One of the mysteries I hoped to solve was what Josh James meant when he introduced The SaaS Company Magic Number. This number tells you how aggressively your company should be spending on marketing and sales, according to Lars Leckie.
The Top Ten Do’s and Don’ts of SaaS series has now become the Top Eleven. I will show why this benchmark works, introduce what IMHO is the single most important financial metric for measuring overall health in a Saas business, but first lets make it clear that Josh has already claimed “The One Number You Need to Grow Your Business.”
SaaS Metrics Rule of Thumb #9 – Joel’s SaaS Magic Number
Joel’s SaaS Magic Number is the average customer rate of return, or rather 1BE0. It has consistently popped up as a driver and constraint in our rules-of-thumb.
This is the magic number that tells you whether or not your SaaS business will work. Customer rate of return, which is calculated by dividing ARR (average recurring revenue per customer) with CAC (customer acquisition cost), takes into account both revenues and costs to see if a company’s venture has economic viability.
Intuitively, a long-term SaaS company should be profitable because the revenue from current customers covers acquisition costs. But this isn’t always true.
Joel’s SaaS Magic Number is the amount of money that a customer spends with your company on average before they stop using it. The more you spend, the better off you are because then if each person pays for themselves within one year andor has an annual return rate of 100%, VC funding becomes unnecessary (call me old fashioned). Personally I would recommend aiming to be profitable in 2 years or less which means making sure J ≥ 50% per year; meaning make at least $50k per new client who stays with your business for two years.
It is very important to set goals for the average customer rate of return that are significantly higher than your churn and target growth rates. This ensures you will be able to build up a sustainable company, even if it takes some time before profitability becomes possible.
The SaaS Company Magic Number is the ratio of “Monthly Recurring Revenue (MRR)” to monthly customer churn.
A popular way to measure the success of a SaaS company is by taking ARR (Annual Recurring Revenue) and dividing it by CAC (Customer Acquisition Cost).
I have found that there is no way to reduce churn rate without spending more on customer acquisition.
Joel’s SaaS Magic Number is a more realistic metric of financial health for software-as-a service companies. It includes the full measure of both recurring revenue and total cost of service, which gives it an edge over The SaaS Magic Number.
Joel’s SaaS Magic Number is calculated by taking the amount of annual recurring revenue minus average customer support costs and dividing it over your ARR.
Joel says that you should figure out the contribution margin of your product, and then multiply it by a number between 1.5 to 3 depending on how much sales experience they have.
Let’s use some numbers to compare the SaaS Magic Number calculation and Joel’s. We’ll take a contribution margin of 50% for both, as this is an average number for many software companies in their early stages.
When Contribution Margin = 50%
The magic number for Joel’s SaaS company is the sale price of his software divided by 2.
You might want to consider speaking with Lars if your The SaaS Magic Number is greater than 1.5, because this means that you are primed for a profitable annual viral growth rate of up to 75%. VCs love companies like these! However, I disagree when it comes pouring on the gas in instances where the number only exceeds .75 – in cases such as this one, your average customer return has been 38%, meaning that best case time-to-profit would be 2.7 years (if everything goes well). If our company’s yearly growth rate approaches 38% and we have anything less than 50% contribution margin at any point during its early stages then our real time-to-profit will likely double or triple what it currently stands at 8 years. Depending on my actual contribution margin percentage figure may very well lead me into burning through wads of cash by stepping too hard onto the gas pedal while driving forward.
I’m almost done! There is one more post in this SaaS metrics series, because clearly we can’t stop until we reach the tenth and final rule of thumb for calculating your company’s value. The next article entitled “The Value Of Your Customer Lifetime” will take things up a level to examine what could be considered the highest-level financial metric of all: Company Valuation. I’ll also include some fun math notes at the end for those who are really into it.
SaaS Metrics Math Notes: What’s YOUR SaaS Average Customer Rate of Return? The theory is only useful if we put it into practice, so today’s SaaS Metrics Math Note includes the homework assignment to calculate the average customer rate of return for your SaaS business (your very own SaaS magic number!). In practice, calculating average customer rate of return requires a few decisions about how you’re going to measure recurring revenue and costs, but the basic formula for calculation is as follows.
The idea of variable costs and fixed costs is not very important in a SaaS company. A lot of the time, these two categories overlap because everything that goes into acquiring new customers will be recouped with recurring expenses like rent and support staff.
I recommend making two charts to show your revenue and customer metrics. One chart would have the average customers’ rate of return, while another could include growth rates, churn percentages and other relevant SaaS statistics for comparison purposes. This example shows how lowering total cost of service (decreasing ACSCAC) will also improve ARR as implied in Rules-of-Thumb 6, 7 & 8.
There are many different ways to calculate metrics for SaaS companies, but whichever you choose should be consistent. Personally I prefer cash.
There are several different time periods that can be used to calculate these SaaS metrics. One month is too short, and one year is probably too long. But for most companies, three-six months would give the best result.
Check out the rest of the SaaS Metrics Rules-of-Thumb
- SaaS Metrics Rule-of-Thumb #1 – SaaS Churn Kills SaaS Company Growth
- SaaS Metrics Rule-of-Thumb #2 – New Customer Acquisition Growth Must Outpace Churn
- SaaS Metrics Rule-of-Thumb #3 – Viral Growth Trumps SaaS Churn
- SaaS Metrics Rule-of-Thumb #4 – Company Time to Profit Follows Customer Break-Even
- SaaS Metrics Rule-of-Thumb #5 – Best Case Time to Profit is Simple Break-Even
- SaaS Metrics Rule-of-Thumb #6 – Growth Creates Pressure to Reduce Total Cost of Service
- SaaS Metrics Rule-of-Thumb #7 – Churn Creates Pressure to Reduce Total Cost of Service
- SaaS Metrics Rule-of-Thumb #8 – Upselling and Upgrades Accelerate SaaS Profitability
- SaaS Metrics Rule-of-Thumb #9 – Joel’s SaaS Magic Number
- SaaS Metrics Rule-of-Thumb #10 – SaaS Customer Lifetime Value Drives SaaS Company Value
