Residual Compensation Plans Neuter Your Sales Force

There are a number of businesses I have worked with that have sales commission plans based on "residual" revenue.  What does this mean?  It means that in situations where the sale creates a monthly stream of revenue the sales reps commission also has a monthly component that follows the revenue stream into the future.

For example, if a business sells services like annual or monthly services programs that are paid monthly or quarterly and may extend for years with renewals the companies paying residual commission plans map their commission program to the timing of stream of revenue.  In this case, the sales rep is then paid a percentage of the contract as commission as the contract is paid by the client into the future.  The rep draws a commission for the duration of the contract and its renewals.  Many companies implement this kind of compensation system by paying the sales rep that makes that sale a bigger piece up front when the contract is initiated and then a recurring residual commission based on the ongoing stream of revenue from the customer  through the life of the contract.

The reasons a company would like this residual based commission structure are generally three fold:  Firstly, they like this structure because it allows them to match cash inflows with the cash outflows for commissions.  The alternative commission structure of just paying a big commission on the signing up of a new customer for a sales with constant monthly payments will inevitably mean that the company will be cash flow negative on the sale in the first  month or for several months.  This is because the set up cost in services and/or the cost of goods sold in products or services is not sufficient cash flow to pay the all upfront commission.  Secondly, there is the belief of business leaders that this type of structure aligns the interest of customer retention with the sales rep.  In other words, the sales rep has an interest in keeping the customer happy and on board so that their commission stream continues.  Thirdly and finally, companies like the residual commission model because they believe that it forces loyalty.  Sales reps need to stay on board to continue to receive their residual commission.  If the rep leave to go to a competitor or leaves at all they can forfeit their residual commissions.

For a very long time, the insurance industry worked in this residual way such that, for example, when an insurance broker sold a life insurance policy, the broker got a stream of commission payments that spanned as long as the insured kept paying on the policy.  The insurance industry is moving away from this model by reducing magnitude of the "backend" over time and, if your company has a commission structure like this, in most cases, I believe you should too.

While I accept that the cash flow consideration is real for many companies, this type of program ignores some important issues.

• It is de-motivating for new sales reps - This type of plan is de-motivating for new sales reps because it is predicated on the idea that a sales rep only starts to make "good" money once they have established a "book of business" that can produce a monthly recurring commission stream for them.  The downside of this thinking is that it ignores that it will very likely take a sales rep some considerable time before they develop that book of business.  In the meantime, a new sales rep is probably struggling financially and being frustrated which negatively affects their performance.  This type of commission system, in my experience, leads to a lot of unnecessary new sales rep turn over for this reason. 
• It is de-motivating for established sales reps - When a sales rep knows that they are going to get a chunk of residual commission whether or not they lift a finger it doesn't exactly create an intensity in their new sales efforts.  By contrast, when a sales rep is getting exactly zero or even a recoverable draw if they don't perform there tends to be a greater intensity to their sales activities.  I think every company would prefer to have a high intensity sales team than a low intensity sales team.
•  It leads to neutering "hunter" sales people and turns them into "farmers" - As a sales reps "book of business" grows, it is inevitable that he/she will be either spending more time on keeping their base of clients happy or ignoring their responsibilities in keeping their base of clients happy.  If they are spending more time keeping their book of clients happy ("farming"), they are not spending that time looking for new customers ("hunting").  If they are very focused on hunting and not focusing on their book of clients, then the company is neglecting its most profitable customers and will be underperforming in customer retention. Generally speaking, a company is always looking for more hunters in its sales department and once a company finds a good one, the last thing they should be considering doing is turning the proven and successful hunters into farmers.
• Customer retention for a recurring service or product sale is primarily an operations issue, not a sales issue - While it is extremely important to maintain an ongoing dialog and relationship with clients, in most businesses the dissatisfaction that lead to losing a client or the elements that keep a client happy and an ongoing client are the result of operations--the delivery of the promised value of the goods or services.  For each company the issues of managing customer retention remains an absolutely critical one.

By comparison, the benefits of a front loaded commission structure are:

• Puts a healthy management focus on retention - Management needs to focus on customer satisfaction and retention because management needs to earn back the commissions that they paid out on signing up the client.  By not having to pay commission on the residual, the monthly or quarterly payments from the customer become more profitable than they were before to the company so the impact of improving retention has a bigger affect on profits than it would in a residual commission model.
• It creates sales intensity and encourages hunting - Every day, every week, every month the sales reps have to keep a focus on their pipeline or the commission checks won't come in.  It is that simple.  The reps who want the Porsche know what they need to do and can affect change NOW, not down the road when, in theory, the residuals build up.
• It simplifies and clarifies the expectations of the sales team - I have personally found that most employees benefit from having a simplified mission.  For the sales team in a front loaded commission structure the mission is simple:  Make the sales, make the money.  Actions performed today will benefit you in the near term.
• It rewards top performers - Top performing sales people don't have to wait months or longer before they rewarded for their efforts.  The first rule of reward and punishment is to closely tie in time to the reward or punishment to the act that created the response.  If you are going to reward someone, tie the reward closely in time to the behaviors that brought about the reward to reinforce that behavior and its reward.  Rewarding a sales rep on the long tail of a transaction doesn't create that connection but paying them up front does.
• It matches the sales rep personality - Guess what?  Most sales reps are motivated by money and success and aren't terribly good at long term planning.  I know that this is a generalization, but it does usually hold true.
• It automatically culls the weak reps - Weak reps will not be able to hide.  Everyone's sales and compensation will be immediately evident to their peers (peer pressure) and management.

No sales commission is simple because baked into it is that we are trying to encourage certain behaviors, discourage other behaviors, reward success, allow our sales reps to make a living through their development and during downturns outside of their control.  This is never done perfectly and cleanly without some negative unintended consequences popping up.  With that consideration in mind, there are certainly some commission plans that are better than others and management shouldn't be shy about tweaking their commission plan from time to time to get better behavior   Next time, I will write more about these ideas of how we shouldn't be afraid of losing money on a new customer during the first few months or first order or two.