During the annual budget and planning process, SaaS Finance leaders focus on making sure that resources are allocated appropriately across the company so the company achieves its performance goals – usually revenue and profitability goals – for the upcoming year. Resource allocations should be fine-tuned by looking at how the Return on Investment (ROI) can be impacted by changing resource allocations across each of the major functions, especially sales and marketing, as well as product investments.
ROI is calculated as:
ROI = (result or benefit of investment – investment) / investment
Like any analysis, the devil is in the details. The hardest part of the analysis is to identify what investment is affecting what result and what the right measurements are. Did the investment in SEO result in increased click-thru’s that result in converted sales – or some other driver? Did the new training program for Business Development Reps result in better conversion rates? Did changing the sales comp plan result in improved sales productivity? At the micro-level, it is really hard (but important) to tease out the direct link between an investment and the correlated result.
While managers should always be working to analyze the link between specific investments and results, at a company level, the Finance department needs to focus on the macro-level results of departmental resource investments.
For SaaS Sales and Marketing, the best ROI analytic is called the “Magic Number” for Sales and Marketing productivity. The Magic Number is calculated as:
The net change in subscription revenue between Q3 and Q4, annualize it (multiply by four), and divide the result by the Sales and Marketing spend for Q3.
The Magic Number tells you how much revenue results from each dollar spent in Sales and Marketing, all other things being equal. $1 dollar in S & M spending achieves $1 net new revenue is not a great result – for all the efforts of your sales and marketing teams, you are just covering their cost. Worst case, you are spending more than you are getting back in net new revenue, not even breaking even.
A better result is 2X or 3X and a highly productive Sales & Marketing investment is getting 4X or more. The larger the company, the higher the multiple, ie., Sales & Marketing productivity should increase with scale, although it is usually not perfectly linear growth. SaaS companies often experience ups and downs with ROI and productivity as they grow. Hiring too fast, trying to grow too fast as large amounts of capital are applied, and various factors can affect productivity. Few companies manage to maintain operational excellence year in and year out. To stay on top of ROI, best practice is to continually measure, to measure over time, and to compare against benchmarks for peer companies.
Unit Economics is an imperfect measure of ROI
In subscription businesses, KPIs like Customer Acquisition Cost (CAC), and Customer Lifetime Value (CLV) and the ratio of CLV to CAC are important to understand the ROI of your customer acquisition efforts. Simply stated, the ratio of CAC to CLV indicates the return on the customer acquisition investment. If it costs $20,000 to acquire a customer with a resulting CLV of $60,000, then that is a 3X return on the customer acquisition investment.
Best in class companies get 7 or 8 times CAC, so in that example, the initial $20k investment returns $160,000 over time. Most companies measure average CAC and average CLV for the company as a whole.
Segmenting CAC and CLV by customer groups
However, average CAC and average CLV can mask different ROIs for different customer segments. Most SaaS companies find it difficult to get accurate CLV and CAC measurements given the widely different costs to acquire different types of customers. Many companies don’t do a great job segmenting their customers and the costs associated with the acquisition of the different customer segments. CRM data quality is often unreliable. This is an area that is improving, but still has a long way to go. We find that newer SaaS companies are establishing systems from inception to do a much better job tracking customer segmentation, but more established companies don’t have the systems in place and tend to have a great deal of data cleaning debt to pay off first before they can get good metrics.
The goal in measuring ROI is to ensure that you are getting a “good” return on your resource investments. A second, and more actionable goal is to look at whether applying greater resource would result in even better returns.
If we have a Magic Number of 4X, could we grow even faster if we invested more in lead gen and hired more account managers? Similarly, if you find that certain customer segments have a CLV/CAC ratio of 8 and others have a ratio of 2, it makes sense to divert investments from the lower performing segments to the higher performance areas, unless there are low-cost ways to improve the outcomes for the underperforming areas.
SaaS and subscription businesses are all about incremental improvement, whether of the product, the sales process or customer engagement. SaaS companies should always include ROI analysis in the budget process, across departments and functions. It is a good management practice to instill throughout the company, at the macro and at the micro-level. ROI analysis gives Finance an easily understandable context to explain budget decisions and constraints.