When I was out on lunch with the CEO of an early-stage SaaS startup, I asked him how his company was doing.
Quite well, I was told. The revenue is growing month on month, we have enough money in the bank, and the employees are happy. Life’s good.
Always a data-oriented guy, I asked him if I could take a look at his books. And when I did, I found out that while on the surface things were going well, a deeper look told an entirely different story.
On the aggregate, the company’s revenue was growing, but month on month, a good chunk of small customers kept canceling the service. The aggregate revenue from these customers was small, which is why their cancellation got lost under revenue increase from a few large customers. Were these cancellations driven by lack of features? Lack of good customer service? Or something else? It is generally a combination and you have to decide where to invest to fix the problem.
Mentally, it’s impossible to track too many pieces of information, and most companies at this stage make these decisions more on gut feeling and less on hard data.
Personally, I have always followed the pithy saying that my an ex-boss would repeat to me weekly:
In God we trust, rest everybody please bring data.
As on-demand CFO service providers, this is the discipline we bring to startups: diligently gathering data and deriving conclusions that will make or break the company at this young stage.
A case in point would be measuring the efficiency of a company’s investment in sales and marketing. An excellent example of this is the “magic number” metric defined by a veteran Silicon Valley investor Rory O’ Driscoll of Scale Venture Partners. A lot of disciplined operating KPI tracking goes into coming up with this number. But once you have the systems in place, the resulting insight for a SaaS company is priceless.
In Rory’s words:
“An investment is made in Q1 in sales and marketing (S&M). The revenue starts going up in the books, usually in the next quarter (Q2). The correct ratio to look at, is not the relationship between S&M expense to revenue, but the ratio of S&M expense in that quarter to the change in revenue for the following quarter.”
Let me simplify it. Take the change in subscription revenue between two quarters, annualize it (multiply by four), and divide the result by the S&M expense for the earlier of the two quarters.
(Quarterly Increase in MRR x 4) / (Sales and Marketing spend of previous quarter)
The idea is that if your magic number is > 1, the company is growing efficiently, and your S&M expense is in the right direction. You can consider increasing it. If it’s <0.5x, the company is still figuring out its model, and you need to take a step back and re-strategize. Anything in between could eventually be successful but in a relatively capital inefficient manner.
This is the magic number that SaaS enterprises often get wrong. And this is one of the many myths we at myStartUpCFO help our CEOs bust. We have done it for dozens of companies, and would be happy to help you. Feel free to reach out through a comment below or directly at firstname.lastname@example.org