We started our SaaS metrics blog series with finance leader Christina Ross (CFO turned CEO/co-founder of Cube) on the topic of measuring customer retention and growth. This month, we turn to a central key performance indicator that every enterprise software company should look at: the so-called “SaaS magic number.” While it might take some magic to nail this target, you don’t have to be Harry Potter to learn how to analyze and optimize for it.
Below, Christina shares her plain-speak explanation and some handy tips for calculating and interpreting what is considered by many investors to be the most predictive measure of SaaS success.
At a high level, what is the SaaS magic number and why does it matter?
CHRISTINA: The SaaS magic number is a starting point for determining when an enterprise software company is ready for explosive growth. The TL;DR is that it signals your preparedness to go full-steam-ahead and spend more on sales and marketing.
This metric uses monthly recurring revenue (MRR) to analyze your company’s health by asking, “for every dollar we spend acquiring new customers, how much revenue do we create?” For those of us growing (or investing in) SaaS businesses, knowing when it’s time to pour resources into growth is a crucial insight.
Of course, equally important is knowing when to pause and reexamine marketing and messaging. A founder who knows her metrics has more control and advance warning of potential bottlenecks such as market calibration, sales adjustments, or cost reduction.
Walk us through the magic number calculation.
CHRISTINA: The standard formula to calculate your magic number is:
Magic Number = 4* (QR[X] – QR[X-1]) / Sales+MarketingExpenses[X-1]
Where:
- QR[X] is the current quarter’s revenue
- QR[X-1] is the preceding quarter’s revenue, and
- Sales+MarketingExpenses[X-1] is all of your sales and marketing expenses from that same preceding quarter.
For instance, if your company’s third quarter was $100M, and sales and marketing expenses for that period came in at $50M, and then your fourth-quarter revenue hit $115M, your current magic number would be 1.2. [(4 * ($115M – $100M)) / $50M = 1.2].
So, how should an operator interpret that magic number?
CHRISTINA: Basically, a magic number over 1 means it’s time to spend more for growth. When raising capital, most firms want to see a SaaS magic number at or above 0.75. Here are some basic guidelines to help you interpret your own magic number:
- ≤ 0.75: You’re definitely not ready to put more money into growth. Focus on optimizing your existing spend.
- ≥ 0.75 but ≤ 1.0: You’re probably ready for growth, but there are still a few things to optimize.
- ≥ 1.0: Time to increase your sales and marketing spend and grow!
If a company’s magic number is below 1, what are some specific steps they can take to improve it?
CHRISTINA: Since the SaaS magic number is a simple metric, the ways to improve it are also pretty simple: either earn more revenue or optimize your sales and marketing spend. Ideally, you want to do both.
Here are four strategies that I’ve seen work well:
- Expand with existing customers. The cheapest customer to acquire is the customer you already have. If you can deliver more value from an upsell or a cross-sell, these expansions will boost your MRR (which directly boosts your SaaS magic number).
- Shorten your sales cycle. Sales efficiency is incredibly important for growing SaaS businesses, since longer sales cycles are more expensive and limit how quickly you can grow. That said, shortening your sales cycle can lead to higher churn since you might end up selling to unqualified leads, so it’s important to continuously refine your approach.
- Invest in low-cost, high-yield marketing. Your best marketing ROI will come from content marketing, SEO, and cultivating a healthy relationship with the non-buyers on your email list. Quality evergreen content can deliver a steady, high volume of qualified leads and pay dividends for years to come.
- Slash underperforming paid channels. Ads work, but it’s easy to overspend on ads if your ROI isn’t as high as it needs to be. Think about simplifying or consolidating your ads. Optimize your ad spend by repeating what works and spending less on what doesn’t.
Some companies seem myopically focused on their magic number. What are the potential blind spots?
CHRISTINA: That’s very true, and the SaaS magic number isn’t a silver bullet to unicorn status on its own. Like any metric, this one has its limitations, so we need other KPIs to give it context and uncover the full picture. The SaaS magic number is merely a flag (red, yellow, or green)—not a deciding factor. Your gross margins anchor your reality and are a huge factor in how quickly you actually can grow. You should also consider your runway, your customer acquisition cost (CAC) payback periods, churn ratios, and overall cash flow.
Since the magic number only uses MRR, you don’t know if that revenue is due to expansions or to new logos. If the bulk of your revenue comes from expansions, then your strength in acquiring new customers could be questionable. Likewise, if most of your MRR comes from new bookings, you need to look at your NRR to understand how well you’re retaining customers and revenue.
What’s the difference between this and the Bessemer magic number?
CHRISTINA: What some folks call the Bessemer magic number is a CAC ratio that tells you how efficiently you can acquire new customers. It specifically looks at how quickly your gross margin pays for new customers. This is important context because the standard SaaS magic number doesn’t account for the expense of running a business. You can calculate it as follows:
Bessemer CAC Ratio = (Gross Margin * New Annual Contract Value[X]) / CAC[X-1]
If your ratio is over 1, it means you have room to keep investing in sales and marketing. But if it’s less than 1, you need to continue to monitor your spending.
To learn more about the SaaS magic number and other important metrics, check out Cube’s recent blog post on what they consider “The Single Most Important Growth Flag in SaaS.”
