The Rule of 78s–Sales Compensation Solutions for the Cloud, Part 1By: Alexander Group Cloud Computing, Cloud Sales, Sales Compensation, Technology Sales
Cloud computing is one of the biggest technology disruptors of our time in that it allows customers to refocus on core competencies while reducing total cost of ownership for technology solutions. For vendors, it promises a high growth platform comprised of sustainable revenue streams. Unfortunately, the design of sales compensation plans for pure play cloud companies is not as simple as replacing “License Bookings” with “MRR” in your plan documentation. The fundamental differences between a perpetual license and a subscription revenue business model necessitate a closer look at compensation design in order to address the unique challenges that cloud companies face today. From a finance perspective, these differences in compensation design can have a significant impact on the sales planning process including role design, quota setting, sales crediting, measure tracking and rules of engagement.
Take for example, the Rule of 78s.
This concept has its origins in lending, but has become commonplace in industries with recurring revenue models such as telecommunications and more recently cloud computing. Originally used as a method of calculating yearly interest, the “Rule of 78s” has been adapted to cloud as a way of explaining the compounding effect of bookings which occur throughout the year.
Simply put the timing of deals matters in a subscription revenue model. Cloud based companies actively seek to bring deals in earlier in the period (the month, quarter, or year) to allow more time for accounts to generate revenue. The shift in bookings either earlier or later in a quarter can have a significant impact on recognized revenue at year end. This impact to the top and bottom line of consistently “early” bookings in the period can be significant even with similar total results in bookings. The sales compensation program can serve as a lever in the manager’s toolkit to drive this type behavior.
Common Compensation Traps
Unfortunately, designing a compensation plan that drives early bookings is not as easy as it sounds. Too often, we see companies institute a “fast start” bonus or higher commission rates earlier in the quarter or year. Each of these tactics is aimed at providing richer incentives to salespeople to start booking deals earlier in the performance period. Unfortunately, these approaches have their drawbacks. More often than not, we will see salespeople “shop the plan” and calculate what scenario will provide them with the greatest financial benefit. Will booking the deal in this particular performance period benefit the salesperson more due to accelerators built into the plan? Or will they see greater financial benefit if they “sandbag” the deal, holding it until the next performance period when they can collect the higher commission rate?
Is There a Silver Bullet?
One possible way to solve this dilemma is to augment common cloud measures such as MRR and ARR with derivative measures such as territory revenue. By setting a territory revenue quota based upon a desired timing of bookings, you can incent the behavior you are trying to drive. Early bookings in the performance period will allow the salesperson to exceed their territory revenue quota whereas bookings which occur late in the performance period will have very little impact on territory revenue. However, this approach does not come without its own set of challenges. Namely, quota setting becomes more complex and sales people that fall behind in performance early in the period can give up hope of ever achieving their quota.
Sales compensation can serve as a strategic lever to support your sales strategies and for cloud companies, this means driving early bookings and thus getting the “Rule of 78s” working in your favor. Doing so correctly can have an immense effect on the success of your business.
Originally published by: Dale Chang