How to Calculate SaaS Magic Number
The Software as a Service (SaaS) “Magic Number” is a sales efficiency metric used to determine how efficient a SaaS business is at making sales. Calculating the SaaS magic number helps companies answer the question of how much incremental revenue is generated for every dollar they invest in sales and marketing efforts. In this article, we will first review how to calculate the Magic Number and interpret the results, followed by three Magic Number calculation examples and how to improve your Magic Number
How Do You Calculate the SaaS Magic Number?
The formula for the SaaS magic number may seem complicated at first, but it’s more intuitive than you may think. Here is the formula:
In the numerator, subtract the previous quarter’s revenue from the current quarter’s revenue, and multiply it by four to get an annual number. Now divide this number by the previous quarter’s sales and marketing expenses.
How to Interpret Your SaaS Magic Number
Your SaaS Magic Number implies how long the business will take to recover the sales and marketing expenses incurred to earn incremental revenue between the past two quarters. Below are three ranges and what a Magic Number falling between each one of these generally means.
SaaS Magic Number: Between 0 to 0.50
A magic number between 0 and 0.50 is generally a red flag that the current business model isn’t working or sustainable. This could be due to a SaaS product not resonating with the target market or inefficient sales and marketing activities. In this situation, it would make sense to evaluate its product-market fit. If the number remains below 0.50 over subsequent quarters, the business will eventually run out of cash.
SaaS Magic Number: Between 0.50 to 0.75
If a business has a Magic Number between 0.50 and 0.75, they are on the right track, but it needs to continue to evaluate and optimize its sales and marketing efforts. This means continuing to dial-in sales and marketing efforts that are working, dropping those that clearly aren’t working, and making educated investments in new sales and marketing efforts.
SaaS Magic Number: Greater than 0.75
Finally, if the magic number is greater than 0.75, the business is in a solid position to start investing and building out its sales and marketing strategies. At this point, the SaaS business likely has a proven product-market fit, its marketing and sales efforts are generating results, and investing in further growth activities makes good business sense.
SaaS Magic Number Scenario and Calculation Examples
Below are three simple examples where the Magic number has been calculated using different information, and how the results can be generally interpreted.
Scenario #1
In Q4, a company had $1,000,000 in recurring revenue, and had 950,000 in recurring revenue in Q3. It spent $1,000,000 in Q3 on sales and marketing activities. The Magic Number is 0.20, with the calculation shown below.
Calculation
Interpretation
The magic number is far below 0.50, and the business needs to review its sales and marketing activities as they far exceed the incremental revenue being earned. At this point, the business will eventually run out of cash because it isn’t generating enough from operations to support its marketing and sales efforts. The business will also need to reevaluate its product-market fit to ensure there is a reasonable path to a Magic Number greater than 0.75.
Scenario #2
In Q4, a company had $1,000,000 in recurring revenue, and had $800,000 in recurring revenue in Q3. It spent $950,000 in Q3 on sales and marketing activities. The SaaS Magic Number is 0.84, with the calculation shown below.
Calculation
Interpretation
With a Magic Number greater than 0.75, the business has a proven product-market fit, and is generating enough cash to support further investments in sales and marketing. However, the business must continue to evaluate the effectiveness of its sales and marketing activities, as their cost can quickly erode the SaaS Magic Number.
Scenario #3
In Q4, a company had $1,000,000 in recurring revenue, and had $750,000 in recurring revenue in Q3. It spent $1,000,000 in Q3 on sales and marketing activities. The SaaS Magic Number is 1.00, with the calculation shown below.
Calculation
Interpretation
With a magic number of 1.00, the SaaS company is in an excellent position for exponential growth. The business has a proven product-market fit, it’s sales and marketing activities are dialed in, and it makes sense to further invest in sales and marketing activities.
How to Improve Your SaaS Magic Number
A SaaS business will want to continually focus on activities that positively impact its Magic Number. Below are three ways a SaaS business can improve its Magic Number.
Sell to Existing Customers
Selling additional services to existing customers that already know, like, and trust the company and its products typically offers the greatest return on investment and is often referred to as Expansion Monthly Recurring Revenue (MRR). Increasing the average value of each SaaS customer requires considerably less sales and marketing expense. As such, incremental revenue from existing customers has an outsized positive impact on the SaaS Magic Number. Here are a few examples of expansion MRR activities.
Cross-Sell: Selling additional products and services outside the core offering that may provide a more comprehensive solution.
Up-Sell: Customers upgrade from their current plans to higher-paid plans.
Add-ons: Additional products or services can only be added to the base product subscription.
Reactivation: Having previous customers resubscribe.
Reduce Sales Cycle
Reducing the time between when a prospective customer first engages with the business to when they become a customer can positively impact the Number. For example, reducing the sales cycle from three to two months would both increase incremental revenue and may reduce sales and marketing expenses. With a higher numerator and a lower denominator, the Magic Number will improve.
Adjust Sales and Marketing Activities
Review the effectiveness of current sales and marketing channels, and determine what channels are responsible for generating the most new customers. With this information, sales and marketing dollars can be moved to these channels from those underperforming.
Certain marketing activities require continual review and refinement, such as digital marketing. This would include testing the marketing copy, incentives, and if the digital advertising platform makes sense given the target demographic. For example, if business professionals between 30 to 55-year-old are the target market, LinkedIn may be more appropriate than Facebook.
Ultimately, the appropriate approach to improve the Magic Number will depend on the business context, such as the target market and strategic objectives. Generally speaking, taking a good look at your sales and marketing spend is a good place to start. By taking the time to re-evaluate your sales and marketing strategies and costs, you may be able to determine which areas have room for improvement.
Summary
In SaaS accounting, the Magic Number is an excellent metric to evaluate the efficiency of sales and marketing activities. Given the incremental revenue earned, it helps SaaS companies determine if their sales and marketing costs are efficient. A low Magic Number requires a business to review its product-market fit and review its sales and marketing activities. A mid-range Magic Number indicates the SaaS business is on the right track, and it should continue to optimize and invest in sales and marketing activities. Lastly, A high Magic Number confirms a strong product-market fit, and the SaaS business should aggressively invest in its sales and marketing activities.
Frequently Asked Questions (FAQs)
What is the Rule of 40 in SaaS?
The Rule of 40 is a financial ratio that can be used to assess the overall health of a SaaS business. According to the Rule of 40, a healthy SaaS business should have a profit margin and growth rate that adds up to 40% or more. To calculate the Rule of 40, a company needs to simply add its revenue growth rate and its profit margin percentage together.
What is the Difference Between the Magic Number and the Payback Period?
The similarities between the SaaS magic number and the CAC payback period tend to confuse people. The main difference is that the CAC payback period takes gross margin into account, and the SaaS magic number does not. This means that the CAC payback period will provide you with greater insight into the actual profit a company may or may not be making. The SaaS magic number, by comparison, compares incremental revenue earned to the sales against the marketing expenses incurred.
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