When you bring a new sales representative into a territory, he will often ask about a “draw.” The first time you hear the term, you may not know what it is or why it’s important. A draw is a pay advance against expected earnings or commissions. It can be important to both your sales representative and your company, but for different reasons.
Importance to Your Sales Rep
Selling high-priced, complex products or services can involve a lengthy sales cycle. From first contact through the close of a sale, months may elapse. The time needed to develop a fully productive territory can range from as few as three months to a year or more. During this ramp-up period, your sales rep may experience severe personal cash flow shortages. His or her base salary is usually significantly less than the total expected compensation plus commissions haven’t kicked in yet. To help your sales rep get through this initial period, you may pay your rep a draw – an advance against future commissions.
Sales cycles can also be seasonal. In the utility industry, energy demand is highest during the summer and winter months; it is significantly lower during the spring and fall. As a result, companies that service the power generation equipment for utilities experience a well defined seasonal sales cycle. Sales reps earn much greater commissions in the spring and fall months; summer and winter month commissions can be near zero. Draws can help smooth out your rep’s seasonal cash flow in these situations.
The draw provides several benefits to your sales rep:
- Provides a “living wage” during the period when a territory is being developed and commissions have not yet been earned.
- Reassures your sales rep that the company has faith in his or her ability to be successful in the territory.
- Smooths cash flow across seasonal earnings.
Importance to Your Company
As a company, you have two key interests when placing a new sales representative in a territory. First, you want your sales rep to succeed, developing relationships and driving sales. Second, you do not want to lose the substantial investment your company makes in hiring and training a new sales representative.
By paying a draw, you can help promote these interests. The draw reduces your sales rep’s cash flow concerns. Instead of worrying about meeting monthly cash flow obligations like rent or mortgage payments, your sales rep can focus on learning the territory, developing customer relationships and moving customers along the sales cycle. Without immediate cash flow concerns, your sales rep is also less likely to look for a new job which is less risky from an income perspective. The draw reduces your sales rep’s perceived income risk and keeps him or her focused on the job – selling your products and services.
Recoverable vs. Non-recoverable Draws
Draws can be either recoverable or non-recoverable. Recoverable draws are loans against future commissions or bonuses. Each month during the draw period, you pay your sales rep the draw amount. If your sales rep earns commissions that are less than the draw amount, you pay your rep the commissions. However you only pay enough draw so that the commissions plus the draw total the amount of the full draw. The outstanding draw amount accumulates from month to month. When earned commissions exceed the draw, use the excess commissions to repay the outstanding draw. Once the accumulated draw is repaid, all commissions are paid to the sales representative.
In the event that a sales representative leaves your company owing an outstanding draw, most companies will write off the outstanding debt. It is very difficult, if not impossible, to collect monies paid to a departed employee. Some companies will deduct the draw amount the sales rep owes from other amounts the company would normally pay, such as unused vacation, severance, etc. However, before withholding benefit payments, check with a labor attorney to ensure you meet local regulatory requirements.
Non-recoverable draws are also loans against future commissions or bonuses. However, a non-recoverable draw guarantees your sales representative a minimum level of income for each commission period. If earned commissions are less than the draw amount, your sales rep receives the draw amount. No accumulated draw is carried to the next commission period.
Recoverable draws are more advantageous for your company. Non-recoverable draws are more advantageous to your sales rep. There is a trade-off. How much risk is the sales rep willing to accept to work for your company versus how much is your company willing to pay your sales rep?
Time Limits
Draws should have a time limit. The length of the draw period should give the sales rep enough time to establish his or her territory plus the time needed to repay the accumulated draw. Usually, this works out to one to two sales cycles.
Draw Amounts
The amount of the draw can vary by sales representative or by territory. I generally look at several factors when determining the draw amount.
- On Target Earnings (OTE) – What are the OTE for the sales rep? An aggressive draw can bring the rep’s base salary plus draw to 85% or more of OTE.
- Territory – What do I expect the territory to generate in revenue and commissions? Based on this information, I may increase or decrease a planned draw amount.
- Sales Rep Experience – How quickly do I expect the sales rep to get up to speed? How much revenue or commissions do I think this particular sales rep will generate? Again, using this information, I will target a draw equal to 65%-80% of my expectations.
- Market Expectations – What draw amount and for what time period will it take to get the sales rep to agree to work for my company? Depending on the competitiveness of the market and how badly I want a particular sales rep on my team, I’ll increase or decrease the planned draw amount.
As with all sales compensation issues, there are no right or wrong answers when determining your draw structure. You need to consider the goals of your business, the level of risk (draw repayment) you are willing to assume, and how much competition exists for attracting the best sales team you can afford.
For more information, contact Wallace Management Group at (203) 834-0143 or email David Wallace.
© 2009, David P. Wallace
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dear mr wallace: i am a manufactures rep. my product takes a long time to sell sometimes 18 months. in 2010 the company paid me a straight draw. there were no sales. early in 2011 the account was opend and the purchse orders have begun. immediatley the comapny has begun deducting my draw from commissions. here is my question: was the 2010 1099 income? was it a loan? how do i book it withthe irs? how will i book the repayment in 2011? please offer me any assistance on this subject. i will find out a way to return the favor. thank you. bobmac
Bob Mac, As a manufacturers’ rep, I assume you work as an independent contractor as your own, separate legal entity. Given that status, there are a number of ways that you might account for the 2010 1099 income. I recommend that you consult with your accountant to ensure that you account for payments in a manner that is both legal and appropriate to your particular financial situation. — Dave
Mr.Wallace,
I am a Financial Advisor and have been in the business for 3 years and have been doing very well with the firm that I am employed with. I currently work on 100% commissions. I receive a 36%-40% payout of gross commissions. I have been contacted by a very prominent Local Investment firm that would like me to work for them and would like to structure some type of draw against commissions and I was looking for some guidance of how much to negotiate as a draw. My Total comp for 2010 was $86,000 not including profit sharing or health insurance benefits. Projected 2011 $100,000. Should I target $86,000 as my draw since that is what I made last year and as I transition some of my own clients over to the new firm that I could eventually remove the draw against commissions? The firm is aware that I really wouldn’t be willing to switch Firms unless I could realistically double my current income. Thanks for your help. Adam
The question of what’s an appropriate draw against commissions depends on your perspective. From the employer’s perspective, the employer wants to pay as little draw as possible, but still provide its employee with enough cash flow to be able to focus on performing the job. So, if an employee needs $5K per month to meet basic needs (health insurance, food on the table, transportation to work, perhaps a portion of mortgage/rent), then I pay that amount. If they can manage with less, then I pay less. The key is to meet basic needs, but still keep the employee hungry enough to do better. If the employee is too comfortable, there may not be an incentive to drive more sales.
From the employee’s perspective, you will want look at whether the draw is recoverable or not. Plus, look at what the draw is recoverable against. If the draw is non-recoverable (i.e., you get it no matter what and you don’t have to pay it back at the end of the year or if you leave the company), then ask for as much as your employer will give you. There’s no risk beyond being viewed as greedy, needy or otherwise a high-maintenance sales person. This will allow you to focus on developing sales and not worry about money.
If the draw is recoverable, then you will want to look at the mechanisms for recovery. Is it recoverable against future commissions (most common)? Base salary? Expenses? Other monies owed to you? On demand (unsecured loan)? In this case, you need to determine how much debt you are comfortable carrying. Also, what is the likelihood of earning commissions that exceed the draw and when will commissions surpass the draw amount?
Given what you’ve outlined below, I would target $86,000 for the draw (they may or may not agree to this amount). I would also negotiate for the draw to be non-recoverable for some period of time (6 mos? 12 mos?) based on a realistic period you need to transition your client base. Thereafter, you and your employer may agree upon a draw amount, recoverable against commissions, that smoothes out cash flow until you are established.
Dear Mr. Wallace,
I was recently terminated after only 3 months with an employer who established an at-will base+ draw compensation package. The sales goal for the first quarter was overly ambitious, but I agreed to it because I wanted a new opportunity for growth. The employer and the job was not a good fit, and I did not meet my sales goals. My employer terminated me, even though I had 2 proposal meetings scheduled including one the very next week. He held my last paycheck to put against my draw, and has been harassing me about the remaining draw. I reviewed our agreement, which stated that draws not met in the first quarter would be taken from my base compensation, but there is not language about re-payment after termination. I strongly believe that I do not owe this amount as it was an unfair work environment (in the CEO expected me to also perform marketing functions for the company in addition to attending time-consuming meetings with his sales coach). I also learned after leaving that this CEO has a reputation for being difficult to work with, and even abusive. Does he have any legal recourse for making me pay the remaining draw?
Don,
Compensation and commission issues can vary tremendously from agreement to agreement, employer to employer, and state to state. I don’t know the specifics of your situation beyond what you have provided. I am also not an attorney.
If the disputed or withheld amount is significant, I recommend you contact a labor attorney, particularly one with expertise handling compensation issues in your state. After reviewing your situation, your attorney will be best able to advise you.
If a company decides to change marketing strategies for inside reps who make commission based on leads provided by the company, should the company offer a draw against future earnings or non-recoverable ramp to compensate for the change in marketing? My company is deciding to head up-market, now involving much longer sales cycles, RFPs, etc. The risk and reward are both potentially much higher. We could make a lot of money, but are all afraid that without the SMB deals we were dropping in routinely we won’t get paid much for a while, and draw money we have to pay back means a loan, essentially, against what may turn out to be a bad marketing strategy, or one that needs refinement over time. I feel like we did not do anything wrong, and the company should, in good faith, give us non-recoverable money to compensate for lost commissions in this fallow time. Even a true-up number would work, where we would be able to sell and if we fell below a certain number they would make up the difference for the short term, until we see how the new strategy works out. Your thoughts?
You put forth good reasons for a non-recoverable draw. The bottom line depends on several factors. First, how valuable is the current sales team to the company? Are you generating sufficient revenue and margin for the company? Are you helping the company achieve its objectives? How much would it cost the company to replace you if you leave? Second, how is the market for sales reps who can replace you? Will the company lose market share or sales if you leave? How quickly can you be replaced? What would be the cost to train a replacement? Third, what is the culture of the company? Is the company paternalistic where they would take care of you during the transition? Is the company cut-throat where it’s survival of the fittest?
I understand that this economy is challenging for many sales reps. It’s challenging for companies too. Whether or not a draw is put in place, and whether it’s recoverable or non-recoverable will depend on your company’s financial position and its culture.
Dear Mr. Wallace – I signed on with a company back in July of 2011 and negotiated a draw against commission for a ramp up period of 90 days since the sales cycle could be lengthy and commissions would not be enough to substantiate my finances for a while. The agreement was a base salary plus a guaranteed amount per month (draw) for a period of 90 days. I stated in the interview that I wanted an unrecoverable draw. There was never discussion of repayment of the draw. I would never have agreed to such a thing and politely declined the job offer. I have never and do not believe in a recoverable draw. It would be impossible to ever catch up if you were required to pay back a draw. The 90 day period passed and my commissions had thankfully kicked in and I was able to transition nicely without financial hardship. The past 3 months I have attained over 100% of my target sales goals and am on target to reach 200% in January. I am their top sales manager at this point in the month, so I have contributed quite substantially to this company and performed above expectations. On the last paycheck of 2011, Dec 31, I saw that they had deducted over 2k from my check and called it “draw”. I was horrified. I had not been notified of, nor had there been any discussion of terms of repayment. I was put in such financial hardship by this event as I was expecting to pay some Christmas bills with the extra commissions I had earned for the holiday. The next check they took even more out. I never agreed to repay nor was I ever told when or how they would deduct this 7k in draw that they say I now owe them. I have no idea what to do. How can they just take it out without notice or my agreement? Is that legal? What is my recourse? Why would a company do that to a top producing sales manager? Thanks for any insight you can provide.
Mr. Wallace, I have worked for my current employer for 10 + years and since 2011 they have been paying us on a 100% commission structure in a sales roll. They give us a weekly draw against and then at the end of the months sales, deduct this draw against from the commision paid. ie: 60, 000 in sales gives me $6,000 less the draw. They are only paying vacation pay on the amount given after the draw???I live in Canada/in Ontario…is this right??? I inquired and they said , I only get commision on the amount they pay after the draw against, yet they deduct my draw against the full amount from my 10% commission??
There are a few routes I suggest you explore to determine if you have legal recourse against your employer. First, review all notices and documentation provided to you by your employer when they switched to the 100% commission structure. Read all the large print AND the fine print. Did they state explicitly how they would treat vacation pay? Do they pay you an amount equal to an average of commissions earned over time? Second, check with your province’s department of labor. The province or federal government may have laws that define how vacation pay must be treated by your employer. Third, consult with an labor attorney. Review with him or her all the notices and documentation. Your attorney should be able to tell your quickly whether or not you’ve been wronged.
As an employer, if I was paying my 100% commissioned employee vacation pay, I would pay on an average of commissions earned over a recent period such as a month, quarter or year. I would not pay on the draw amount. The draw is a payment to smooth out cash flow so that sales reps can make their personal obligations (rent, mortgage, car payments, food, etc.). For high performers, the draw is normally much less than their commissions. Therefore to pay them for vacation at the draw rate would be short changing them. For under performers, the draw is normally much more than their commissions. To pay them a vacation rate at the draw level would be to overpay them. The under performer should spend the vacation time looking for a new line of work, because he or she is likely to be let go soon.
Dear Mr. wallace,
I am in commercial roofing sales. My title is Project Manager/ Sales Representative. I was hired with a salary of 50,000/year aprox 8 months ago. Back in April I was told I was going on 100% commisions. The deal was presented as follow: I would continue to receive my weekly pay of $961.00. I was told that I was able to continue with my weekly pay amount because of my sales for the previous three months, or the first quarter(not quite sure which) I found it curious that they switched me with only two month remaining in a quarter, although its probably no coincendence that I had sales in excess of 330,000 in the month of April. I woukld have made 6-7 percent of the gross sale based on the profit margein and where the job comes in. The dollor amount would have been 16,000 to 19,000. Nevertheless, In May and June i had sales of 130,000 and 119,000 respectively. Back to the way it was presented; I would stay at my regular wekly pay but now it was a draw. At the end of each quarter we would “settle up”. Last quarter I generated aproxikately $600,000 in sales, yet on the 13th of july I was told I was now only going to be receiving a draw equal to minimum wage at 40 hours a week, which is equivalent to $248 per week. My job doesnt pay for gas unless you sell over 100,000 in a month, and then it is just an allowance of 500. I spend 180 a week in gas. that would leave me less than 100 dollors a week to live on. I dont know what to do. The sales ccyle is realisticaly 120 days at best 60 to 90, Yet they are analizing my sales on a weekly basis, which would be appropriate if the sales cycle for our product was 1 day. How do I get them to be reasonable. They offer little to no training. Am I being forced out.?
Steve,
I don’t think you are being forced out, but I do think the owners of the company are re-evaluating how much they are willing to pay for new business. Or, they may be trying to manage their cash flow in a seasonal business.
You need to have a frank conversation with management and come to agreement about how much the company values your contribution. Include everything; salary, draw, guaranteed minimum income levels, commission rates, timing of commission payments, mileage reimbursement, expenses, other benefits (health insurance, paid vacation, holidays, sick time, disability insurance – long-term and short-term, life insurance, personal days, working hours, etc.). Then, put everything in writing to ensure that both parties understand the agreement and commit to it.
When this is done, you may find that you receive compensation in areas that you were not aware of (benefits). Or, you may find that your compensation is not what you need or find fair. At this point, you need to decide if that job at that company is good for you.
When you negotiate (and this is a negotiation), define the value you bring to the company. How much revenue do you produce? What is the profit on the jobs you bring in? How much did you grow the business in your territory since you were hired? How much business was the company doing in the same territory before you joined them?
Also, what other business can you bring to the table that the company might be interested in? Gutter cleaning services? Chimney repair? Clearing snow and ice from roofs in winter? The roofing business can be a seasonal business in some parts of the United States. If your compensation is 100% commission, your income will fluctuate seasonally as well (the company’s revenues will also rise and fall with the seasons). By identifying other work your company can do during the off season, you may be able to generate a smoother income for yourself.
Dave
Dear Mr. Wallace,
Please help me understand the following in my impending employment contract (please note I am new to commission sales jobs):
In the original contract…$50k as a draw against commissions. Co pays commissions at a rate of 12% of sales booked and shipped. To get started, the Co will absorb the first 90 days of draw against commission salary as a way to ease into new structure. At the end of each subsequent calendar quarter, the company will pay you any excess commissions earned over the draw amount already paid.
In the counter, not knowing, I countered the following to request a lesser draw of $40K and a more detailed explaination of this process works. Here is the reply…I can discuss this in detail when you are here but basically, each year stads as a whole. We allow payments on a quarterly basis so that you can enjoy your commission checks and the company doesn’t end up owing a large year end payout.
For example on a draw of $50k per year, you will need to have sales in excess of $416,667 per year to generate excess commissions. Each quarter, if you have generated more than 1/4 of that amount, a commission check will be issued. If you fall short one quarter, that shortfall must be made up in the following quarters before a commission check is issued. Again we can discuss this in detail once you are on board.
Is this clearly written? If the sales don’t reach the goal will I be forever in debt to this co.? How does a company come up with this formula? I’m not sure of how my goal and draw work, please help.
The draw against commission program that your employer has outlined looks reasonable and generous. Basically, your employer is evening out your cash flow. Commissions can vary in amount based on how much you sell each month. What your employer has offered is to provide you with a draw of $50,000 per year, paid in regular installments (bi-weekly or monthly is normal). Think of it as base-line income. At the end of each quarter, your employer will compare the commissions you earned in the quarter with the amount of the draw you received. If you earned more in commissions than you’ve been paid so far, your employer will pay you the additional commissions he owes you. If your earned commissions do not amount to what you’ve been paid, then the difference is carried over into the next quarter.
You are correct that if you don’t sell enough so that your commissions exceed the draw, you will be further in the hole in the next quarter. If you continue to not sell enough, you get further in the hole. However, your employer is likely to change your draw or end your employment before the hole becomes too deep. Your employer has hired you to sell. If you don’t sell, your employer will replace you with someone who will sell at the levels they need to make their sales goals. But keep in mind, it’s costly for your employer to keep hiring sales people who can’t sell. Your employer wants you to succeed. It’s in their interest.
If your employer decides you will not be successful in a sales role, then he has a few options. First, he can fire you and demand that you repay the draw you were paid, but did not earn with commissions. This is a real possibility, but often it is a futile exercise since you don’t have a job and likely don’t have much money. Second, he can move you to another job in the company. In this case, he may or may not try to recover the shortfall in commissions. It depends on how hardnosed he wants to be. Third, he can fire you and forgive you the owed shortfall in commissions, considering it a cost of doing business.
Finally, you may decide to leave the company and sales position when you are uncomfortable with how far in the hole you’ve become. If you leave owing money against a draw, your employer will likely try to recover the shortfall against other monies he owes you, such as expenses. He may also ask that you repay the shortfall immediately or over time. He may even enlist a lawyer to sending official-sounding dunning letters. This will be particularly true if you leave to join a competitor.
In any case, before you sign up for a program that makes you uncomfortable, consult with a qualified labor lawyer. A little money spent now may save you a lot down the road.
In the end, ask if this is the right career path. If you are uncomfortable with a draw, then perhaps sales is not right for you. Sales demands someone who is confident in their skills and ability to sell. If you don’t think you will sell enough to surpass the draw, then ultimately you may not be successful in the position.
Dear Mr. Wallace,
Thank you so much for your reply, it clearly explains the position of sales and draws. Your advice is very helpful and will help in my decission making process.
Most Grateful!
Ruth
Dear Mr Wallace,
I am an independent contractor for a company who has agreed to an “enhanced commission draw” verses a “base commission draw” for the first two years of my contract. I will be coming up on my 1st year anniversary in January however I have been offered a great opportunity with another company I would like to pursue. For the first 6 months of my contract my draw was $5000/month and 4 out of 5 months I exceeded that amount in commissions earned, but never had the draw deducted for the months $5000 wasn’t made. In the next 6 months my draw was $2000 and I have exceeded that amount monthly. Per my contract it states that if I am to quit within the first year, I would owe 30% of the “enhanced commission draw” paid to me for the first year, which “both parties agree represent the difference between the enhanced commission draw and the base commission draw.” Nowhere in my contract is either “enhanced commission draw” or “base commission draw” defined nor is a formula provided. Also, on my actual commission schedule provided my the company it does not call my “monthly draw” at “draw” it refers to it as a “garauntee.”
I spoke with a previous employee who left the company and he said he was charged 30% of all draws even when most of his commissions exceeded his draws.
Do you have any insight as to how this could pan out should I leave before my 12 year anniversary?
Kelly,
You state that you are an independent contractor. As such, I assume you are working independently. You set your own hours, schedule, etc. As an independent contractor, you are also free to take on other contracts to develop your business, provided they are not competitive with or violate the terms of your other contracts.
However, your responsibilities and obligations to your current company should be spelled out in your contract. You need to read that carefully to know exactly what you are accountable for. In many cases such as yours, I recommend having an attorney (preferably a labor lawyer or a contracts lawyer) review your agreement and advise you what your options are.
I don’t know how iron-clad your contract is, especially with respect to draw. The previous employee may have succumbed to intimidation by the company without really having to do so. Have an attorney look at the agreement. Let your attorney tell you if the definitions for enhanced commission draw and base commission draw are in place. It sounds like you may have some bases for negotiation, if not outright walking away from the deal. However, don’t take my word for it. Review your contract with your attorney. It will be money well spent and it may well save you a lot more than it costs you.
Dave
David,
I own a staffing firm. One of my employees in currently on a draw (or what we have both called a draw). At this time he is way ahead of his draw (his earned commissions this year are at least double his total draw amount), but he is still receiveing the draw. How is the draw supposed to work, when the salesperson is ahead? It would seem to me that the draw would stop for a while. Is that correct?
Jay
The purpose of the draw is to help smooth out earnings. This may be necessary either at the start of a sales person’s tenure in a territory (new hire, change in territory or responsibilities) or when there is a long time period between commission payments such as annual or semi-annual commission payments. Effectively, draws are no-interest loans from the company to the employee. Draws are repaid with earned commissions. In other words, paid commissions are equal to earned commissions less outstanding draw. Don’t pay twice by paying both draw and commissions.
For a sales person starting in a new territory or for a new sales hire, the draw is normally set at a level to enable the new sales person to meet expenses or otherwise afford to build the territory while in the start-up phase. Draws are usually set at a level that is less than targeted earnings. The draw period should approximate the length of time you expect the sales person to become fully productive. The draw also shows good faith on the part of the company that they are confident the new slaes person will become successful. When the new person’s commissions consistently exceed their draw, the company can end the draw payments since they are no longer necessary. If a draw has been guaranteed for a specified period of time, say the first six months or year, draw payments may be suspended during months where commissions exceed the draw, but reinstated later when commissions are lower.
When commission payments are paid annually, semi-annually or even quarterly, draws may be used to help the sales person maintain an even cash flow between commission payouts. The draw amount might be a specified monthly or semi-monthly amount, a percentage of expected commissions, or a percentage of estimated commission run rate. In this situation, companies may continue the draws indefinitely because their sales people need the cash flow to meet their basic needs such as mortgage, car payments, groceries, etc.
In any event, the draw should be repaid by successful sales people through the commissions they earn. If your company does not expect the commissions to exceed the draw payments or if the company does not recover the draw payment from commissions, the company needs to make a choice. Either fire the sales person because they are not meeting your sales goals or reduce the commission payout percentage and convert the draw to a base salary.
Mr. Wallace,
I am negotiating a position with a company and we have discussed several options. We are looking at a sales position paying a salary + 8% commission (based on total sale), originally I was looking to make the sales and maintain the customers for repeat business. Now they are looking to pay a much lower commission for a period of time and I turn over the customer, they are also looking to lower commission by same amount that something would sell below a set gross margin. (Ex: If the gross margin is 30% and the sale was only 27% they would lower commission by 3% – does not seem apples to apples) I would prefer keeping the customers and nurturing those relations and doing repeat business. I am now looking at some other options, can you give me your thoughts on the following questions.
When considering a commission, which is better a percent of total sales or a percent of gross margin?
How much commission seems fair in a 30% gross margin sale? Let’s say based on a 2 million dollar sale.
Have you heard of being a contractor making your own schedule working on a draw at 100% commission, yet getting benefits + expenses?
To me it makes more since to pay a commission based on gross margin not total sale, and I was thinking to maintain a fair adjustment to recommend the commission percent be the same as the gross margin. (Ex: 30% gross margin on 2,000,000 = 600,000 = commission of 30% = 180,000. If 20% gross margin then commission 20% etc.) This would be compensation for landing the client, closing the deal and maintaining the client. What are your thoughts?
Thank you,
Ragan,
Your prospective company appears to be focused on growing its business by acquiring new customers. I suspect that the company is also fairly young and new. The company principals are confident that once the customer is on board, they will be able to develop the relationship. They want you to find more prospects and close them.
Generally, companies pay new business representatives or business development reps a combination of salary and commission. The salary is necessary to compensate for the long sell cycle associated with new business. Alternatively, a company may pay its sales rep commissions only, but at a significantly higher commission rate. Account representatives are generally paid at a lower commission rate (% of revenue or % of margin) since they can generate more volume from an established customer.
To answer your questions:
Commission as a percent of total sales vs gross margin – either scenario works. The smart company will adjust its commission rate accordingly. For instance, if the gross margin for new customers runs at 60%, then the company will be indifferent if it pays commissions at a rate of 10% of revenue or 16.67% of gross margin. In both cases the company would pay an average of $10 for every $100 of revenue. However, most sales people prefer to be paid a percentage of revenue since they directly control the revenue they generate. Gross margins may be affected by factors outside the sales reps’ control.
How much commission is fair to pay depends on a number of factors. Factors include new customer vs existing customer, new product vs established product, commissions paid in the industry, is the company breaking into a new market, is a base salary paid, experience of the sales rep, are expenses paid, etc.
With respect to contractor status, the IRS and individual states provide guidelines to help a company determine if a worker is a 1099 contractor or an employee. The following information is from the IRS website,
Facts that provide evidence of the degree of control and independence fall into three categories:
1.Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
2.Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
3.Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.
The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.
Tying commission rate to the gross margin rate is an interesting thought. It would certainly motivate you to drive business with higher margins. However, your employer may prefer to use commissions to drive behaviors other than maximizing gross margin. Your employer may want to pay different rates for new customers, product introductions, market penetration, balanced product portfolio, etc.
Hello Mr. Wallace,
I would like to thank you for responding to my questions.
Overall I agree being paid commission on revenue makes more since, however since they are now trying to create an adjusting commission based on meeting a 50% gross margin I was trying to think outside the box. The 50% margin is high for this company and few people reach it. I don’t mind a challenge, but the adjustment does not seem apples to apples.
Ex: Let’s say on a 1 million dollar sale my commission based on revenue is 10%, however they want to be able to adjust my commission lower by the same percent that a sale is below their target of 50% gross margin. So if the sale were to come in at 40%, I would not get a commission.
That is why I was thinking out of the box and tying a higher commission based on gross margin and having it automatically adjusted with the gross margin.
Any other last thoughts on this?
Again, thank you for your response.
Ragan,
I have two thoughts here.
First, when setting up a commission plan, I prefer to provide positive incentives. In the case you describe, I would pay commission that is in line with industry norms for deals that are in line with industry norms. However, if I strive to achieve better than industry norms, I might offer a commission “kicker” for attaining certain milestones. In the case you outline, I might pay 8% for sales with margins between 45% and 50%, but pay an additional 2% for deals over 50% margin.
Second, the company should always have the right to reject a sales opportunity. If the sales person lands a deal with unacceptable margins, say under 40%, then the company can simply refuse to accept the deal. However, if the company accepts a deal with low margins, then that becomes the company’s decision. The sales rep should still be paid.
Dave
Dave,
Thank you for taking a moment to read this, any input is greatly appreciated.
I recently left a company after working for 22 months as an independent contractor. I started in January, on a non recourse draw (pay based on $30,000 a year) for 6 months. At the end of this sixth month period, per the contract I signed, it switched to a recoverable draw.
The typical sales cycle with my job is 24 months and thus had no commissions come in the door during 2011, so when 2012 came around and I received the tax form for 2011, it only showed my income as roughly $15,000 (the non-recourse draw). When I asked my controller why it did not show the full amount I received ($30,000)I was told that I will not pay taxes on draw until commissions come into the door. At the time i recently left, no commission had made it into the door yet. While I had around $40,000 accumulated in draw when I departed, the company will not be pursuing me for the money owed.
My question is, will I pay taxes on this $40,000 of draw I received during 2011 and 2012? I believe I read that if a company forgives the debt, then it is considered a gift. At that point, the company would pay taxes on that amount, not me. Thank you very much for your help.
Will
Will,
You pose an interesting question. “Is a draw that you have been paid, but not earned, considered income by the IRS?” My initial reaction is “Yes, the IRS will deem draw that you have been paid to be income.” Similarly, draw that you repay may be considered a reduction in income. However, I am not a tax accountant. I recommend you contact a tax accountant or qualified tax advisor and ask for their opinion. You can also pose your question directly to the IRS via telephone or by visiting a local IRS office. Here is a link to the IRS contact web page.
Dave
David,
I have a small business with two admins. I have been handling sales since I started the business but am stretched in so many directions now as I am owner, bookkeeper, sales, customer service and banker you get the picture. I think I need a full time dedicated sales person to get above the number we have been stuck at for a while. However, not much money to offer them other than an aggressive commission. I have tried extremely aggressive only plans and don’t get any bites or have had two people waste my time for a couple weeks and then quit. I goggled draw compensation and found your site. As the employer if I offer a recoverable draw against commission it sounds like I might attract more candidates to apply? Do you know of any templates or calculation examples that may help me come to a conclusion the plan?
Thank you
Darren
Darren,
I understand the challenges you face. Generally, an aggressive commission-only plan will attract unemployed or under-utilized sales reps who are desperate to generate income. If they don’t start making money right away, or if they get a better offer, they will leave your company in a heartbeat. A draw against commission will provide a starving sales rep with some degree of security and staying power. However, you need to be realistic in your expectations. How long is the sell cycle? What is the size of the market? Who is your competition and how do you stack up?
I recommend that you read through the other postings on my blog about sales compensation. I cover many of the issues you are facing. You can find them at http://www.wallacemanagement.com, then select Sales Compensation Plans on the left side bar.
Dave