The SaaS Magic Number: A Guide to Calculation and Analysis

What is the SaaS Magic Number?

The SaaS Magic Number is a performance metric used to measure the efficiency of a Software as a Service (SaaS) company’s revenue growth relative to its sales and marketing expenses. It gives stakeholders like investors and company management insight into how effectively the business is investing in selling and marketing its products and/or its services. Basically, the magic number calculation helps answer the question of whether the company is increasing revenue relative to its sales and marketing efforts.

While there are different ways to calculate the SaaS Magic Number (discussed below), the basic idea is to divide a SaaS company’s revenue growth by its sales and marketing expense. This results in a ratio that measures sales efficiency. If the SaaS Magic Number is greater than 0.75, this indicates the company is relatively efficient in generating new revenue from its sales and marketing efforts.

While the magic number calculation could be used in other industries, it’s fairly specific to SaaS companies, which rely heavily on recurring revenue, relatively high gross margins, and significant customer acquisition costs (CAC).

Why is the SaaS Magic Number Important?

The SaaS Magic Number is useful for internal decision-makers as well as investors analyzing SaaS companies. Below are a few reasons why the magic number is important:

• Measures Sales and Growth Efficiency: The magic number metric shows how efficiently the company turns its marketing and sales investments into revenue. All else being equal, SaaS companies with high magic numbers are generally growing more efficiently, meaning they generate a higher return on each dollar spent on customer acquisition.
• Provides Operational Insights: Company management may use this metric to make decisions on whether to increase growth (by increasing spending) or re-evaluate spending if growth is disappointing. For example, a low SaaS Magic Number might signal that a company should refine its marketing and sales processes to avoid unsustainable or inefficient spending.
• Decision-Making Tool: The SaaS Magic Number can be used to guide strategic decisions, especially regarding the investment in sales and marketing. Companies with high magic numbers can reinvest more aggressively, while lower-performing companies might need to alter their sales efforts.
• Investor Analysis: Many analysts and investors use the SaaS Magic Number as a quick benchmark to assess potential SaaS investments. A SaaS Magic Number of over 0.75 usually indicates effective growth, potentially making the company more attractive to investors.

It should be noted that a high magic number does not necessarily mean a company is profitable, as there are many other expenses that have to be deducted before determining a company’s profitability. However, this metric does reveal the existing correlation between sales and marketing efforts, and revenues.

How to Calculate the SaaS Magic Number

Calculating the SaaS Magic Number is relatively straightforward. However, there are different methods for calculating revenue. Fundamentally, the magic number formula is:

SaaS Magic Number = (The Current Quarter’s Recurring Revenue Minus the Previous Quarter’s Recurring Revenue) * 4 ÷ Previous Quarter’s Sales and Marketing Expense

The numerator in the above equation (the difference between the current quarter’s recurring revenue and the previous quarter’s recurring revenue) is multiplied by four to annualize this metric (since there are four quarters in a year).

Note that the formula uses recurring revenue to calculate the SaaS Magic Number. However, companies may not disclose recurring revenue (ARR or MRR) since these are non-GAAP metrics (although they may be reported in earnings announcements or investor presentations like Adobe does below).

In the event that recurring revenue metrics are not reported, an analyst may then either consider total revenue or subscription revenue. As shown below, Salesforce reports subscription revenue and professional services revenue. In general, only subscription revenue is considered recurring.

If only the total revenue is disclosed, then analysts are limited to using these numbers when calculating the SaaS Magic Number.

A Step-by-Step Guide to Calculating the SaaS Magic Number

1. Determine the appropriate revenue metric for the current quarter. Ideally, this is the company’s recurring or subscription-based revenue, but total revenue can be used if necessary.
2. Find the corresponding revenue for the previous quarter.
3. Calculate the revenue growth by subtracting the previous quarter’s revenue from the current quarter’s revenue.
4. Annualize the revenue growth by multiplying the revenue growth by four.
5. Divide the annualized revenue by the previous quarter’s sales and marketing expense. We use the previous quarter’s expense since there is usually a lag between the expense and when the revenue is generated.
6. Bottom line: The SaaS Magic Number = (Current Quarter Revenue – Previous Quarter Revenue) * 4 ÷ Previous Quarter’s Sales and Marketing Expense.

Alternative SaaS Magic Number Formulas

Like many financial ratios or key performance indicators (KPIs), different companies and analysts may calculate the SaaS Magic Number slightly differently.

Alternative Calculation 1

SaaS Magic Number = Current Quarter Net ARR ÷ Previous Quarter’s Sales and Marketing Expense, with Net ARR defined as New ARR + Expansion ARR – Contraction ARR – Churned ARR

Alternative Calculation 2

SaaS Magic Number = 1 ÷ CAC Payback Period

Note that the CAC payback period uses gross margin in its calculation, while the magic number does not. By including the gross margin, the CAC payback period factors in direct costs to providing the service or subscription. Most analysts do not factor gross margin into their magic number calculations since gross margin can be volatile and different SaaS business models will have different gross margins. By ignoring gross margin when calculating the SaaS Magic Number, this metric becomes more comparable across different SaaS companies.

Additionally, some analysts like to use customer acquisition costs as the denominator instead of sales and marketing costs.

At the end of the day, the calculation should be the formula that best represents a company’s underlying business model and reporting metrics.

Interpreting the SaaS Magic Number Formula

Here are a few ways on how to interpret the SaaS Magic Number Formula:

Examples of SaaS Magic Number Calculations

Calculation Example 1

Current Quarter’s Recurring Revenue (QRR) = $1,000,000

Previous Quarter’s Recurring Revenue (QRR) = $750,000

Revenue Growth = Current QRR – Previous QRR = $1,000,000 – $750,000 = $250,000

Previous Quarter Sales and Marketing Expense = $150,000

SaaS Magic Number = $250,000 ÷ $150,000 = 1.67

Interpretation: A SaaS Magic Number of 1.67 suggests that the company is growing sales very efficiently. With such a robust magic number, the company may even consider increasing its sales and marketing budget to further boost growth.

Calculation Example 2

Current Quarter’s Recurring Revenue (QRR) = $700,000

Previous Quarter’s Recurring Revenue (QRR) = $650,000

Revenue Growth = Current QRR – Previous QRR = $700,000 – $650,000 = $50,000

Previous Quarter Sales and Marketing Expense = $100,000

SaaS Magic Number = $50,000 ÷ $100,000 = 0.50

Interpretation: A SaaS Magic Number of 0.5 indicates that the company’s growth is inefficient. Accordingly, company management should review and potentially adjust its customer acquisition strategy or otherwise address its sales efficiency and marketing spend.

Analyzing the SaaS Magic Number

There are a handful of general rules to follow based on the magic number. Keep in mind these are quick, “back-of-the-envelope” guidelines, and more robust analysis should be performed when deciding on a course of action.

If the SaaS Magic Number is below 0.50, the company should generally avoid further investment in sales and marketing costs and explore other actions.

A SaaS Magic Number between 0.50 and 0.75 is in between what is usually considered acceptable and what is a poor number. Further analysis should be performed to better judge sales and marketing efficiency and marketing strategy.

If the SaaS Magic Number is greater than 0.75, this indicates that the company is basically on track but may further review its sales and marketing spend to evaluate the impact on revenue growth.

If the SaaS Magic Number is greater than 1, then the company’s sales efficiency is quite robust, and the company may consider further investment to increase revenue growth.

How to Improve Your SaaS Magic Number

If the SaaS Magic Number is below the targeted threshold, management should consider various strategic actions to improve sales efficiency:

Optimize Marketing and Sales Efforts: Review marketing expenses and direct the sales team to target the highest-quality leads. These efforts should improve sales efficiency and reduce unnecessary spending.

Improve Customer Retention: Reducing churn can lead to improved revenue growth. A company can potentially improve retention by investing more in customer support and improving its product offerings to shore up existing customers. Happy customers are more likely to renew as well as recommend the product, with minimal incremental costs.

Review Pricing Strategy: The company may also consider adjusting prices. If the company can increase its average revenue per user (ARPU), it may be able to increase revenue without increasing acquisition costs, thereby resulting in a higher magic number.

Upsell and Cross-Sell: Similar to modifying its pricing strategy, a SaaS business may develop strategies to increase the value of existing customers by upselling or cross-selling complementary products or services.

Evaluate Product-Market Fit: Achieving a good product-market fit means that customers recognize the product’s value and are willing to pay for it. This further leads to sustainable growth and customer retention. Poor product-market fit occurs when a product fails to meet the needs of its intended market. This can occur if the product lacks differentiation, is overly complex or overly niche, or solves a problem that doesn’t actually exist.

Conversion Rate Optimization: Conversion rate optimization (CRO) is the process of improving a website, landing page, or other digital assets to increase the number of visitors to take a desired action. These actions may include signing up for a subscription, making a purchase, or downloading a resource. CRO focuses on understanding and optimizing user behavior, removing barriers to conversion, and testing changes to optimize for higher conversion rates.

Leverage Partnerships and Customer Referrals: Partnerships and customer referral programs can lower customer acquisition costs while attracting high-value leads that convert more readily.

Conclusion

The SaaS Magic Number is a crucial metric for analyzing SaaS companies and their growth strategies. It can provide insight into the efficiency of sales and marketing efforts, guiding company management on whether current strategies are efficient and sustainable. By calculating and analyzing this metric regularly, SaaS companies can make informed decisions to optimize growth, improve efficiency, and build long-term value.

Additional Resources

Thank you for reading CFI’s guide on the SaaS Magic Number. To keep advancing your career and skills, the following CFI resources will be useful:

• Customer Acquisition Cost
• CAC Payback Period
• Return on Ad Spend (ROAS)
• SaaS Quick Ratio
• The SaaS Rule of 40
• See all accounting resources
• See all valuation resources