Companies often end up in situations where they have to recover the payment, assets, benefits, etc. they had provided to their employees due to fraudulent actions, breach of contract, or when the employee was given a performance-based incentive but failed to meet the required standards later on.
Clawback provisions are contractual and usually non-negotiable, as long as the company can justifiably prove that the employee satisfies clawback conditions. They are widely used in financial firms to mitigate insider trading, manipulation of financial statements, etc. but are also used in sales to recover underserved sales commissions.
In this guide to clawbacks, we'll understand how clawbacks work in sales along with their types and a few illustrations to provide more context.
What is a Clawback?
A clawback is a provision in any employer's contract with their employee that allows the employer to recover payments, assets, or other benefits that have already been disbursed to the employee.
In sales, clawback policies are made to recover all or part of the sales commissions from a salesperson when they meet certain pre-defined conditions stated in the employment contract. For example, if a customer cancels a contract within 2 months after closure, the company can recover commissions from the salesperson who closed the deal according to the clawback clause in their contract.
A clawback clause ensures that salespersons cannot resort to fraudulent means to close deals and earn commissions, and the conditions for a clawback are designed in a way that any deal that does not bring actual benefit to the company leads to a clawback. Some of these conditions are:
When the customer fails to complete payment, but commission has already been disbursed to the salesperson.
When the customer terminates their contract in a short duration after onboarding.
If contract terms are renegotiated, resulting in a lower value than what the commission was based on.
Fraudulent activities by salespersons to close more deals and earn more commissions.
Thus, clawback rules ensure fair corporate governance and prevent the company from incurring losses on deals that fell through. So much so, that according to SEC Clawback Rules, all NYSE and Nasdaq listed companies were required to have board-approved clawback policies in place by December 1, 2023.
Types of Sales Clawback (With Illustrations)
To understand the different methods of a sales commission clawback, let's take an example scenario.
Salesperson Name: Michael
Quota for Period 1 (Jan-Feb-Mar): $150,000
Quota for Period 2 (Apr-May-Jun): $250,000
Commission Rate up to Quota: 6%
Commission Rate Above Quota: 9%
Clawback Clause: Contract cancellation by customer within 6 months.
Here is the info of deals closed and commissions earned by Michael.
Michael's Sales in Period 1
Michael's Sales in Period 2
Method #1: Direct Commission Clawback (Commission Only Clawback)
Suppose Deal A ($50,000), closed in January, is cancelled by the customer in April (3 Months). As the clawback clause states that if the deal is cancelled within 6 months of closure, the commissions will be recovered, Deal A's commissions are subject to being recovered. Hence, Michael will have to pay back the $3000 commission he received for closing Deal A in the subsequent period when the customer actually leaves.
Alternatively, if Deal C had churned instead, the commission recovered would be $5400 since Kelly is also earning accelerated commissions on Deal C.
This method is the most straightforward for both the sales reps and the administration. It does not affect quota amount at all.
Method #2: Negative Quota Credit
This method treats the churned deal as a 'negative deal' and applies a negative quota credit to the current period in which the deal has been cancelled. It benefits companies as it essentially increases the quota for the current period. It is beneficial for companies using tiered sales commissions.
Suppose Deal A is cancelled by the customer in June (within 6 months). The deal amount ($50,000) is applied as a negative credit in Period 2, which brings down attainment. This negative amount essentially increases the quota for Michael to $300,000 instead of $250,000 because of the negative quota credit.
This method creates clearer commission reports and is easier to implement in automated systems.
However, there is a clear drawback, Salespersons may be incentivized to push or delay their deals to future periods knowing that their quota for the current period has been increased due to clawback. Hence, they will try to stall the deal in order to earn more commissions in the future, when the quota is normal and they can exceed it normally to earn accelerated commissions.
Method #3: Retroactive Negative Quota Credit
This method applies a negative quota credit to the previous period in which the deal was closed. It overcomes the main drawback of Method #2, as the quota for the current period remains unaffected. It reduces the quota for the previous period, which removes over-attainment. Then, the difference between the commission paid in the previous period and the commission that is actually earned (reducing clawback) is deducted from the current period's payout.
Delta= Commission Paid For Period 1 - Commission Actually Earned in that Period
= $11700-$7800 = $3900
Now this difference will be subtracted from current period's payout without affecting current quota.
Benefits of Sales Clawback Provisions
There are many benefits to companies when using clawbacks. Some of these are:
Financial Security: Sales commissions are given to sales reps to motivate them to generate more revenue, as they receive a cut of the revenue in the form of commissions. However, if the company does not end up generating revenue from a deal because of early termination by the customer, failure of payment by the customer, etc., then the commission paid out on the deal is causing a loss. Hence, it is recovered through commission clawbacks.
Legal Security: In the rare event of a sales rep engaging in fraudulent activities to close more deals and earn more commission by using shady methods (fake deals, providing wrong information to customers, etc.), the company can simply take back commission through clawback, hence, it provides legal protection against fraudulent activities. Although this is rare, it acts as a strong deterrent for sales reps against fraudulent activities since they know commissions earned in unjustified ways will have to be repaid through commission clawbacks.
Improved Customer Quality: Clawback provisions push the sales teams to focus more on customer quality and retention. Early termination by customers is the biggest trigger for sales commission clawbacks. Hence, sales reps are driven to focus on more comprehensive onboarding support and ensuring that customer quality is high and the chances for churning early are as low as possible.
Improved Accountability: Commission clawback clauses make sales reps more accountable for customer experiences and quality of revenue. They ensure that sales reps do not run after commissions blindly, causing misconduct, but ensure high standards of deal quality. It also encourages them to help customers understand their offering better, give onboarding support, and maintain smooth communication with customers. This fosters a culture of 'owning' each deal sales reps bring forward, and ensuring smooth operations afterwards.
Disadvantages of Clawback Provisions
Even though they serve as protection measures for companies, commission clawbacks also have potential ramifications if not handled properly. Here are the most common problems companies face when implementing sales commission clawbacks:
Employee Dissatisfaction and Demotivation: Unclear or cloudy clawback policies may make sales reps feel that there is always a sword hanging at their neck, and their commissions can be taken back whenever the company wants, which can create demotivation and negatively affect sales performance. Clawbacks can also discourage innovation in sales and deter sales reps from trying out new methods in fear of the commissions being recovered later on.
Perceived Lack of Trust and Harm to Organizational Culture: Sales clawback policies and the entire administrative process around them is often opaque and unexpected for sales reps. This creates a rift between sales administration and the sales reps who think that their commissions are always at risk. This builds up negativity and harms the organizational culture.
Administrative Complexity: Accounting and monitoring customer journeys and commission cycles to manage sales commission clawbacks proves to be extremely complex work for sales operations and finance teams. Different clawback methods may add multiple hours to the commission cycles, leading to delayed commissions and frustration.
These disadvantages of commission recoveries can be mitigated by making sure the clawback schemes are transparent and visible. Doing this is much more effective with the use of sales compensation software that can handle clawbacks, such as Visdum.
Best Practices For Creating a Clawback Provision
Despite their perceived demerits, clawbacks are an important protective measure for companies. It's the implementation that requires some extra effort, and it can lead to wonderful outcomes for both reps and the administration.
Here are the best practices for creating and implementing commission clawback:
Fairness amongst all reps: Companies should ensure that the entire sales team and all sales reps in it are subject to the same triggers and conditions for clawback of sales commissions. Unfair or selective conditions may display bias and cause negativity.
Clear triggers and few conditions: Companies should ensure that there are not too many clawbacks and also limit and clearly define situations where clawback will occur. For example, a sales rep's commission can be recovered in the case of fraudulent activities, cancellation of a deal, or a change in order value. Then, each of these cases should be sub-defined. For example, it should be clear what constitutes a 'fraudulent activity' such as tampering of financial statements, lying to the customer, etc.
Clearly communicate clawback scheme to sales team: The sales operations and finance teams should ensure that all sales reps are aware of clawback terms and any new clawback rules in advance. Routine sessions going over these topics should be conducted to keep everyone in the loop. The sales reps should be communicated the legal responsibilities, goals, and process of the clawback scheme.
Automate the clawback process: Manually handling commissions for a team of sales reps is complex and time-consuming, and introducing clawback just multiplies this complexity. This can lead to a severe lack of understanding of the commission calculations and deductions on the salesperson's part. Automating this entire process saves many hours for operations and finance teams, and keeps the reps up to date on each commission calculation.
Wrapping Up
Even though clawbacks prevent undeserved commissions, they may also lead to dissatisfaction and mistrust among the sales reps if not handled properly. Therefore, clawbacks should be extremely clear and fair in their implementation. Any lack of visibility on the sales reps' part may lead to frustration, lower sales performance, and lower employee retention in the long run. The negative effects of clawbacks and complicated commission structures can be mitigated by using sales compensation software like Visdum.
Visdum automates sales commission management and ensures that reps have complete visibility into their commission paychecks, including any clawbacks. Visdum's dashboards ensure complete visibility into each deal for different hierarchical levels. It also prevents any commission calculation errors or disputes, leading to a collaborative and positive sales environment.
FAQs
What is the clawback clause for sales commission?
A clawback clause for sales commissions refers to a legal clause in the sales commission agreement of a salesperson that states that their employer or organization can recover or take back commissions for a deal (wholly or partly) in the instance of certain triggers also mentioned in this clause- usually the early termination of contracts or fraudulent activities.
What is the difference between a refund and a clawback?
The main difference between a refund and a clawback is that clawbacks represent a penalty- They aim to ensure that salespeople consider customer retention and quality as top priorities and do not indulge in fraudulent ways of closing deals. Refunds, on the other hand, are simpler and are returns of money to customers for their purchases in case of grievances.
What does clawback mean in sales?
A clawback refers to the case of the company having to take back a part of or the whole commission paid out to a salesperson for closing a deal because of certain clawback triggers being met. These triggers can be early termination by the customer, failure of payment by the customer, fraudulent activities, etc.
What is an example of a clawback?
Suppose a salesperson closes a deal worth $50,000 on which he gets a 3% commission ($1500). However, the customer cancels the contract within 1 month, but the company has a clawback provision that states that if contracts are canceled within 3 months, then the commission paid out for it is to be recovered. Then, the salesperson who closed this deal has to return the $1500 commission they had received. This is how clawback works.
Are clawbacks enforceable?
Yes, any clawback terms mentioned in an employee's contract are legally enforceable by the employer. However, the applicability has to be fair, clear triggers and conditions must be defined and known beforehand, and a legal team must oversee jurisdictional and legal provisions for applicability on a regular basis.
How far back can clawbacks go?
Sales Clawbacks usually go back only a few months at most, since they are centered around customer retention. However, clawbacks are also used extensively in corporate finance, and can go back a few years if mentioned accordingly in the contract terms, but they cannot go back significantly in time to protect employees from unjustified clawbacks.
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