Nearly every kind of software is now offered online as “Software as a Service“, or SaaS. If you’re thinking of creating a SaaS business model, you can look forward to recurring revenue and high profit margins… if it works. But the key to growing a great SaaS business is to sell a lot of customers while keeping the cost of sales in check.
[NOTE: All facts in this article relate to ANY high-growth subscription business model. SaaS is just one example of a Subscription-based business model.]
A lot of entrepreneurs and VC use a “Magic Number” to judge SaaS companies’ success. The theory is that you can only be successful if your annual revenue for a customer is greater than 75% of what it costs you to make the sale.
Sometimes this Magic Number theory starts to sound like hocus pocus, but the meaning is about the same. Invest no more than a dollar today to make at least 75 cents over the year ahead:
“Looking at SaaS deals over the past ten years 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. Trying to be cute, we called this the Magic Number.“
A good rule of thumb doesn’t have to always be right, but it ought to be true more often than not. Unfortunately, this SaaS Magic Number turns out to be way oversimplified and quite misleading.
My friend David Brode did the calculation long hand using Net Present Value (NPV) and agrees. As you may know, NPV calculates the value of cash flows over time. Brode found that the magic number “can give both false negatives (indicating you’ve got a good business when you really do not) and false positives (indicating you’ve got a bad business when you really do not).”
Why? A couple of things that a rule of thumb cannot take into account are the timing of customer payments (do they pay monthly, quarterly, annually?) and the churn among customers (how many dropped out and were replaced). A good NPV model is the only way to know the true value of your SaaS business.
Fortunately, it’s not hard to create a great SaaS Business Model Excel spreadsheet that calculates NPV.
Call a FUSE Finance CFO today!
Dedicated to your (positive NPV) profits,
[With thanks to my friend David Brode, a business valuation and financial modeling expert in Boulder, Colorado and online at at www.BrodeGroup.com!]