenue. That extra $30K for the company will more than compensate the commission payout you earn – so it’s a win/win for the salesperson and the company.
This was a quick update as it came up in a conversation I had the other day on comp plans. I hope you found it helpful. As always – happy to discuss/write-up anything of interest. As always – ending with Ollie who decided that taking a nap on my bed was the best place to be on a Wednesday.
Best,
Steve