July 13, 2020

Metric Deep Dive: Magic Number

Updated: 5/5/2022

What is the Magic Number?

The magic number measures how many dollars of annual revenue growth are gained from every sales and marketing dollar spent.

What does the Magic Number mean?

The SaaS magic number is a sales efficiency metric. Through this metric, investors can gauge the growth sustainability and efficiency of your business.

Magic Number Formula

The magic number takes the ratio between the annualized net revenue from two consecutive quarters to the first quarter’s sales and marketing spend. To calculate the magic number, you will need the current quarter’s revenue, the previous quarter’s revenue, and the previous quarter’s sales and marketing expense. Plug these numbers into the formula below:

Formula: Magic number = [(current quarter's revenue - previous quarter's revenue) x 4] ÷ previous quarter's sales and marketing expense  

Example X (1).png

Magic Number Benchmarks

Interpretation of the magic number can vary, but this is how we recommend measuring sales and marketing efficiency.

Magic+Number+Benchmark.jpg

What do the benchmarks tell us ?

Magic Number = 1

A magic number of 1 is considered efficient because it means that your sales and marketing investment is able to create incremental revenue resulting in a payback period of 1 year (i.e. it would take your company 12 months to recoup your sales and marketing spend from last quarter).

Magic Number < 1

If your magic number is less than 1, this means that your sales and marketing expenses are not efficient in creating additional revenue. Here, your payback period will be longer than 1 year.

Example Y.png

If you can only generate $20,000 ($5,000 for 4 quarters) of incremental annual revenue from $30,000 of sales & marketing expenses, then it will take you 1.5 years (or 6 quarters at $5,000 of incremental revenue) to recoup that sales & marketing spend.

Magic Number > 1

A magic number greater than 1 is considered very efficient in generating additional revenue, but it also means you may be underinvesting in sales and marketing. With a magic number greater than 1, your payback period will be less than 1 year.

Example Z.png

How to Improve

Equal to 1 - Ideal

Your sales and marketing investments from that quarter are being recovered from incremental revenue generated just after 12 months or in other words, you break even in 1 year.

Knowing when you break even is important to compare against your cash runway. Make sure your company will break even before your runway diminishes.

When your magic number is below or above 1, that is when you want to start looking at the health of your company’s sales and marketing processes.

Less than 1 - Time to evaluate.

It takes your company over 1 year to pay off their initial investment at this benchmark.

Ways to Improve:

  • Test out different sales and marketing strategies
  • Focus on the ROI of each channel to maximize your return going forward
  • Find the most cost efficient client acquisition strategies
  • Identify where you can scale back on sales & marketing spend
  • Improve your business model

Greater than 1 - Time to invest.

Having a magic number greater than 1 might sound like a good place to be, but it also indicates that you have an opportunity to scale your sales & marketing teams! Investments are quickly being recovered, so you likely have more money to spend to generate new or expansion revenue.

Ways to Improve:

  • Broaden customer scope
  • Add new channels
  • Double down on existing ROI positive sales & marketing channels
  • Expand your sales and marketing team

What does the Benchmark not tell us?

While the magic number can be effective in showing the health of a business, it is important to remember that the magic number is a sales efficiency metric and it does not fully describe a company’s health. Incorporating other SaaS metrics can give a holistic view on a company’s performance.

LTV:CAC:

This ratio not only measures the effectiveness of the sales and marketing spend, but also considers the impact of churn which helps measures the effectiveness of the customer success team.

Churn:

Keeping track of logo and revenue churn is directly related to the future profitability of the company since it considers both revenue and users lost. The more users and revenue you lose the more you will need to spend on sales & marketing to replace those users and grow.

Gross Margins:

The magic number only covers the sales and marketing expenses, not COGS (cost of goods sold). Gross margin is another key driver of your company’s profitability.

Payback Period

The magic number only implies a payback period because this period can be confounded by other metrics such as gross margins, making the payback period shorter or longer.  

Revenue

The magic number formula uses revenue, but it does not differentiate between new revenue generated from new users or revenue generated from up-sells from existing users. Keeping track of where your revenue is coming from (new subscriptions or upsells) can help you better evaluate your business and its sales and marketing channels.

For further reading, check out Scale’s take on the simplicity of the magic number when isolated from other metrics.

Profitability vs. Revenue

Another pitfall of the magic number is its focus on revenue with no consideration for profit. Profit is the money leftover after subtracting your costs to run the business from your revenue. For SaaS companies, revenue growth, instead of profits, has mainly been focused on during the early stages of a company. Check out Tomasz Tunguz’s article about profitability and why most SaaS companies focus on revenue growth.

With a focus on revenue growth to please investors and raise a company’s IPO, founders tend to neglect profits, but it is valuable to consider the attractiveness of profitability even at an early stage. High cash flow may also be accompanied by high costs that result in a break even or worse a negative net income. Investors’ focus on positive net income may become a priority now especially with businesses like Uber that are struggling to become profitable in the long run.

The magic number can offer valuable insight into your sales and marketing channels and their ability to generate additional revenue. However, make sure to not solely focus on revenue, but also keep in mind profitability. The magic number can be an informative marker, but it does not have the final say in the growth sustainability or profitability of your company.

TL;DR

The magic number is a sales efficiency metric that measures how many dollars of new revenue are gained from every sales and marketing dollar spent. The benchmarks for the magic number can measure how efficient your channels are and it can also imply a payback period. Any magic number above or below 1 should be evaluated to see where improvements in the channels can be made to optimize its efficiency.

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