What does the SaaS magic number mean for business growth?

SaaS Magic Number: How to Calculate, Consider, & Act On Yours

The SaaS magic number is a KPI to help you balance revenue growth with your sales and marketing spending. It is a key SaaS performance metric that measures your sales and marketing efficiency.

The SaaS Magic Number can help you make sure your sales and marketing investments are appropriate relative to your sales growth. This is to ensure that you are neither overspending nor under-investing. The number can help you know when your sales and marketing machine is ready to scale, and when it still needs to be optimized and premature scaling would break the bank.

In this article, you will learn how to calculate and interpret the SaaS magic number. Moreover, you will know what actions to take to boost the number. You can also download our template to calculate the SaaS magic number and some related metrics for your company.

What is the SaaS magic number and why is it important?

Lars Leckie, the managing director of Hummer Winblad Venture Partners and Aspenwood Ventures, introduced the SaaS magic number in 2008. He has over two decades of experience with software and subscription businesses. The SaaS magic number measures recurring revenue relative to sales and marketing expenditures. It is a sales efficiency metric widely used by CFOs and investors. 

In its original form, the SaaS magic number is calculated by taking the difference between the recurring revenue of the current quarter and the recurring revenue of the last quarter and multiplying it by 4 to get the annualized new recurring revenue. That is divided by the sales and marketing expenses incurred in the previous quarter. The reason is that these expenses fuel future growth, but with a delay. The magic number formula is: 

A value of 1.0 means that for every $1 you spent on sales and marketing, you generated exactly $1 in annual recurring revenue (ARR). In other words, your customer acquisition cost of $1 has been recovered within 1 year and the customer starts to contribute profit thereafter.

As a rule of thumb, a SaaS magic number over 0.75 is required to justify pouring money into sales and marketing teams. A number below 0.75 implies that your business should refrain from scaling up sales and marketing spend because it doesn’t translate into recurring revenue efficiently enough. Ideally, you want a value that is greater than 1.0 because it shows that you are highly efficient in acquiring new customers.

SaaS magic number benchmarks

The quarterly formula can easily be reformulated in a monthly formula, which might be appropriate if your sales cycle is shorter than a quarter, or if you want to have a more frequent performance measure to be able to react more quickly.

The only actual difference between the two formulas is that you need to multiply the revenue difference by a factor of 12 instead of 4 and divide the number by the previous month’s spend:

Calculation and interpretation of the SaaS magic number based on an example

Now, it is time to illustrate the dynamics of the magic number based on the monthly formula (follow along and adjust the assumptions by downloading the template). Let’s say that a fictitious company generated $200,000 in monthly recurring revenues (MRR) and spent $125,000 in sales and marketing expenses in January 2022. Note that the highlighted cells are the model’s drivers, and the black figures are automatically calculated by the model.

In the table below, we’ve created a simple sales and marketing budget. The budget growth is mainly driven by hiring one additional employee in July and by a 5% month-over-month growth of online advertising.

Total revenues are derived by multiplying the active numbers of customers by the monthly subscription price of $25. The number of active customers, new customer growth rate, and monthly churn rate are explicit assumptions. Note that the customer growth rate is projected to decline by 0.25% per month. 

The interaction between recurring revenues and the marketing  and sales expenses leads to some interesting insights regarding the SaaS magic number. While the value of 1.10 in month 2 suggests that the company should continue to invest in sales & marketing, the magic number continues to fall. In our example, the monthly recurring revenues stopped growing at a satisfactory rate despite an increase in the overall sales and marketing budget. By December 2022, the number declined to 0.64.

Levers to Pull in Your Business to Improve Your Magic Number

There are several actions you can take to elevate your magic number, discussed below. 

Improve Magic Number by increasing sales and marketing efficiency

The most straightforward action you can take is to either reduce the marketing and sales budget or find more effective marketing and sales channels.

You could reduce, for example, your spending on online advertising or delay the hiring of an additional headcount. When we reduce the spending by $25,000 in July, the SaaS magic number for August-December is instantly improved (recall there is a 1-month delay before a spending change affects the magic number). Of course, be mindful that reducing advertising or delaying hiring will probably also reduce marketing outputs! 

Alternatively, you can spend resources on more effective marketing channels, such as content marketing. For example, if we reinstate the original sales and marketing budget and lower the reduction in growth rate in cell Q12 of the Rev & CoS tab from 0.25% to 0.10%, the SaaS Magic Number is above 1 across the entire period.

Lower your customer churn rate

For a SaaS company, customer churn is also a vital metric to monitor. The churn rate represents the percentage of subscriber revenue that stops paying for your service. No matter how effective your sales and marketing strategy is, you will not be able to grow monthly recurring revenues if you bleed subscribers. This would translate into a low SaaS magic number. If we reinstate the base scenario and change the churn rate from 0% to 3%, the SaaS magic number becomes extremely unfavorable. 

You want to keep the churn rate as low as possible because it affects your monthly recurring revenue growth. Every dollar you lose to churned revenue is a dollar your marketing and sales investments have to recover, on top of the new revenue they’re usually focused on finding. 

For a SaaS business, the average monthly churn rate is around 4.80%. While a high churn rate isn’t unusual for an early stage product, the rate should trend downward over a longer period. You can achieve this by enhancing your product, improving customer service, and offering convenient payment methods. You can also lock in customers for a longer period — like an annual subscription — to increase retention.

Maintain healthy gross margins

The SaaS magic number only accounts for sales and marketing costs. It ignores the costs of service, such as hosting and data center costs, customer support, and payment processing fees. The cost of service, which is similar to the cost of goods sold (COGS), needs to be subtracted from the net revenues to find the gross profit.

In our example, we have set customer growth rate at 6% and churn rate at 0% across the period and hiked the cost of web hosting services from 5% to 10%. This has a significant adverse effect on the company’s gross profit and gross profit margin. While the SaaS magic number is above 1 for all months, the payback period gets stretched from 18.2 months to 22.9 months. In the next section, we will cover the payback period in more detail.

Healthy SaaS businesses aim for a gross margin of around 80% or higher; if you’re nearing it or have a path to that level, the magic number is a more useful measure.

Final remarks

The SaaS magic number is a useful high-level sales efficiency indicator. The value is quite sensitive to other drivers, such as the product’s pricing, new customer growth rates, upselling, marketing and sales budget, marketing channel efficiency, and churn rates. 

However, there are two important aspects you should know:

1. The magic number provides more powerful insights in combination with other SaaS metrics.
2. You need to stay on top of your cash burn.

Combine with other SaaS metrics

The magic number in isolation does not reveal much about the underlying drivers. We strongly recommend that you combine it with other closely related SaaS metrics, such as the Payback Period, Customer Acquisition Cost, and Customer Lifetime Value to have more context.

• Customer Acquisition Cost (CAC)

The Customer Acquisition Cost measures your average spend to acquire each new customer. It can be calculated by dividing sales and marketing expenses by the number of new clients for the period. The CAC is expressed as a dollar amount.

• Payback period in months

The payback period uses the difference in gross profit instead of the difference in revenues and divides it by the sales and marketing expenses for the period. So, the period payback not only gets affected by revenue and marketing and sales budget drivers but also by the gross profit margin. The payback period formula is: 

• Customer Lifetime Value (LTV)

Another important SaaS metric is Customer Lifetime Value. It represents the estimated profit the company can generate from an average customer from onboarding until churn. The higher the churn rate, the lower the customer LTV becomes, because the churn rate is the equation’s denominator. The formula is:

Ensure sufficient cash flow generation

Acquiring new customers costs money. As counterintuitive as it may sound, growing too fast might mean trouble ahead because the acquisition costs come before you can reap the rewards. Meanwhile, you have other costs to pay, such as general & administrative expenses and interest expenses. Since your company’s profitability is not the same as its cash generation, you should keep track of your company’s cash position. If you run out of cash, your startup’s exciting growth story will end abruptly.

Don’t forget the bigger picture

Keeping a close eye on the SaaS Magic Number, in combination with other metrics, can ensure you aren’t spending more money to bring in new revenue that you’re getting out of it. But it’s also important to take a broader strategic view. If growing rapidly with a low magic number accelerates your ability to raise your next round of funding or scare off competition, it may be a tradeoff worth making. And, especially in the early stage, a lot of sales and marketing spend is experimental — trying new channels, new pricing models, new regions. These experimental investments will necessarily have a mix of successes and failures, and you may wish to segregate them from your magic number calculations to understand if the core sales and marketing strategies driving your business are capital-efficient and scalable.

Further reading and links:

Will Price: Magic Number for SaaS Companies

What’s an Acceptable Churn Rate? | Visible.vc

SaaS Metrics 2.0 – A Guide to Measuring and Improving what Matters — For Entrepreneurs

Subscription Business Model Metrics Guide | Recurly

How to Calculate the SaaS Magic Number? – SmartKarrot