It is no news that a well run subscription business will typically focus on MRR (monthly recurring revenue), ARR (annual recurring revenue) or ACV (annual contract value) growth as the basis for growth compensation. What these metrics have in common is that they are closely aligned to recurring revenue growth (monthly or annually) as opposed to bookings or TCV which are too fuzzy when it comes to impact on recurring revenue growth. TCV stands for “Total Contract Value” which is the total customer commitment incl. recurring and one-time payments. There are many articles that discuss how to build SaaS/Subscription compensation plans so I will not elaborate on the basics.
This article means to raise awareness for how multi-year agreements (i.e. TCV or Bookings) tend to be an important, yet not well optimized part of a subscription compensation plan. And by not managing this aspect of the compensation plan well, companies may be driving behavior which is misaligned with their business realities.
In a subscription business the focus is on maximizing ACV and not TCV. Therefore, the assumption is that you’ll always prefer to maximize ACV with a goal to maximizing recurring revenue growth. The thinking is that there is no value in discounting TCV in order to get a three-year deal if you can close at a significantly less discounted rate on ACV (unless cash is in short supply which I will cover later on).
However, we also know that subscription businesses churn and a reasonable amount of that churn is outside of our control (project ended, company gets acquired, company goes out of business, leadership change). As a result there can be value to the company in closing multi-year deals whether those are commitments or prepayments. Knowing that multi-year deals can help counter balance churn (at least for a period of time) subscription compensation plans typically do have a commissions kicker for a 3-year deal. A 20%-40% increase in base ACV commissions is quite typical (we will focus on three-year deals here although the same applies to other terms). Note this is in stark contrast to the days where reps would get 3x the commissions for a three-year deal when they were compensated on TCV (Bookings). Having a moderate kicker tries to ensure the focus remains maximizing ACV while still encouraging longer terms if it doesn’t require a significant discount.
Here’s what a sales rep’s commission would be on a plan with a flat 9% commissions rate and a 20% kicker for a three-year deal (assuming no discounting):
Now where’s the fine print? The very knowledgeable rep will actually dig deeper here and try and figure out if it’s in his best interest to try and spend the time and energy to close a three-year deal. This is where, with not very careful compensation plan structuring, we may find misalignment between the rep and the company’s best interest.
Let’s assume the rep needs to offer an additional 10% discount in order to incent the customer for the three-year deal. Here’s what the above calculation would look like with a 10% discount on the three-year deal:
You can see that the rep only makes a tiny bit more on the 3 Year deal. Is 8% higher commissions enough incentive to make the rep spend time and energy to work through the additional hurdles of extracting 3x the commitment out of the buyer and the procurement team? In most cases the answer is an absolute no. The rep will prefer the path of least resistance, get the easier deal closed and move on… I have observed this happen countless times.
Now let’s test the difference between these two scenarios to the company assuming a 15% annual ACV churn rate which is high but for on premise Enterprise software not atypical (note that ACV churn rates tend to be higher than MRR churn rates because they are calculated only based on what is up for renewal and do not benefit from prior multi-year deals in their non-renewal year):
You can see that even with a 10% discount the company brings in more revenue in the 3 Year scenario than in the 1 Year scenario – in fact almost 15% more. Needless to say that the lower the churn rate the more companies will want to focus on maximizing ACV but the reality is that with non-SaaS based offerings we typically do see higher churn rates and there is also an opportunity cost of spending the renewal reps time on the renewal vs. looking for additional growth opportunities.
This is not just theoretical fine print but I’ve actually seen this play out in such a way and having a negative impact on future revenue growth. In an Enterprise subscription business where the cost of doing business is significant and the ASPs are non-trivial to the buyer ensuring your reps are incented to close the “right deal”, meaning the right balance between discount and term, can make a material impact on MRR growth.
So what are the actions you should be taking to ensure that your comp plan truly drives the desired behavior on this front?
- Make sure you understand what your churn rate is and how it’d impact the average deal over three years. This would tell you how much you’ll lose on average to churn and what the value of a longer term agreement is to the company.
- Make sure you model out what the right maximum discounting incentive should be to drive a customer into a longer term deal.
- Put in place a kicker for multi-year deals which ensures the desired deal pays a real incentive over a one-year deal – at the desired discount rate. It should be significant enough to grab the reps’ attention. Don’t forget you can be generous because you’re saving the year 2 and year 3 commission payments!
If you take these factors into account, you’ll typically find that you can create an incentive plan which is good for the company and the salespeople. As long as you ensure to limit the discounts the rep is allowed to offer it will allow you to leverage the “savings” in churn and saved future commissions to create more aggressive incentives for both the customer and the sales rep.
Other facts you should be taking into account:
- Don’t let a multi-year term customer make you “lazy”. You should be managing customer success on an ongoing basis. If you don’t, you will have an unpleasant surprise at the end of the multi-year period. It will kill the assumption of this article that the churn rate on a 1-year deal is the same over the three years as on a three-year deal.
- While it can be considered borrowing from the future, in some cases multi-year prepayments can have a dramatic positive impact on short-term cash flow and in certain situations can be the cheapest short-term source of capital. It can be a win-win for both the company and the customer. In such cases you may want to consider additional incentives. This is not a long-term strategy but can be beneficial for short-term requirements e.g. your fundraising is taking a bit longer than you hoped for…
- Best practices in subscription businesses dictate that new business and renewals are separated (new business team vs. customer success team). Therefore, it’s critical to realize that the salesperson has little incentive to think about the future renewal but rather at closing the deal that will pay him maximum commission today.
- The buying and procurement process for a renewal of Enterprise software can be quite cumbersome and take up a significant amount of company time even for what would appear to be a simple renewal. Therefore, the benefit of multi-year deals is not purely a question of maximizing revenue on the deal but also lowering the overhead of working on renewals. That time is better spent by your customer success team in focusing on making the customer successful and ensuring they become passionate advocates.
- The goal of maximizing recurring revenue and new logo acquisition needs to always be top of mind for the company. It is a best practice in subscription businesses to focus quotas on ACV and not TCV. The salesperson should be recognized for hitting their ACV targets. No bragging rights for TCV. The multi-year calculations above are meant to represent commissions only incentives. Only ACV should retire quota and salespeople should only be hitting accelerators when they exceed their full ACV quota.
In summary, multi-year deals can be valuable to your company but there are many details to consider when building them into your compensation plans. While every situation is unique I’ve tried to cover most of the critical aspects of multi-year deals that need to be considered as you work them into your compensation plans in a way which is aligned with your company’s goals.