The Payment Tail: The Sales Compensation Plan That Destroys Companies
This content was originally posted to LinkedIn on 3/2/23.
One of the biggest mistakes companies make is paying their reps a commission on recurring revenue when the company receives that revenue. If the rep sells a five-year contract where the customer pays annually, the rep gets paid annually over the course of five years. This is a payment tail – one of the biggest throttles on growth that a company can have. The best way to illustrate one of the dangers is with an example. A company pays reps a commission on subscription contracts over the life of the contract. The company says to the rep, ‘you get paid when we get paid.’ The rep starts out in year one hunting and they build a sizable portfolio of customers. In year two the rep must make sure that the customers continue to pay, so this good hunter will become a busy farmer. In other words, in year two the rep could sell nothing and yet be the highest paid person in the company.
The Problem with Payment Tails
The growth rate of the company will slow over time as successful hunters become busy farmers. The company may have had 10% growth rate in year one, but as growth slows the company has no choice but to hire more reps to drive growth. This will work for a short period of time, and the company will grow with a new cadre of hunters. However, as these hunters build a portfolio and transition to farming the company will need to hire another group of reps. At a certain point the company will not be able to hire enough reps to meet historical growth (a company can grow by 10% by hiring new reps when it has $10M in sales, but it cannot hire enough reps to grow by 10% when it hits $100M in sales). There is a point when the cost of paying the farmers is so high that growth needs to be well above the historical level.
Note that even using account managers who are solely responsible for driving renewals and usage after the rep lands the contract do not solve this problem. If the company pays a commission on the life of a contract the reps will still be able to create portfolios of customers that drive a larger pool of commissions (the top paid person may not have sold anything in years!).
The Compensation Plans Cannot Change
A payment tail also creates other major issues for the company. If the company wants to change the compensation plans it is usually not feasible. For example, a company has been paying a 5% commission on revenue received from usage contracts. The company needs to pay less for captured clients as they want to invest money in new technology. If the company wants to change the commission rate to 3.5% they face an outright revolt from the sales team (for a famous example, Knight Trading formed when Schwab tried to lower the commission rate on captured clients and the entire sales team left to form a competitor).
Yet More Problems
If the reps can negotiate pricing and get paid for renewals, then there is more trouble ahead. Reps face significant risk in losing a client in their portfolio, so they are highly motivated to reduce pricing over time to retain them. I have seen companies where the majority of their tenured rep’s portfolios had negative margins.
Since reps who have built large portfolios of customers will focus on maintaining the customers in the portfolio, they will feel less pressure to sell down-market. I worked with a staffing company that paid reps a percent of the monthly salary of each person they helped place at a company. So long as that person remained staffed at a company, the rep would get paid. This payment tail made it so a rep who had placed a number of people at companies made a very healthy income. The rep did not feel the need to be aggressive with smaller companies. The reps had an income cushion so they could focus on landing whales who would need large numbers of people staffed. Meanwhile, the company would actively recruit people to be staffed at their customers. Once a rep made a sale, these people would then work the job. Since whales were landed less frequently than smaller accounts, the company had a large number of people sitting on the bench waiting. There were very few smaller staffing assignments that could keep people off the bench. The company had a very lumpy sales cycle and huge costs because of their compensation plan’s payment tail.
How Do I Get Out of This Payment Tail Mess?
There are many remedies to stop a payment tail, but the strength of the medicine largely depends on how long the disease has been present. If the company has had a payment tail for a short period of time and the reps have not fully ‘transformed’ into well fed farmers, the transition may be as simple as changing to upfront payments or moving to a quota based bonus plan.
However, if the company has had a payment tail for a long time the severity of the disease may require a strong cure. The dental supply company that I mentioned had a payment tail that was so embedded in their culture that even after the company explained that they may not survive to the sales team, the reps refused to change. The only way to rip apart their payment tail was to link pay to margin improvement (i.e., change the strategy of the company).
A company can get creative and try to grandfather captive accounts and begin to pay less for new accounts, but this will just make tenured reps whole, and it will be difficult to hire new reps to drive the growth needed to achieve the desired internal investment (and it will be a major pain to administer two incentive plans). I have seen companies introduce a commission rate that declines over time, but this will not generate the savings needed, and the same sales team revolt will occur. As a side note, I have spent a good portion of my career coming up with creative ideas to get a company off a payment tail, but it is obviously best to design a compensation plan that avoids this issue in the first place.
Whatever the design solution to get rid of the payment tail, the trick is to link pay to growth. Do not pay a premium on maintenance. For example, if a rep generates $10M in year one and those same accounts generate $10M in year two, there is zero growth in the second year. A payment tail is one of the few compensation plan designs where it is possible to cause a company to stop growing and eventually get consumed by compensation costs.
Note that this is true for companies that sell usage/consumption based plans. There are ways to design compensation plans for these contracts that avoid the payment tail, even when the lifetime value of the contract is not known. The same rules apply – link pay to growth.