Tuesday, March 04, 2008

Magic Number for SaaS Companies

Guest post by Lars Leckie. Another great one and real food for thought.


Josh James, CEO of Omniture (a Hummer Winblad portfolio company), gave an inspiring talk on building a SaaS company last week at the Opsource summit. Josh walked through the history of Omniture as a case study for building a SaaS company. He talked about the need to invest in the company with a firm hand on the wheel as the recurring revenue slowly built up over time. He outlined the different stages of evolution of the company:

1) Product: build a rock solid product. Prove you can sell it as founders before moving past this step.

2) Sell: Sell like crazy, build out a team, hire some QBSRs (Quota Bearing Sales Reps)

3) Retention: focus on churn and retention issues, hire more QBSRs

4) Marketing: spend on marketing, hire more QBSRs

The next phases, not surprisingly, also included hiring more QBSRs but interestingly it is not until later that investments in efficient infrastructure and operations hit their ToDo lists. This outline displays a strong focus on finding a product market fit and then adding gas to the fire as the market opened up. The key metric that Omniture used to decide how much gas to pour on the fire was the Magic Number.

The Magic Number

The magic number ("MN") is a metric that can be used to tell you the health of your company from the perspective of growing monthly recurring revenue ("MRR"). It is a common mode metric to compare companies MRR scaled by sales and marketing spend. The MN provides insight into the effectiveness of previous quarter Sales and Marketing spend on MRR growth. Your MN will be penalized if the spend is wasted (bad marketing, bad sales execution), if your churn is high or if the market has issues (saturation, competitive forces). It also has a very high correlation with Q/Q growth rates so in general, high Magic Numbers are good.

To calculate:

QRev[X] = Quarterly Recurring Revenue for period X
QRev[X-1] = Quarterly Recurring Revenue for the period preceding X
ExpSM[X-1] = Total Sales and Marketing Expense for the period preceding X

Magic Number = (QRev[X] – Qrev[X-1])*4/ExpSM[X-1]

For example, consider a hypothetical company with the following financials
Q1 Q2 Q3
Revenue (recurring total) 1M 1.2M 1.5M
S&M Expense 800K 900K

Then the magic number is 1.0 for the end of Q2 and 1.33 for Q3.

Fundamentally, the key insight is that if you are below 0.75 then step back and look at your business, if you are above 0.75 then start pouring on the gas for growth because your business is primed to leverage spend into growth. If you are anywhere above 1.5 call me immediately.

Josh provided the following gas-pouring throttle chart for SaaS companies to evaluate how much to invest in their go-to-market spend. The data on the charts if from Omniture and other public SaaS companies.

Calculate yours…and get back to me if it is interesting! For fun and extra credit take a look at difference in Magic Number for some of the public SaaS companies like Omniture and SuccessFactors. I can be reached at lars@humwin.com


4 comments:

  1. This is a very compelling way to think about managing my business where the lion's share of my revenues are in fact recurring. What I like about the "Magic Number" is that it still requires that I responsibly allocate my sales and marketing spend to mediums that will generate additional recurring revenues. The metric forces me to manage my membership attrition rate which could possibly net out the benefits of increased sales and marketing spend. What's best about the metric is that it is simple to calculate, and leaves little room for creative manipulation.

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  2. Great post. The approach is very interesting. I think it can be refined by looking at the gross margin instead of the revenues. Gross Margin is a more relevant metric given its variation by application type and size of the saas company. See my post on the topic: http://cracking-the-code.blogspot.com/2008/03/measuring-sales-and-marketing.html

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  3. Alan - CEO - Oprius1:36 PM

    I like this idea but in the initial stages of growth we need numbers that are WAY more frequent than Quarterly. Does this work if you take it to MOnthly recurring revenue or do you have to change the scale?

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  4. Great post. We are using this to track growth at LeveragePoint. I agree with Philippe on using gross profit rather than revenue and with Alan that this should be used monthly, not quarterly if being used as a management tool. I also think there is a component missing here, something along the lines of customer service investment, which should correlate with retention.

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