If you’re a budding entrepreneur hitting the market with a SaaS startup, then it is very likely that you have heard about the SaaS magic number.
It’s one of the most widely recognized standards for measuring sales efficiency in any kind of subscription-based software business model. In simple terms, the SaaS magic number deals with identifying the revenue that a company can generate for every single dollar it spends on new customer acquisition.
Before going into the specifics of SaaS magic number calculation, let’s go through a brief overview of how SaaS is reshaping the digital economy.
What’s driving the SaaS boom?
Gartner predicts that SaaS spending will top nearly $145.3 billion in 2022. From making big tech affordable to all players to accelerating time to market for new digital channels, there are several reasons why SaaS is becoming a de-facto industry standard for technology innovation. SaaS is fundamentally changing the way software vendors contract deals and realize revenue. Two decades ago, expensive license fees and upfront implementation costs were the revenue USP of software companies.
With SaaS, everything moves into a recurring revenue-generating subscription model where customers end up paying only for the resources they need and only when they need them. Up until the late 2000s, technology companies had a fairly large revenue bucket from which to draw their working and expansion capital since license fees were captured either upfront or in different milestones of implementation and or customization. SaaS companies, however, face the challenge of having to bootstrap their business with funds either from their promoters or external investors until their volume of recurring business revenue reaches a critical threshold.
This operational model results can raise quite a few questions such as: How can SaaS companies define profitability? How can SaaS companies calculate ROI from their revenue streams? How much can they afford to spend on customer acquisition and marketing initiatives? The list just goes on.
To answer these questions, let’s move on to the discussion of SaaS magic number calculation.
How do we calculate the SaaS magic number?
The SaaS industry has created a feasible formula that allows any software subscription business to identify its magic number:
(current quarterly ARR – prior quarterly ARR)/Prior quarterly CAC
where ARR is the annual recurring revenue, and CAC is the customer acquisition cost.
Why is it important for SaaS businesses to calculate their magic number?
The SaaS magic number is a financial metric that can be used to obtain a high-level understanding of how well the sales model of the business is performing. Here are three key reasons why the magic number can prove to be a great strategic asset for SaaS businesses:
The SaaS magic number sheds light on how effective a business’s go-to-market strategy is and how well their sales and marketing can realize deals from leads. Historical analysis on this metric enables a SaaS vendor to forecast their growth figures well in advance. This gives them the leeway to plan their team expansion or business scaling in alignment with the projected figures needed to support the forecasted growth volume.
Prioritize spending and focus
The magic number is a direct indication of how well your business is promoting its offerings across different channels to prospective customers. By drilling down further into the data, it becomes easier to understand which channel helped them win more customers or witnessed a better go-to-market strategy. This insight can help in prioritizing sales and marketing budgets and leadership focus to replicate the success formula tailored to other channels or, in the case of identified failures, leverage new tactics to rectify them.
As mentioned earlier, SaaS startups often need access to large volumes of capital for their operational and expansion plans. The magic number theory can help in drawing up an elaborate data-driven report of how the business model is positioned in the market and what its potential to grow is. These are very fundamental aspects that investors evaluate before funding any business idea, let alone SaaS startups. When they see that the business has a strategic metric to be tracked for their effectiveness, it increases transparency and trust levels, which, ultimately, gives them the confidence to invest in the business.
The SaaS magic number sets the direction for growth
The SaaS magic number is a fundamental concept that can help clear up uncertainties in your journey to profitability. It may have flaws and shortcomings, but for budding SaaS startup businesses, the magic number is a metric that helps derive a clear picture of a business’s financial health and business viability.
If your SaaS startup is trying to mitigate challenging market conditions to improve your magic numbers, our experts at VeryCreatives can show you the right path. We are a digital product agency that works exclusively with innovators to help bring their SaaS business to life. Talk to us today to learn more.