If you’ve ever reviewed a sales rep’s commission agreement, you’ve likely encountered a “clawback.”
A sales commission clawback is a provision (or clause) in a contract that allows a company to recover commissions (or other compensation paid to a salesperson) under certain circumstances.
Why do they exist? Typically, to protect the company from financial losses if the salesperson's actions (or the resulting sales) are fraudulent, illegal, or not in compliance with company policies. Clawbacks are most common in highly-regulated industries (think: finance, healthcare, etc.) where compliance violations can result in significant financial hits.
Commission clawback provisions typically require that a salesperson return all or part of their commission if certain conditions are not met — below are some examples:
- If a customer cancels an order
- If a customer returns a product
- If a customer fails to pay an invoice for a product or service
- If a customer churns within a specific window of time
In some cases, commission clawback clauses are also implemented to adjust for deals with margins below target — or even if the salesperson does not meet specific targets or violates company policies. It’s also worth noting that clawback clauses aren’t limited to commission payments. They can also be used to recover bonuses or other performance-based compensation.
Naturally, you might have some questions:
- What’s the most common commission payment frequency?
- How are negative commission balances factored into compensation plans?
- Are clawbacks good or bad?
- Should you include commission clawback clauses in your reps’ contracts?
- What are clawback best practices?
- What are some example scenarios?
Sit back and get ready — we’ll answer these questions (and maybe a few more) in this article.
What triggers sales reps to get paid commissions?
At first glance, you'd assume that most companies pay their sales reps upon customer contract close — and in looking at a sample of our customer base, this holds true.* We found that 76% of our customers pay their commissionable employees upon contract close.
The second most common payment frequency model is at delivery (26%), and the third most common is when the customer pays (10%). Interestingly, organizations that require customer payment before “releasing” some or all commissions to their employees are less likely to have clawbacks (more on this in the next section!).
*This finding is based on a small sample of our customer data and might be skewed toward the technology industry. We expect these results to shift as we broaden the data sample. Additionally, percentage totals may not equal 100% due to plans having multiple payout triggers (e.g., a sales plan that pays 50% when the deal closes and the remaining 50% when the customer pays.)
How are negative commission balances applied to compensation plans?
Clawbacks vary widely from company to company and plan to plan. According to a sample of our customer data, here are the four most common systematic approaches that we observe:
- Reducing quota credit the following period (35%): This approach is popular because it can be effective in certain contexts, such as when high-volume sales plans are in place and the “negative quota” evens out over time, and also, when the approach is relatively easy to implement.
- Recalculating the prior commission and true up (32%): Recalculating commissions after taking into account the net of the clawback tends to be a better fit for longer sales cycles or larger sale amounts, where a negative quota credit in the current period can have a demotivating impact. For example, a large clawback could ruin the current period and motivate the rep to slow other current-period sales into the next period to maximize the opportunity for above-quota multipliers.
- Clawing back the specific amount paid on the deal (27%): Sales organizations may claw back the particular amount paid on a deal for several reasons. For example, if the organization discovers that a transaction was fraudulent or made under false pretenses — such as a salesperson misrepresents the product or service being sold — it may attempt to recoup any payments made as a result of that sale. Another reason is to encourage salespeople to focus on building long-term customer relationships and customer satisfaction — e.g., if a customer cancels their contract shortly after closing, the organization may claw back some or all of the commission paid to the salesperson who closed the deal.
- Using management discretion (13%): This flexible approach allows the organization to consider each situation individually, considering the specifics involved. This can be especially useful when there isn't a clear-cut policy or contract clause that addresses the issue at hand — e.g., if a rep makes a sale but then engages in unethical behavior or behavior that damages the company's reputation, management may choose to withhold some or all of their commission payments as punishment.
As you can see, clawbacks differ depending on the company, plan, and context of the situation. So, naturally, they’ve been the subject of much debate, with many questioning if they are a beneficial incentive for employees or simply an old-fashioned practice that is no longer necessary in today’s workforce.
On one side of the argument, there are those who believe that clawbacks act as a motivator for performance because they create a monetary reward if performance goals are met while keeping employees accountable.
On the other side, some argue that clawbacks may lead to too much focus on short-term profitability and put too much emphasis on what can be gained rather than what needs to be achieved over time.
Depending on an individual’s viewpoint, clawbacks can be seen as a useful tool for companies and their employees or as a mechanism of distrust. Let’s dig into this some more.
The argument for clawback clauses
Clawbacks can be an important protection for companies. Sure, salespeople need incentives and rewards, but paying out commissions on contracts that fail to convert to revenue or cash collected is not the winning model for a sustainable business. Clawbacks provide a level of protection for businesses.
Clawbacks also incentivize sales reps to follow through with their customers and take ownership through onboarding — ultimately supporting company objectives related to customer retention and engagement.
This is especially useful for subscription companies.
For example, let’s say a company has instituted a four-month clawback clause. If a customer cancels their subscription plan within four months of the sign-up date, the sales rep must return some or all of their commission payment. This encourages sales reps to ensure customers are satisfied with their purchase and shift their focus to customers who they believe will derive long-term value from the products or services being sold. Also, this clawback mitigates the potential of reps signing up less qualified or “poor fit” customers.
“Clawing back” commission payments? Become familiar with the breakdown of the commission payment model. Are you paying 80% at booking and 20% at invoice date? Are you invoicing during the onboarding stage or earlier in the customer lifecycle? Is there a threshold (say, $50,000) for clawbacks on customer non-payments?
Lots to consider. We’ll cover more in-depth scenarios later on!
The argument against clawback clauses
A clawback clause can be detrimental to a business in two significant ways:
- Shifting a sales rep’s focus away from deal flow and towards “shadow accounting” to accurately predict total income.
- Causing additional stress (and chaos) on financial statements and the accounting team.
From an accounting standpoint, companies must capitalize commissions and have an accrual model for commissions when an expense is booked. Read our overview of ASC 606 and what this accounting standard means for your business.
If a commission can be retroactively changed, thus impacting past accruals made, there is a possibility that a public company would have to restate earnings reports. Furthermore, financial projection models are less useful and accurate when a significant input variable (such as commission expense) can be dramatically altered.
Finally, clawbacks tied to commissions on unpaid/delayed invoices can be a huge demotivator for sales reps — 100% out of their control!
Commission clawback best practices
You’ve weighed the pros and cons and decided clawbacks make sense for your industry, organization, and sales team.
Keep the following points in mind:
- In most cases, sales clawbacks are legal. However, the legality of a clawback depends on several factors, including contract terms and applicable laws and regulations. Ensure there are no employment laws in your state that would prevent clawbacks from being implemented — for example, some state laws prohibit an employer from withholding commissions from a paycheck. Lawsuits can be very costly. See the infamous $150M Oracle case.
- Take the necessary steps to clearly define and communicate the clawback clause to new employees. Each salesperson on your team should be aware of the possibility of a clawback and what circumstances may trigger it.
- Similarly, employers and employees should both understand their rights and responsibilities under employment laws, commission agreements, and other workplace policies.
- A clawback provision must be reasonable in scope and duration. It must not be so extensive as to undermine the fundamental purpose of the compensation plan.
- Consider one of the three sales commissions clawback methods (explained below).
Examples of sales commission clawbacks
Quotas: Let’s say Kelly is commissioned on the annual recurring revenue (ARR) of closed won deals within a quota period. In Periods 1 and 2, the Quota is $150,000 and $300,000, respectively. A base commission rate of 10% is paid on deal ARR through the attainment of period quota (Tier 1), and a 20% rate is paid for ARR amounts above the period quota (Tier 2).
Commission and Clawback Rules: Commissions are paid on bookings but are subject to a clawback for customer non-payment.
The following deals are closed in Periods 1 and 2. At the end of Period 2, the company determines that Deal A will not pay, thus triggering the clawback due to customer non-payment.
With that scenario in mind, let’s look at three different clawback methods.
Clawback Method #1: Exact Payout Amount
This method is the most common, thanks to its operational simplicity and intuitive nature for sales teams to follow.
Kelly earned a $5,000 commission for a sale that was not fulfilled, so she must then return the $5,000.
This method creates a relationship between deal order and the clawback amount. As Kelly moves through attainment tiers during the quota period, the clawback amount is artificially tied to when in the period the deal closed.
For example, since Deal A is entirely within Tier 1, then the clawback amount is 10% of the deal ARR. However, in the same period, Kelly earns accelerated commissions due to being above quota.
Alternatively, if Deal C were the deal that was clawed back, then the clawback amount would be $15,000 (20% of the deal ARR). Kelly’s payout at the end of Period 2 would be $16,000.
Why we like Method #1: Most intuitive and straightforward for both employer and sales rep.
Clawback Method #2: Negative Quota Credit to Current Period
Method #2 protects the company from over-attainment by applying the clawback as a reduction of quota credit. The clawback is treated as a negative deal amount ... as if it were a sale made with a negative revenue amount.
In the chart below, Deal A (Clawback) is added as a negative amount to the attainment in Period 2.
This method is operationally straightforward to automate in a calculation spreadsheet or system as most CRMs can provide debookings records in the exact negative amount as the original deal.
This negative deal amount can be referenced and considered in the current period’s commission calculation. Additionally, there is no need to reference historical payout periods, as you would in Method #1 (or in Method #3, described next).
A potentially negative impact is incentivizing the wrong behavior — motivating sales reps to defer deals to later periods if the attainment of Tier 2 commissions seems out of reach in Period 2.
How this could play out: Kelly anticipates Deal A to turnover in Period 2. This means Deal A effectively creates a period quota of $350,000 in closed ARR in order for Tier 2 commission rate attainment to be achieved. If Kelly thinks this is not attainable during Period 2, she will be incentivized to defer deals into Period 3. Both larger size and lower count of period deals contribute to this potential disincentive.
Given the operational simplicity of this method, it can be beneficial where there is high deal volume that can limit any disincentives to deal performance.
Why we like Method #2: The need to match records to ensure the correct cancellation date is no longer necessary — simply add a new entry with a negative sale. Additionally, this method creates clearer commission statements.
Clawback Method #3: Negative Quota Credit to Past Period
Method #3 balances fairness to the company and the salesperson by reducing quota attainment due to the clawback. However, unlike Method #2, this one applies the clawback to the original period of the deal.
The adjustment to the quota attainment made in the preceding period reduces the over-attainment in Period 1 yet still protects the salesperson against the negative incentive of a negative quota event in the current period.
Operationally, it is very complicated for a spreadsheet to retroactively re-calculation sales commissions each time there is a clawback. Moreover, further complexities arise from using this approach when a company is capitalizing its costs in compliance with ASC 606 due to the needed care it takes to ensure that clawbacks limit their impact on deal amounts previously recorded.
Why we like Method #3: All the benefits of Method #2 without incentivizing the wrong behavior (deferring sales to future periods).
To have or not to have commission clawbacks: The choice — and method — is yours.
As our favorite economists say, “incentives matter.”
Each industry, company, and team will be unique. Consider the behavior you want to incentivize and use that as the key criterion.
Also, consider the realistic limitations the accounting team may face when given your organization's sales commission calculation tools.
Ready to learn about a popular alternative to the Immediate Payment and Clawback approach? The hold-and-release approach lets sales reps receive their commissions immediately while protecting cash flow.
Schedule a custom demo with our team to learn how CaptivateIQ can automatically track sales clawbacks and commissions.