Growth is the primary driver of value for early- and mid-stage SaaS companies. In subscription models, you invest in revenue acquisition up – front and then generate value over time by managing churn. Acquiring new recurring revenues burns cash, mostly in Sales and Marketing. SaaS executives need to understand how efficient their organizations are in acquiring new recurring revenues to ensure they are investing the right amount in revenue acquisition.
Two related metrics to measure revenue acquisition are the Magic Number and the Growth Efficiency Index. These KPIs, and benchmarks for them, are critical for measuring, and planning for the expense required for growth, particularly at early stages when cash management is key. At later stages in a company’s growth, knowing the benchmarks for these metrics is critical for companies to understand how investors will evaluate them.
The Magic Number was first publicized by Scale Venture Partners for companies and investors to use as a strong predictor of whether a SaaS company had a profitable model for acquiring subscription revenues.
“Take the change in subscription revenue between two quarters, annualize it (multiply by four), and divide the result by the sales and marketing spend for the earlier of the two quarters, “ wrote Rory O’Driscoll, partner at Scale Venture Partners.
He goes on to say that this metric is a better measure of resource allocation than looking at the traditional metrics of Sales & Marketing expense as a percentage of revenue, which is not highly correlated with revenue growth. Here’s a current example of how Sales and Marketing expense is not a good indicator of Revenue growth. We took 10 SaaS Vendors with revenues between $100M and $200M and looked at how their revenue growth compared to S & M expense:
Some companies have high (above 50% Sales and Marketing spend) and low revenue growth, while other companies have low S & M spend with high revenue growth, whereas others show spend and growth relatively aligned. The differences could be in the time lag between Sales and Marketing spend and revenue growth, a transition to the uptake of a new product, or offering, or could be inefficient sales and marketing. Just looking at S&M spend doesn’t give much hint about the profitability of the business model and S&M efficiency.
In contrast to just looking at Sales and Marketing spend and picking some arbitrary target for spending, the Magic Number gives you a measurement of the ratio between spend and new subscription revenue (ARR). Of course other factors are involved, such as customer success, on boarding, etc., but everyone can measure sales and marketing spend compared to new ARR. And the Magic Number provides a lag between the quarter when spending occurs and the quarter when the revenue happens. The Magic Number can be looked at a gauge of sales efficiency in the next year – it is somewhat predictive. By using the Q4 change in ARR, presumably the next year will be at least as productive as the previous year, all other things being equal (important caveat).
In addition, the Magic Number relies on GAAP metrics of Sales and Marketing expense and change in revenues for any company, which for public companies is more easily available and consistent as a benchmark. OPEXEngine develops Magic Number benchmarks for both private and public companies.
Magic Number Calculation
Take the change in ARR from Q3 to Q4, and annualize it (multiple by 4) and divide it by Q3 Sales & Marketing expense.
Numerator: Q4 ARR $1,000,000 – Q3 ARR $800,000 = $200,000ARR * 4 = $800,000
Denominator: Q3 Sales and Marketing Expense = $400,000
Magic Number = $800,000 / $400,000 = 2
Magic Number Interpretation
< 0.5 – reduce Sales and Marketing investment
0.5 – 0.9 – needs improvement, be careful about additional investment
> 1.0 – you can invest more in Sales and Marketing for faster growth
Growth Efficiency Index
Another KPI which is similar to the Magic Number and measures the strength of a SaaS company’s subscription model is the Growth Efficiency Index (GEI). This metric looks at how much it costs to earn $1 of net ARR. A GEI value under 1.0 is viewed as optimal revenue acquisition, whereas values over 1.0 indicate suboptimal revenue acquisition.
The Magic Number takes total annual sales and marketing expense and divides it by the change in subscription revenue (12 months of this year’s ARR change over previous 12 month ARR). Think of it as Sales & Marketing expense per net new dollar of ARR, a useful metric to track and use in planning. The GEI will help you answer the question “how much does my company need to spend next year to achieve X dollars in new ARR?”
Tom Peff, Director of Finance at Adaptive Insights says that the GEI helps them plan for their cash burn against targeted growth. “At Adaptive, one of the metrics that’s been most helpful to track for managing growth and burn is just a simple ratio of the New ARR we add in a period versus the sales & marketing expense.”
Growth Efficiency Index Calculation
Divide current year Sales and Marketing expense by Net New ARR in the Current Year (Net New ARR = Current Year ARR minus Previous Year ARR)
Critical to Track Your Growth Efficiency Index through Company Revenue Growth Stages
In general, the Growth Efficiency Index goes down as a company becomes more efficient at acquiring new revenue. Few companies have a perfect trend line down of GEI, though, and most companies bottom out or slow the reduction of their GEI. Most companies will have ups and downs in the metric as they introduce new products, expand the sales organization, enter new markets, experiment with new sales models among other variables affecting the KPI.
We tend to find that the biggest increase in GEI for private companies often happens with a major growth investment to reach the $100M milestone. Companies often hire too quickly in sales, disrupt territories and need time to ramp and build out the sales organization. The company should target a GEI of at least the same as before the disruption aimed at greater growth and work to improve it.