Magic Number Math
Product companies, including license software companies, recognize revenues immediately upon sale and delivery of the product. Subscription companies (SaaS, open source), sign customers up front but recognize revenue over time as the service is delivered. This is a commonplace fact, but it has unintuitive consequences in terms of how to use financial numbers to understand and assess the business. Classic sales and marketing efficiency metrics are utterly misleading.
For a product company, sales and marketing expenses produce sales that show up pretty quickly in the revenue line. As a result, a ratio like sales and marketing expense, expressed as a percentage of revenue, (S&M%) is a meaningful approximation of sales efficiency. High is bad, low is good.
For a subscription company, sales and marketing expenses drive bookings that only show up in revenues over the life of the contract (typically one year). Thus the revenue for a given quarter is by definition not a proxy for sales and marketing efficiency that quarter at all, but is the result of all the prior months and years of selling, that are now showing up in revenue. So how do you measure current sales and marketing efficiency? What is the correct calculation and what is an acceptable number?
Sales and marketing effort attracts new customers in a quarter. The revenue then starts to show up in the financials as an increase in new subscription revenue (net of any churn), usually in the following quarter. The correct relationship to look at, is not the ratio of sales and marketing expense to revenue, but the ratio of sales and marketing expense (for a quarter) to the change in revenue for the following quarter. This makes intuitive sense as it maps to the business reality. You spend the cash and then build the annuity base in a way that only shows up in the financials over time.
Looking at SaaS deals over the past ten year at Scale, we have found that a simple calculation is highly predictive of which companies have a profitable subscription business model and which ones do not. Take the change in subscription revenue between two quarters, annualize it (multiply by four), and divide the result by the sales and marketing spend for the earlier of the two quarters. A result greater than 1x, has proven to be a compelling business investment, a result below .5x is a company that still has not figured out it's model, and a result in between, is a deal that will probably get to success and cashflow breakeven but only in a relatively capital in-efficient way. We called this the Magic Number.
There are lots of reasons why this metric is way too simple. It does not take account a whole host of factors such as churn, gross margins, difference between new sales and upsells, all of which are important and can add nuance to the picture. There are other great metrics like Customer Acquisition Cost, MRR, ACV and many more, that are way more specific and complex. However the Magic Number has one redeeming virtue that in our view outweighs all the negatives. Because it is a GAAP based number it is freely available for all public companies and it is comparable between companies. No one is going to share their internal data on churn, upsells, and rep productivity, and when they do the basis on which the numbers are calculated varies widely, but if you fudge your GAAP numbers you go to prison. They tend to be accurate and all you need to calculate the Magic Number is GAAP revenue and GAAP sales and marketing spend.
So does it work? By work I mean, does it allow companies and boards to make better decisions about when to invest and when not to. In particular is it a better guide to "how are we doing" then the traditional metric of sales and marketing expenses as a percentage of revenues. In the next post I will look at twelve publicly traded companies and their results over time. What the data will show is that the Magic Number is a good indicator of how much you should be investing, and S&M%, is not. The S&M% is however a good indicator of how much you are actually investing and thus ironically, a high S&M% can be a positive indicator rather than a negative one. This is wildly counter intuitive. When did you last hear someone in a board meeting, "oh great we are increasing our burn". However the facts support the conclusion that this is sometimes the right thing to do. Looking at the two together allows you to figure out which companies can grow fast and cost effectively, which companies will grow fast but burn cash, and which companies should not be investing. In short it allows you to make good investment decisions and thus make money.
Originally published April 19, 2010.