The Magic Number for SaaS

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Way back in 2008 Lars Leckie published a seminal piece on SaaS metrics titled Magic Number for SaaS Companies. From the piece, here are the stages of evolution of the company:

Product: build a rock solid product. Prove you can sell it as founders before moving past this step.
Sell: Sell like crazy, build out a team, hire some QBSRs (Quota Bearing Sales Reps)
Retention: focus on churn and retention issues, hire more QBSRs
Marketing: spend on marketing, hire more QBSRs

Then, on to the magic number. The magic number is a ratio of the scaling of recurring revenue to the sales and marketing spend. Here’s the formula:

(Quarterly Revenue – Previous Quarter Revenue)*4 / (Previous Quarter Total Sales and Marketing Expense)

So, take the growth in revenue between the quarters, annualize it by multiplying by four, then divide by the total of all sales and marketing expenses. If this number is greater than 1, things are going well and more should be spent on sales and marketing. If this number is less than 1, the cost of customer acquisition relative to the value of the customer is too high and the focus should be on making sales and marketing for effective.

Scaling a SaaS startup is expensive. Use the SaaS Magic Number to understand how efficiently the business is growing based on relative growth to customer acquisition costs.

What else? What are some more thoughts on the SaaS Magic Number?

Comments

14 responses to “The Magic Number for SaaS”

October 13, 2016

Brian Marshal

Hi David,

I have been following your blog and I love it. Anyway, as for this blog post, I believe the following statement should exactly be the opposite. Bigger number means better (in terms of sales and marketing effectiveness). Greetings from Jakarta.

*”If this number is less than 1, things are going well and more should be spent on sales and marketing. If this number is greater than 1, the cost of customer acquisition relative to the value of the customer is too high and the focus should be on making sales and marketing for effective.”*

Reply
1. October 14, 2016
  
  David Cummings
  
  Thanks! Good catch about the numbers being reversed. I just fixed it.
  
  Reply
October 14, 2016

Peter-Jan Celis

Your less than 1 / greater than 1 conditions should be the other way around.

Interesting how you focus on selling before retention. In my opinion without amazingly low (or negative) churn you haven’t passed step 1.

Reply
October 14, 2016

Adam Shepherd

Don’t you mean
this number is *MORE* than 1, things are going well and more should be spent on sales and marketing. If this number is *LESS* than 1, the cost of customer acquisition relative to the value of the customer is too high and the focus should be on making sales and marketing for effective.
??

Reply
1. October 14, 2016
  
  David Cummings
  
  Good catch about the numbers being reversed. I just fixed it.
  
  Reply
October 14, 2016

Lucas Prim

Hey David,

I think you made a little mistake on the numbers: If the number is below 1 you should look back at your company and if the number is greater than one everything is working since you’re generating more revenue for every dollar spent on S&M.

Best Regards,

Reply
1. October 14, 2016
  
  David Cummings
  
  Good catch about the numbers being reversed. I just fixed it.
  
  Reply
October 14, 2016

Ariel Perez

Hey David,

Great metric! I think however, the interpretation of the magic number is backwards!

If the number is less than 1, doesn’t it mean we’re generating too little revenue for our marketing/sales spend?

Thanks,
Ariel

Reply
1. October 14, 2016
  
  David Cummings
  
  Thanks! Good catch about the numbers being reversed. I just fixed it.
  
  Reply
November 2, 2016

Ivo

What I don’t understand about the Magic Number is the factor 4. You write it’s to annualize the revenue growth but why is then the sales & marketing spend not annualized? It seems to me that the Magic Number is comparing apples and oranges. Am I missing something?

Reply
1. November 2, 2016
  
  David Cummings
  
  The 4 is in there to annualize it since it’s based on quarters and there are four quarters in a year.
  
  Reply
  1. January 18, 2017
    
    Ivo
    
    I understand the idea of annualizing the revenue growth in the nominator, but why do we compare it to the non-annualized S&M spend in the denominator?
2. November 2, 2016
  
  Adam
  
  I think the idea is that you’ve spent the sales and marketing dollars just once to acquire the customer, but for a SaaS business, the revenue is assumed to be recurring (say an annual contract) so you count that four times
  
  Reply
3. January 26, 2017
  
  Ivo
  
  I think I now understand what confused me: The factor 4 makes sense if your subscription renews monthly (or quarterly). The newly acquired revenue will thus contribute to next quarter’s revenue again.
  
  My presumption was that the subscription renews yearly and fully counts towards the revenue of the quarter when it renews. In this case, the gain in revenue is already annualized.
  
  So more generally, the magic number is the gain in ARR within a period divided by the S&M expense spent to achieve it within that same period.
  
  Reply