Paying to Win
Apr 20, 1997 12:00 PM, Alan Kruglak
In the war of sales, your best soldiers are your sales reps. Your compensation plan should motivate them to fight the most profitable battles, not the easy ones. I n every conflict, there comes a turning point, a time of perfect balance after which everything seems to go one way and the losing side marches with some resignation toward the denouement. Such a turning point - probably several over the course of a business' lifespan - exists for companies as well: The company will either surge forward and become virtually unbeatable (at least for a time), or the business will begin a slow decline and eventually surrender to more aggressive or efficient companies.
One of the factors that determines whether a company will begin that slide into nowhere is, for many small-business owners, rather surprising: your compensation plan.
I learned this lesson from a newly appointed vice president of sales, who continually hammered me with the following mantra during our strategic planning meetings: "The compensation plan drives sales."
When he first said those words, I told him I understood what he was saying. But his response was surprising: "I'm not sure you do. You're no different than most small-business owners, seeing your compensation plan only as a way to pay sales people, rather than as a strategic tool to tell sales reps what you want them to sell and how you want them to sell it. The compensation plan is really a strategy to grow sales." Over time, I learned that no truer words were ever spoken.
A double turnaroundDuring the late 1980s, my brother and I took control of my family's troubled business, GIC, which was heavily in debt, losing money and near bankruptcy. GIC, a low-voltage contractor, specialized in designing, installing and maintaining integrated systems, including security, CCTV, fire alarm and audio communication systems. Although it took three long years, we achieved what many considered to be the impossible: We eliminated our debt and stabilized our revenues at $10 million each year for three years, and we were generating a pretax profit of about $1 million. At that time, I thought I had achieved financial security and the American dream. It was not the first time I was wrong!
At the urging of my financial advisor, we hired a consultant to perform a general review our company. After two weeks of observiations, the consultant delivered two important messages that changed the direction of my company and, ultimately, my future. First, he pointed out that our sales compensation plan was stifling revenue growth, as was proved by our three years of flat revenues. His second statement knocked me off my pedestal: "Alan, unless you grow, your company will die."
I refused to believe it at first, but after careful review of his report, our company embraced his findings and embarked on a policy of growth and development primarily fueled by a change in our sales compensation plan.
Grow what?The word "growth" is an elusive term. What does it mean? How do we grow? What is the risk associated with it? Will I lose control? Without a doubt, the word growth can create anxiety among most entrepreneurs, especially when they're not sure of the right path. We followed our consultant's advice and focused on achieving growth by redesigning our compensation plan.
For many business owners and managers, designing the right sales compensation plan is the ultimate challenge. We want a plan with enough draw to attract, and keep, the best sales talent. At the same time, we may be uncomfortable overpaying our reps, perhaps paying them more than we are earning. Finally, we want a plan that creates a positive growth environment. The biggest problem is that most of us just don't know how to design a compensation plan that satisfies these criteria - a plan that can mean the difference between achieving prosperity, muddling through with the status quo or suffering a slow demise.
Our first step toward growth was to recognize the important role the compensation plan plays in growing sales.
The way it used to beLet's look at how the compensation plan affected growth at my company. Under our old plan, commissions were based on the estimated profit margin generated by a project. During the 1980s, this type of plan was workable because margins on all jobs were relatively high. But the 1990s ushered in an era of increased competition where profit margins shriveled like plucked grapes baking in the sun.
The only clients generating our standard profit margin were existing accounts, which were nearly always awarded in a noncompetitive environment. As a result, our reps spent most of their time milking existing clients. They were trying to maintain their income and follow the directive of our existing compensation plan - to sell projects that generated our standard profit margin. Although business from our existing accounts maintained profits in the short term, it did nothing to expand our client base, which boosts future sales.
Although our reps focused on existing higher margin accounts, they failed to aggressively pursue new ones. New clients received less attention for one simple reason - they generated substantially lower margins and thus lower commissions. Sales reps consciously decided not to chase new projects because of their poor risk-reward ratio. Because new accounts were necessary for growth, our commission plan unwittingly jeopardized our company's survival.
Based upon our consultant's observations and simple business common sense, we knew we had to grow. The only way to do it was to change our approach to sales compensation.
Reviewing our revenue sourcesBefore we began to modify our compensation program, we studied our revenue stream in greater detail, a process that led to two eye-opening discoveries.
If you visit any bookstore, you'll find a business section filled with books written by MBAs, academicians and heavy-hitting retired executives from Fortune 500 companies. Most espouse the traditional market segmentation theory that divides markets into common niches such as hospitals, residential, government and so on, each with its own set of selling requirements. Before our changeover, we followed the typical approach to market segmentation to the letter.
Our first discovery was that the classic market segmentation approach ignores two critical market segments: existing clients and new clients. Although most of us take these segments for granted, both represent very different niches with unique selling and purchasing requirements.
Our observations about our existing clients revealed the following characteristics:
Awarded on a sole source noncompetitive basis.
Usually won at standard gross margins, with limited discounting.
Typically involves only one decision-maker.
Requires reps with limited selling skills, similar to order-taking.
Generates smaller revenues with shorter time elapsed from lead generation to closing the sale.
Are critically important to the growth of the company.
New clients, also known as prospects, have very different traits from current clients. Our review discovered that new clients had the following characteristics:
Awarded in a highly competitive environment.
Usually significantly discounted, with lower margins.
Typically involves multiple decision-makers.
Requires reps with higher-level selling skills and experience in relationship selling.
More failure sensitive, because losing a new job forfeits the chance to benefit from system additions and changes.
Are critically important to the growth of your company.
Historically, we had failed to recognize the differences between these two market segments and consequently had ignored them in our business philosophy and compensation plan.
To our surprise, we also discovered that winning a new client usually meant the client remained with us forever, assuming the client stayed in the same building or survived as an entity. Our competitors' inability to penetrate our accounts, an inability that cuts both ways, was linked to certain limitations:
* Limited access to specific products because of distribution agreements.
The difficulty of breaking the typically strong client-vendor relationship.
* The clients' tendency to take the path of least resistance by maintaining the existing relationship.
So losing a bid usually meant that all spoils of victory went to the competition for the next five years or longer. It was painful to accept when we were on the losing end, but it was axiomatic to doing business in the security industry.
We defined the length of our relationship, which lasted from five to 10 years, as the client's life cycle, coining the long-term revenue generated by that client as life-cycle revenue.
Life-cycle revenue has the following characteristics:
Original value of a contract increases more than 500% over a client's life cycle. Additional revenue is derived from client moves, adds and changes as well as service contracts and client referrals.
An existing life cycle is virtually impervious to competition. As our experience proved, if you fail to win the initial project, it is nearly impossible to regain the lost account over the next five years, even if the competition is providing mediocre service.
This demonstrated to us that the true profit value in a client relationship was not the initial job, where margins can be as thin as ice, but the revenue that followed during a client's entire life cycle. That's why it became clear as day to us: The failure to win the initial bid cannot be an option.
It was clear that we had to radically redesign our sales and compensation program to address these two discoveries.
Team selling: The hunter-farmer programBased upon our understanding of new vs. existing accounts as market niches, we segregated our sales force into two specialized labor categories: hunters and farmers. Our objective was to increase sales productivity by specifically addressing the disparate needs of these two market segments. The result was a hunter-farmer team approach that formed the backbone of our new compensation plan.
Under our new plan, a hunter and a farmer were teamed to a specific sales territory, with both players held jointly accountable for all wins and losses in that territory. The hunter, the senior account executive, was ultimately responsible for the territory, duties that included managing his subordinate, the farmer. The hunter's primary mission was to sell new projects; the farmer was a high-level order-taker who worked under the direction of the hunter to grow existing accounts. The farmer's role included regularly calling on existing clients, processing small orders, renewing contracts, introducing new products to the existing base and performing the more mundane tasks normally associated with a sales position. The farmer thus enabled the hunter to focus on the primary mission: to spend time generating new accounts, the elixir for growth. More than any other factor, dividing these sales tasks into two groups was instrumental in our rapid sales growth.
Regarding income level, our primary philosophy was simple: the sky's the limit. A hunter could earn from $80,000 or more in the first year. We imposed no artificial ceilings, so a hunter could eventually exceed the $250,000 mark, earnings achieved on several occasions. A farmer's income ranged from $40,000 for a newcomer to $90,000 for more experienced farmers with established client bases. The bottom line was simple: If they performed in accordance with our compensation plan, hunters and farmers were well rewarded.
Motivating and directing your sales teamOnce the respective roles of hunter and farmer are defined, it's time to get down to business: motivating your staff to accomplish its mission of growing sales. This is our approach to compensation; you should tailor your compensation plan to meet your unique goals and business environment.
* Task 1 - product reorientation: The message was clear: Growth is achieved by adding new clients with the potential of significant life-cycle revenue. So selling behavior that didn't support this goal was either prohibited or discouraged.
The only major product sales we discouraged were equipment sales. Equipment sales carry slim margins and produce no guarantee of future business. These sales also detracted from the time sales reps spent on developing new accounts.
Before the transformation in our compensation program, we paid a 3% commission on revenue for equipment sales, with such sales representing about 10% of our total business in 1991. Under the new program, we reduced the commission to 1%, with results shown in Figure 1.
The message was obvious. The compensation program clearly drives the sales process.
* Task 2 - adopting life-cycle revenue and winning new business: Based upon our experience of getting locked out of system upgrades when we didn't win the original project, we officially adopted life-cycle revenue as the underlying philosophy directing our sales effort. Our goal was to win the initial job, at all costs. The greater the potential back-end revenue, the more effort we invested in winning the initial project.
Officially adopting life-cycle revenue meant a radical change in how we viewed a prospect. In the old days, we always bid the job based upon the business merits of that specific project at that specific time. Under the concept of life-cycle revenue, we began to evaluate prospects based upon the entire potential revenue that could be generated from a specific account over time.
* Task 3 - shifting to revenue-based commission: Under our new plan, we wanted to shift the selling behavior of our senior reps from existing to new clients. To redirect their behavior, we began rewarding reps based on revenue instead of margin.
For new accounts, the hunter was paid 5% of revenue, as long as the project was sold within established limits. We gave the rep the ability to discount from our established price book to win a new account. If the hunter was inclined to dip below this discount level, he had to get the approval of his supervisor, the vice president of sales. Under this scenario, the commission rate was reduced to 2% of the project's total revenue, which was still a reasonable economic incentive because such projects tended to be larger and the potential of add-on work was substantial.
New business was defined as any revenue generated from an new account for one year from the date of the initial purchase order or contract from the same building. If a hunter won a job on Jan. 1, 1995, any additional work for the project booked before Dec. 31, 1995, was categorized as new. The hunter was compensated at 5% for system additions during the first year.
If an existing client had another building in which we had never worked, the site was considered new, and the work was rewarded at the new rate of 5%. We wanted to motivate our reps to spend time developing multisite clients. The best way to do that was to reward them.
Defining existing business was easy: Everything that wasn't classified as new business. If work occurred at a site at which we had done work for more than a year after the award of the contract, it was classified as existing.
* Task 4 - growing existing clients: Because the hunter is responsible for the entire territory, he received an override commission for existing business booked by the farmer. But to discourage the milking of accounts, the commission rate for existing accounts was downgraded to an override of 1%.
The compensation plan left the cultivation of existing business, a process that required a knowledgeable order-taker, primarily under the purview of the farmer. Caring for and cultivating our existing client base meant that the farmer had to respond to client needs quickly, such as generating proposals within the first 24 hours after a meeting; assist in problem resolution in regard to issues such as accounting and service problems; and most important, listen to the client's current and future needs. Setting prices was simple because all proposals were priced at the established book price unless we had an agreement with the client to discount based upon volume or national account status.
The farmer's compensation schedule was set at a lower rate than the hunter's. If the farmer sold an add-on at the established book price, the farmer's commission rate was 1% of revenue. If the price was discounted more than the established rate, his commission dropped to 0.5% of revenue. Because of the rate structure, the only way a farmer could become a high earner was by focusing on volume, which meant being in contact with existing clients as much as possible to sell products.
As a rule, farmers were not compensated for new business unless they played a critical role in the development of a new account. In such instances, management sometimes extended a farmer the standard commission rate of 1%. Although our compensation plan didn't formally provide for this, it made common sense to reward that type of selling behavior.
* Task 5 - commissions on large projects: Winning the big ones typically extended beyond the abilities of a single individual and depended upon a team effort. To discourage elephant hunting while still motivating our senior reps, we used a declining commission scale for very large projects. Under our plan, we paid 5% commissions for the first $300,000 of an order, with the remainder, up to $1 million in revenues, paid at 2%. Thus, on a $1 million sale, a hunter was paid 5% of $300,000, or $15,000, plus 2% on the remainder, or $14,000, for a total commission of $29,000.
The resultsWe were nervous about the potential impact of these changes when we introduced our new compensation program in 1992. I anticipated that our cost of sales as a percentage of total revenue would increase. And I didn't know whether the teamwork approach would take hold, or whether the hunters, who were specially trained and in short supply, would take their skills elsewhere.
Fortunately, our fears were unfounded. The results of our new program were beyond our expectations. Over a three-year period, changes in compensation were the driving force behind the following dramatic improvements:
* Revenues more than doubled.
* Operating profit increased by more than 365%.
Our cost of sales fell from 6.4% to 4.85%.
We also had some unexpected, less tangible results. First, the teaming program provided on-the-job training for our lesser-skilled reps, the farmers. Second, client satisfaction increased because the client could contact two reps she knew well, the hunter or the farmer. Finally, small orders increased substantially from our existing clients because we had dedicated staff constantly in front of them, actively administering work previously put on the back burner and possibly never pursued.
Our new compensation plan was a huge success. And it was unquestionably the key ingredient behind our company's remarkable growth.