Hi, it's CJ Gustafson and welcome to Looking for Leverage.

A couple weeks ago I wrote about price realization, and how companies can increase list prices every year without seeing much of that increase show up in actual revenue (or profits).

One of the biggest offenders was discounting on new logos.

I’ve learned from experience that if you spend all day telling your sales team to hold the line on pricing, but their comp plans reward them for simply getting a deal done, you’re fighting gravity. And the laws of physics are undefeated.

I had Brett Queener on Run the Numbers earlier this year, the first sales ops person under Benioff when Salesforce launched. We got into how Salesforce compensated reps when annual and multi-year SaaS contracts were still relatively new.

Early on, Salesforce paid its reps equally on three things:

Brett explained:

And reps started getting customers to sign multi-year contracts and pay upfront. Exactly what Salesforce wanted.

The problem was that the plan eventually worked a little too well.

Brett told me about a five-year Merrill Lynch deal where the customer was willing to prepay a huge chunk of the contract. Like, all five years upfront.

Paying full commission on the additional years and upfront cash would have produced a massive payout relative to the work required to win the deal.

It became Salesforce's first “house deal”, and the compensation plan changed.

Brett also described what happened when reps were compensated on the first year of a contract but somebody else owned the expansion.

Ethan Schechter, who helped scale Snyk past $100M and now runs sales at Keycard, has a great perspective on discounts:

He's willing to sacrifice some initial revenue to acquire the customer, provided the deal remains inside the company's growth and profitability guardrails. And provided the company eventually makes its money back.

Ethan talked about showing up at renewal with “a great story to tell about why they need to pay more… or buy the new thing.”

In his eyes, a discounted customer can turn into a fantastic investment if they expand their usage, buy additional products, or eventually renew at a higher price.

But how often do companies actually go back and measure whether the discounts they approved turned into the economics they expected? It’s admittedly something companies don’t close the loop on.

Let's say you're selling a product for $200K annually, and a prospective customer is considering a three-year contract.

You're deciding if you should present the customer with one of two offers:

Deal A gives the customer a flat 25% discount for three years.

Deal B starts with a 10% discount, reduces it to 5% in year two, and gets the customer back to list in year three.

There’s $120K of incremental revenue over the life of the contract, and you are incurring essentially the same product and delivery requirements.

And it gets more interesting in year four (tacked on in the exhibit below).

Deal A has spent three years training the customer to pay $150K annually. Getting them back to list at renewal means asking for a 33% increase. Yikes.

Deal B enters the renewal conversation at $200K.

Of course, the customer has to agree to Deal B in the first place. In a competitive market, they may decide the additional $120K isn't worth it.

Assume your reps receive a 10% commission on total contract value, so Deal A pays the rep $45K and Deal B pays $57K.

But the rep has another variable to consider: the probability of actually winning the deal.

Imagine the rep believes there's an 80% chance of winning Deal A and a 60% chance of winning Deal B.

Under these assumptions, the rep's expected commission is $36,000 on Deal A and $34,200 on Deal B, so the rep is slightly better off pursuing Deal A.

Now run the same two deals from the company's side. The rep's economics end at signature, but the company keeps the customer in year four and pays to serve them every year.

Assume it costs $50K a year to serve the customer under either deal, and that each customer renews at the price they exit the contract at.

Weighted for the odds of closing, Deal B is worth about $24K more to the company over four years.

The rep and the company are looking at the same two deals and reaching opposite conclusions, driven by the $50K renewal difference and the margin on that extra $120K not appearing in the rep’s math.

I'm making up the probabilities and the cost to serve to illustrate the point, but you can see how the math works. And I've left out quota accelerators, the potential impact on a rep's annual attainment, and the fact that most people don't treat a commission check sitting right in front of them the same way they treat a hypothetical one three years from now. All of those push the rep even further toward Deal A.

None of this makes the rep irrational. The rep is simply responding to the incentives you've created.

Let's keep the same two deals and change the compensation structure.

Instead of paying 10% on every deal, imagine we introduce different commission rates based on the average discount over the contract term.

The rep now has a stronger economic incentive to pursue Deal B.

Weighted for the odds of closing, Deal B is still worth about $10K more to the company over four years ($301K vs. $291K of expected profit), even after paying the richer commission.

Note: That commission eats more than half of Deal B's advantage, so the rates you pick matter a lot.

Of course, I wouldn't roll out this exact structure without modeling the implications across the entire sales organization. These are illustrative commission rates, and there are plenty of circumstances where aggressive discounting is justified by the economics of the customer. We all want to brag that Coca-Cola or Johnson & Johnson is a customer. I get it.

If your pricing strategy assumes customers become more valuable over time, your compensation plan should reward reps for negotiating contracts that make those economics more likely.

If your sponsor's value creation plan assumes annual price increases, that assumption only holds if new logos aren't coming in at 25% off list. So if I were evaluating this at a PE backed company, I'd want to understand three things.

1. What behavior are we actually paying for?

Read through the compensation plan and compare it with the economics of an attractive customer.

I'd also model what happens to expected commissions when a rep offers 5%, 15%, or 25% off list.

You may discover that your current plan gives the rep very little reason to negotiate harder on price, particularly when a larger discount improves their probability of closing.

2. What are we getting in exchange for our discounts?

I'd set up a give-get menu, so every concession comes with something in return, and give reps clear discounting authority so not every deal has to route through finance:

These aren't equally valuable. A three-year commitment with reasonable cancellation protections and a price ramp can be worth a lot. A promise to sign this quarter is worth much less if you're simply pulling a deal forward a few weeks. And I'd be careful about giving a customer three years of discounted pricing in exchange for the privilege of locking them into that discount.

I'd also tighten the approval thresholds. Jason Kap, who runs the pricing firm Blue Rocket, suggests moving them off round numbers. If your reps can approve 10% discounts, managers 15%, and the head of sales 20%, he'd move those to 8%, 14%, and 17%.

Then watch whether win rates actually move. A few percentage points may sound trivial in isolation, but across hundreds of new contracts the economics become very meaningful.

3. Did the discount eventually pay for itself?

I'd want to segment customers based on the original discount they received and compare how those cohorts performed over time.

There will be customers who received an aggressive discount and turned into fantastic accounts. There will also be customers who never grew into the economics originally underwritten.

This is also the analysis a buyer's diligence team will run when your sponsor goes to sell. If the discounted cohorts never grew into list pricing, it shows up in underwhelming net revenue retention and in how much price the next owner believes they can take. I'd rather find that out three years before the data room opens than in the middle of diligence.

And remember… You can have all the discount approval policies in the world, but if your compensation plan makes it more attractive for a rep to give away another 10%, you should probably expect them to do it.

Wishing you a ramp to list on every multi-year deal,

CJ

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