We have a tendency to find a magic formula for everything and this applies also to SaaS companies. In my research in this topic, I have found a few resources that give some direction of how to evaluate the healthiness of a SaaS business. It is easy to conclude that Monthly Recurring Revenue (MRR) or Average Recurring Revenue (ARR) is the driver for everything and this number is combined with Customer Acquisition Costs (CAC) we will eventually see whether the company will make money or not. If we add Average Recurring Cost per Customer (ACS) we have the main elements to figure out what the break-even point by using following formula:

BE=CAC/[ARR-ACS]

If we view the formula, it is easy for us to agree that if BE is greater or equal to 1; the company will never be profitable. In other words, Average Recurring Revenue (ARR) less Average Recurring Cost per Customer (ACS) will never be higher than Customer Aquistion Cost and that is not a good position to be in. Therefore, the ACC has to be able to cover the CAC for the company to be profitable. That is a very easy conclusion to come to. I demonstrated this in my previous blog entry where the sixth client finally was able to cover the overall CAC cost and the SaaS ISV started generating profit.

The fourth major driver is Customer Churn and this is specifically important with a SaaS business as nobody uses bad software and this will be very obvious when the customer does not want to sign up for a new contract term.  It was easier in the past when a perpetual software license was sold and the ISV got the money for it. The only thing that the ISV could lose is the annual maintenance and support fee of 15-25%. Today, an unsatisfied customer will never become profitable if walking away the first year (in typical scenarios).

A key number that seems to be a driving “Magic Number” and represent the health of a SaaS business is based on MRR growth when taking into consideration Sales and Marketing spend. The idea is that as long as the company is growing and the “Magic Number” is demonstrating that the sales and marketing spend is generating results, the company should continue on this path. The blogosphere includes a few sources in this topic and Lars Leckie was then one that came up with his blog entry that many others seem to be referring to. His Magic Formula is as follows:

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

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

Let view this formula with real numbers so we can get a feel what it means with some numbers:

So what happens in the calculation is that the current quarter’s sales is subtracted from previous quarters sales and this is then multiplied with four (to annualize it) and then finally divided with previous months sales and marketing costs.

In the case above, the Magic Number seems to be going smoothly until Q4 when the number goes down dramatically with sales plummeting even with increased Sales and Marketing spend. According to Leckie, as long as the company maintains a ratio above 0.75 it should increase its sales and marketing spend, but if it is less than that, it should review its business as something might have changed the market condition.

Joel York takes this number a bit further by including Average Cost of Service (ACS) into the formula with the conclusion that the cost of service should be covered when calculating the Average Customer Rate of Return for the SaaS business. According to York, the Customer Rate of Return is the most powerful metric that a SaaS business can be measured on as it really shows whether the SaaS business will be a business or not. Therefore, York concludes this number (J) to be calculated in following way:

York also includes churn in his discussion where the growth added with churn should always be less than the average Customer Rate of Return (J). This is very logical if you think about it. The contribution from the client needs to recover the Customer Acquisition Costs, Average Cost of Service (ACS) and possible churn to achieve a situation where the customer becomes profitable for the ISV.

The common expectation is that CAC costs should be recovered in a year or so but York has put this additional requirement that the ACS costs have to be paid as well. I think this makes a lot of sense as the ACS could in some cases be considerable whereby the ISV should pay attention to them.

If we assume that the SaaS ISV has a contribution margin of 50% (Revenue less variable expenses), Joel’s Magic Number would be as follows:

When Contribution Margin = 50%

Joel’s SaaS Magic Number = The SaaS Magic Number /2

York takes a more conservative approach in his numbers where he concludes that The SaaS Magic Number of 0.75 just is not enough to “step on the gas” as the needed growth requires aggressive spending which then moves the SaaS ISV further down in time to profit scale. If we furthermore assume that the contribution margin (CM) is anything less than 50%, the time to profit is much longer specifically in start-up phases. York wants to see a Magic Number that is more or equal to 1 with the added requirement that ARR is > 2 x ACS whereby the ISV can quickly recover its acquisition costs.

We can conclude from this blog entry that the SaaS world does have some metrics to measure the health of the operation, and there are many perspectives how each analyst sees it: some view it from more conservative perspective and some have their venture capitalist perspective. The latter is very prevalent in the blogosphere and many of the SaaS authorities are from this domain. It is easy to say that they might not always represent the view of the entrepreneur, but more from an investor perspective and we all know what that means. It will be interesting to see if more entrepreneurs will provide guidance in this field like Josh James, CEO of Omniture gave at a conference and this generated the blog entries from both Leckie and York. Interestingly, Omniture was sold to Adobe and left the company soon thereafter.

Once we get enough people sharing their experiences in different aspects of the cloud business, we will eventually achieve a situation where we can provide guidance in metrics for different types of SaaS vendors.