Avoiding Moral Hazard in Compensation Plans

May 4, 2010

NOTE: This piece was originally posted on the 121 Silicon Valley, Inc. Website on May 4, 2010

When designing processes and setting goals and objectives, there is always at least some element of moral hazard. That’s why in business and any other walks of life, the players aren’t allowed to be the scorekeepers and vice versa , even though the great majority of us are fundamentally honest and ethical. And when it’s hard to keep those roles separate, as often happens in comp plans, sometimes it’s easier and more rational to change the scorekeeping rules (i.e., the comp plan) than it is have unreasonable expectations for employee behavior.

In high tech companies, especially software, a good example of this issue is sales compensation plans based on recognized revenue (“RevRec”). RevRec is an obvious choice for determining earned commissions, because it is always measured, is clearly tied to stockholder value, and is scrutinized by lots of scorekeepers, often – always, if it’s a public company – even including outside auditors. The problem is this: Accurate and credible RevRec accounting depends on honest and open communication between the sales and accounting departments. This interaction is essential answering to questions like:
  • Is the customer making a binding commitment, free of contingencies?
  • Do the customer signatories have the authority to make commitments?
  • What further obligations, beyond simply delivering the product, do we have to this customer?
  • Do we and the customer have the same understanding about what the sales documents say?

In complex deals, these questions don’t always have simple yes or no answers. In the software industry in particular, the RevRec rules are often so complicated that they’re hard for anyone to understand. And sadly, it’s even harder to understand just why those rules are fair or reasonable.

If your company is in this situation, my strong advice is: Don’t put your company in a position where the salesforce regularly has to choose between earning commissions they think they honestly deserve and clear, straightforward, and perhaps even honest interactions with the accounting people. Rather than making heroic efforts to obtain and verify honest answers, you’re often better off instead basing commissions earned on metrics such as bookings, purchase orders, invoiced amounts, or cash collections. This decision should depend on balancing factors including:
  • Which metrics are likeliest to motivate the salesforce to act in the company’s overall interests
  • How complex RevRec is in your company
  • How clear and meaningful each metric is to the salesforce
  • Ease of accurate data collection for each metric

It’s an unfortunate fact of life that in many industry sectors the RevRec rules are complicated, poorly explained, and to many observers arbitrary or even unfair. But they are the rules. You may find that you can create a win-win situation by basing commissions on something other than RevRec, freeing the salesforce to deal openly with accounting on RevRec issues without threatening their livelihoods.

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