As the popularity of Software as a Service has grown, so has the discussion around which are the best metrics and KPIs to judge the growth and performance for SaaS business models, which are based not on monthly or yearly sales, as was the case in the on-premise software world, but on recurring subscription revenue.
Teams I’ve been part of have played around with a bunch of different ways of measuring success. We looked at like CAC, customer acquisition cost. We looked at LTV, lifetime value of customer. We looked at churn. We still look at those things, but I consider those metrics rather than KPIs, because they change frequently.
They’re certainly interesting, but you can’t see the impact of any long-term strategy in them.
There is no one size fits all answer as to what you should measure, the SaaS magic number indispensable for just about any SaaS business. The only question is exactly what should go into the formula at your company, but once you have that agreed upon, the number it outputs is one of the key indicators of the health of the business.
Discovering the magic
I first came across the magic number in a 2008 blog post by Lars Leckie. He was discussing some of challenges of properly attributing sales and marketing costs when you’re only looking at metrics such as CAC, LTV, and MRR and ARR, monthly and annual recurring revenue, respectively.
The central challenge is that these metrics lead you to focus too much on new business and not enough on leveraging your installed base. If you’re doing SaaS right, your sales and marketing aren’t just spending time on acquiring new customers, but also on growing existing accounts and generating renewals. If your marketing people are churning out all sorts of great assets, how do you determine if those assets are used just for to acquire new customers, increase existing business, or a mix of both?
It’s extremely difficult, and it’s not an exercise worth spending time on. The magic number is the best way to figure out, in the aggregate, how your sales and marketing spending is impacting both your existing customers and your new customers, and your revenue.
Here’s the formula.
If you’re in Q3, you take your Q2 net revenue and deduct your Q1 net revenue to arrive at your quarterly revenue growth:
Q2 net revenue – Q1 net revenue = Q2 incremental growth
Then, you multiply that by 4 to arrive at your annualized growth rate, and divide that by your Q2 sales and marketing expense:
Q2 incremental growth x 4 / Q2 sales and marketing expense
Voila, the SaaS magic number.
What makes it so magic? If you just look at revenue and sales and marketing cost quarter over quarter, that doesn’t paint an accurate picture. If you’re like most SaaS companies, you’re typically selling 12-month agreements, followed, you hope, by renewal. You annualize the growth rate because that’s how long it takes to see that return in the form of a renewal. By performing this calculation quarterly and annualizing the current quarter delta, you get a rolling 12-month view of your ROI in sales and marketing.
Higher is better
The higher that ratio is, the better off you are. If it’s only one to one, it means for every dollar you spend in sales and marketing, you only get $1 in incremental net revenue on an annualized basis. That’s not so good.
A good place for it to be is between three and four. The highest I’ve seen a magic number was close to four. It could certainly be higher, but what ends up happening is, when you see that kind of growth, you reinvest. You push the money back into sales and marketing.
Sure, there are some things to iron out for your flavor of the formula, such as, how do you define sales and marketing? Does it include partner success, account management, and sales ops? But what I love about the magic number is that is a true key performance indicator, because it doesn’t change every day.
Magic x 3
It magic is threefold.
First, it shifts the focus from trying to untangle the expenses of sales and marketing. The reality is if your marketing team is building the right assets to be used by multiple teams in multiple stages of the process, shifting away from looking at CAC as your north star is really helpful.
Second, it gives you a longer-term perspective. Most SaaS businesses have 30, 60, or 90-day sales cycles, or even longer. The impact of changes to sales or marketing programs is rarely immediately apparent. The quarterly view allows you see the impact of the changes and the investments that you’re making.
Third, it takes customer churn into consideration, as well as the cross-sell and upsell opportunities, which often have their own cycle times.
A better bucket
It’s just a better way to bucket up everything that’s happening in your business. Then you can pull back that number and figure out why it’s going up or down. Is it because new customer growth is slowing? Was there an uptick in churn?
One challenge that I’ve seen across SaaS companies is a tendency to over emphasize acquiring endless amounts of new customers, often at the expense of harvesting the installed base to cross sell and upsell. That’s what happens when all you look at is CAC.
The magic number also captures the impact of your installed base and your efforts there, which is huge for subscription businesses. It’s razors and blades. You’ve got to always be selling blades. That’s usually where the margin is.