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One of the cases my office is currently handling involves a commission agreement that requires the calculation of compensation as a percentage of profit.

The Problem

The agreement provided that the principal would pay my client one-third of the “profit” for the sale of remanufactured air conditioner compressors sold to two customers.

Several years earlier, my client had procured the two customers for another remanufacturer of air conditioner compressors. When that manufacturer went out of business, my client purchased the remanufacturing equipment and started his own remanufacturing business. He continued selling remanufactured air conditioner compressors to the two customers for approximately five years. He then decided to get out of the remanufacturing business and made an agreement with the new principal to move the business with the two customers to the new principal in exchange for a commission of one-third of the “profit.” The problem is that the parties never explicitly agreed on how “profit” would be calculated.

My sales representative client and the principal were able to agree upon the exact calculation of the commission for the first five years of the relationship. When sales were significantly increasing in the sixth year, however, the principal hired a new bookkeeper who recalculated the commissions. This resulted in the principal claiming that commissions were overpaid in excess of $140,000. The principal also unilaterally changed the commission calculation going forward and started paying commissions at a significantly reduced amount. The parties were unable to resolve the dispute and the lawsuit ensued.

The fact that the parties agreed upon a commission calculated on “profit” turned a relatively straightforward case into a very complicated one. Sales commission cases are usually very simple. The parties generally agree on a commission percentage to be applied to the net sales, so the only real issues are:

• What was the agreed-upon sales commission rate?
• What are the net sales to which the commission should be applied?
• Were commissions paid at the proper rate on all of the covered net sales?

An agreement to pay sales commissions based on “profit” creates some basic problems. First, there are several different types of “profit,” each of which is calculated in a different manner: “net profit,” “gross profit,” “operating profit,” etc. Second, the principal has the ability dramatically reduce certain types of profit, regardless of the amount of sales procured through the sales representative’s efforts. For instance, the principal’s owners could take increased compensation or bonuses to reduce “net profit.” And third, the calculation of any type of “profit” usually involves additional accounting with regard to various expenses and other items to which the sales representative generally does not have access. Even if all of the necessary information is available, the sales representative may need to hire an accountant to perform the necessary calculations.

If there is a legal dispute, both parties will also likely need to hire expert witnesses to calculate the commissions due to the sales representative. An accountant will likely need to review tax returns, financial statements, and other documents as part of the process of verifying the commission amounts. This increases the costs for the sales rep exponentially. If the sales rep is paid on a percentage of sales, however, the commission due is a simple mathematical calculation: sales dollars times commission rate. No need to hire an accountant or an expert witness to calculate that.

In our current case, the principal increased the owners’ compensation by more than $400,000 annually and had many questionable deductions for reimbursement of expenses to the owners. Further, the tax returns showed almost no net profit. This was partly because an unreasonable amount of money was paid to the owners in compensation and reimbursement for questionable expenses.

This case is still pending, and a settlement will be difficult because the parties are so far apart. This is one of the worst possible kinds of cases to be tried before a jury. The jury will be totally lost trying to understand the commission calculations of both the sales rep and the principal. We may end up arbitrating the case, which significantly increases the costs. Arbitrator’s fees are generally $500 per hour or more. The costs for a jury trial are significantly lower because the judges and jurors are paid by the taxpayers.

The Solution

There is an easy fix to prevent this problem. As a general rule, never agree to be paid on profit or margin! One reason to use in arguing against calculating commissions based on profit is that the sales representative has no control over the manufacturing process and most other factors affecting profit. Plus, the principal, not the sales rep, typically sets the price.

There are times when a commission based on profit or margin may make sense. One instance is if the sales representative is soliciting orders for the sale of a commodity (such as gas, oil, paint, etc.) and the principal is buying the commodity and then re-selling it at a markup. Getting paid a commission based on the difference between the cost of purchasing the commodity and the selling price to the customer can make sense in that situation.

Also, as Charley Cohon, MANA’s president and CEO, has pointed out to me, some sales representatives have bonus commission arrangements with their principals referred to as “split the overage.” For example, if the factory quotes $100,000 with a 10 percent commission and the sales rep is able to get the order for $150,000, the sales rep gets $10,000 for the $100,000 plus half of the $50,000 overage for a total commission of $35,000. It is a good idea to keep this option in mind for the right situation.

Conclusion/Moral of the Story

As I have stated in previous articles, a primary emphasis of my law practice is to educate sales representatives so they can negotiate their own sales representation agreements. In the present case, if my client had contacted me when he was in the process of making the commission agreement, we could have prevented the problem that generated the lawsuit. It is almost always better for a sales rep to spend some money on competent legal advice at the time the sales representation agreement is negotiated to make sure that the agreement makes practical sense.

A good resource for sales representatives is the book I wrote and self-published about 20 years ago, Protecting Your Commissions — A Sales Representative’s Guide. Feel free to contact me by email if you would like a copy of my book or any of the articles mentioned above. I would be happy to send them to you at no charge. My email address is [email protected].

Knowledge is power. The more you know about the terms and conditions that should be in your sales representation agreement, and the reasons for them, the better you will be able to perform your job. It is also a very good idea to meet with a lawyer who knows your business and is experienced in negotiating and litigating sales commission disputes prior to negotiating the sales rep agreement and to have the attorney review any written contract before it is signed. A good place to start is the MANA list of qualified attorneys.

MANA welcomes your comments on this article. Write to us at [email protected].