Hello there.
How is the winter treating you? I have recently lost just enough milligrams to be able to fit into the UniQlo 3D Down Jacket. I am extremely cozy but not weighed down. Maybe this is what Bon Jovi meant when he crooned “Someday I’ll be Saturday Night”. I still have no clue whats the 3D part in the name of a jacket.
Two days ago, I wrote a weighty tome on SaaS metrics - Here. Quite a bit of feedback poured in. Thank you for that.
One thing that this community found missing was the Magic Number. I deliberately chose to ignore it but it seems most everyone seems to swear by it. Pls wake up, Sheeple.
I don’t think it is anything other than a vanity metric. It is a highly context dependent number that is very susceptible to gaming.
This highly abused metric was written of by Lars Leckie in 2008. To quote him:
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]
The real world manifestation of this number is - how much fuel to add to your SaaS “rocketship” to get it to escape velocity. Mind you - the more fuel you add, the slower you become (because the additional fuel has to be carried before it can be burnt). Too much fuel is drag.
Lets say you are an intrepid explorer of the SaaS jungle making your way through the thickets of VCs, competition and other impediments. Suppose you spent $50k in S&M and managed to create additional monthly recurring revenues (MRR) of say $5k. So far, so good. Now, if there is no churn, your $50k in S&M spend will become $60k ($5k*12) in annual recurring revenues (ARR). So, your SaaS magic number is $60k/$50k = 1.2. You have spent $50k which will earn you $60k over the next year so your spend will be recovered.
Different folks have different views on this. By and large, MN of <0.75 typically means you are spending too much, 1 or better is typically seen as ideal.
The trouble is - most people tend to focus on this and game this number - which is where it breaks completely. I have had founders arguing with me that they are amazing with their magic number of 1.003 when everything else is breaking apart, sacrificed at the altar of beating the barrier of 1.0.
It’s a derived metric and is not useful in any way when viewed in isolation. Sure, it gives you a great view of the efficiency of your revenue creation flywheel, but little else.
More than the magic number itself, the understanding of the context surrounding this magic number is extremely critical. Instead of the magic number, I’d rather focus on other, direct metrics that give a far better sense of the business state. For example, I will focus on your burn rate, because you cannot be very valuable if you are breaking the bank. I would focus on Gross Margins because that determines efficiency of everything else, and I would focus on churn because no magic number makes sense if you keep losing your customers.
Then there are nuances to the magic number itself. Even a Magic Number of 1 means that you will need a year to generate revenues equal to your S&M Spend - we haven’t yet factored in people, electricity, cloud expenses and so on. Anything lower than 2 usually implies a need for capital to fund it. For funded enterprise companies, low numbers are OK. That’s what the capital is there for.
The biggest distortion one sees is when one starts kicking out the free customers from this. Think about it, the magic number is effectively a report card of your marketing and sales teams. Should they get credit for customers acquired for free (i.e. where we didn’t have any marketing spend) or customers who upgraded on their own (no sales expense)? Maybe, Maybe not. Again, hard to tell from one number.
Now, there is a way to make Magic Number more useful.
Calculate it on Gross Margin instead of ARR. That will likely give a far better view of bottomline impact. As a shortcut, if your margins are stable, you can simply multiply your magic number with the average gross margin to see what is really is doing to your bottomline.
And that dear reader, is a monologue on why I dislike the Magic Number. It’s meaningless at best and downright mendacious at worst.
For aspiring founders, I also want to point you towards an excellent writeup by IVP here. It is a very well written playbook and its way slicker than anything I could write.
As always, I look forward to hearing from you. If you liked this post, pls feel free to share this or subscribe to this newsletter using the links below. I try to write a 1000-2000 word essay once a week.