Finance

Why Companies Need to be Following a Revenue-Based Hiring Model

Why Companies Need to be Following a Revenue-Based Hiring Model

Why Companies Need to be Following a Revenue-Based Hiring Model

In recent years, many leaders have taken a ‘grow at all costs approach’ and really, why not? The cost of capital was cheap, venture firms and banks were dolling out capital and all eyes were focused on growth and not profitability.  With this large influx of capital, management teams were focused on growing and the best way to do that was by hiring. They would raise capital, then subsequently over-hire to try to hit their aggressive targets. Now when times are good, that approach can work, but the cracks begin to appear when the economy turns with the tide shifting when interest rates rise and investment pipelines dry-up. This forces companies to quickly shift their mindset from growth to runway and profitability, which, in turn means that they start looking closely at their expenses.

This expense analysis generally starts with with finance teams taking a quick look at ancillary costs, and  quickly cutting the non-necessities. Once that is done, leaders are forced to analyze their biggest expense – headcount. Chances are, the companies who focused the most on growth without looking closely at their unit economics are the ones who are at the most risk of conducting layoffs, which puts them in a difficult position.

Layoffs can be bad for business in many ways:

  1. Your company and leaderships reputation is at stake as it can show a lack of judgment
  2. You lose trust and confidence from previous and remaining workforce
  3. Expectations and stress put on remaining employees increase as they inherit the responsibilities of their former colleagues

It should be every company’s responsibility and almost mandate to put their employees in positions to succeed in their roles and careers, and business leaders need to incorporate this responsibility into their business planning processes to prevent layoffs. One way to do this is by implementing disciplined metrics to guide their growth.  An example of one of these key indicator is by following a revenue-based hiring model which is a simple, yet effective way to grow to grow responsibly.

What Is Revenue Based Hiring?

There are four important metrics leaders need to know when implementing a basic revenue-based hiring model:

  1. Capacity per head
  2. Initial headcount
  3. Initial revenue
  4. Revenue growth

Capacity per head is the ratio obtained by dividing revenue by the number of employees in the business. This metric serves as an important benchmark against industry comparable, as well as a general gauge of efficiency. It is also a measure of a company’s “scalability” – if the business is scalable, this figure will increase with growth at a greater related rate than if the business does not scale. Capacity per head is a crucial input that can be stress-tested and sensitized.

Initial headcount should be calculated as full-time equivalent (FTE) employees at the company at the time of the analysis, with new hires discounted.

The figure for initial revenue requires a bit of subjective thought depending on the nature of the business. For a fast-growth company, it should generally be the annual run rate based on the past month or quarter. For businesses with a seasonal revenue cadence, it can be the last twelve months or a seasonally adjusted ARR of the last month or quarter (though this latter approach is bringing in more assumptions which reduces level of confidence. For companies that have very high visibility of future revenue, it can be the forecast annual revenue.

Growth rates should determine hiring cadence more than anything else, so the most attention must be paid to it. In most cases, it is helpful to sensitize the projected growth rate to see the suggested hiring trajectory between optimistic and pessimistic scenarios. Referring to the historic growth trend is generally the best guide, but respective business leaders  how to best handicap this growth rate depending on all of the countless factors affecting the business when the study is being affected.

Why a Revenue-Based Hiring Model Should Be Adopted

Whether you’re a fast-growing tech company or a multinational, revenue-based hiring can potentially be a responsible way for you to grow and operate. Tying all these elements together give a clear future path for how many people the firm should hire and when. If the model is suggesting that revenue per employee is getting above the historical average for the company, this could mean that efficiencies are improving and that the company is faring well against the competition, however it could also mean that a company has insufficient headcount. When considering the converse, having an idea of how many people should be hired will caution against hiring too many people too rapidly.

The ease of putting the analysis together means that it can be readily updated as circumstances change. The revenue-based hiring model should be actively giving management a clear message of how many people should be hired and when. It should also serve as a valuable justification for management teams looking to right-size the organization chart, providing easy-to-read charts and metrics for boards and investors to follow. With capital becoming scarcer, management teams need to be more convincing in how they are allocating capital and revenue-based hiring can serve as a useful arrow in the quiver.

Using a Revenue-Based Hiring Model

As you look to incorporate your own revenue-based hiring model, we’ve created our own to help guide you. By setting revenue growth and capacity per head metrics, you’ll be able to get a good idea of how many hires you need to make over the coming years

Free revenue based hiring model, powered by Causal

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Building on Your Revenue Based Hiring Model

Revenue-based hiring and the relatively simple calculation useful, but it can also serve as a building block for more sophisticated analysis.

  1. Cost of Capital: Layering in the company’s cost of capital can help to better indicate if the company is able to invest in its human resources. A company with a comparatively lower cost of capital can afford to hire more people and enjoy a longer timeframe to realize the expected revenue associated with the incremental personnel. Whereas a company with a higher cost of capital should generate the revenue from new hires sooner.
  2. Gross Profit: Using the company’s gross profits per employee instead of the revenue per employee is a different way of looking at incremental hires and depending on the business it could be a more useful metric. With the turn in the capital markets cycle and investors generally focusing more on profits than the top-line, using gross profits as the numerator in the formula likely makes sense. Even EBITDA ex-salaries is a metric to consider. Each management team will have to decide how to best apply the formula to suit their specific needs, and the needs of their boards.
  3. Sales and Marketing: Another approach is to split the metric between the sales and marketing team and the rest of the organization, using the same revenue figure for the numerator but two different denominators – effectively creating two revenue per employee metrics that can be examined and tracked in tandem. The revenue per sales employee will be a very clear indicator of sales team productivity while the rest of the business can be compared against a lower yet reasonable amount.

Limitations of Revenue Based Hiring

Revenue-based hiring is not meant to be a rule of law and is not designed to replace deft management. It is a yardstick to get an idea of balance between revenues and hiring, in order to raise some questions and provide a bit of analytical rigor. Chances are leaders will have to change their assumptions on capacity per head but overall, it is really useful to understand the revenue per employee to benchmark your growth and efficiency, as well as how you are doing compared to your competition.

In good times and bad, management teams need to stay disciplined and rules based to ensure long term viability of the business. Using a Revenue-Based Hiring Framework either on its own or as a building block for more nuanced analysis can be a very useful tool to help them do that. It not only helps to understand the hiring needs of the company and benchmark against competition but also serves as a living metric that can be tracked on an ongoing basis and reported to the board or investors. It can help to prevent undue risk and avoid the mistake of over-hiring.

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