This is a follow-up post from my previous, The SaaS Magic Number: A Guide to Measuring Marketing & Sales Efficiency, to further my point about supporting metrics telling the full story. As I mentioned in the section, What is a Good Magic Number?, the ratio alone doesn't tell the full story and shouldn't be taken at face value. It is directional and leads you down the path to examining additional metrics that can explain the value, quality, and longevity of customers that are being acquired during different periods. Some of these metrics I will dig into deeper using the same example from the previous article, are CAC, LTV, LTV:CAC, and Gross Churn. From examining these metrics, along with the magic number, a clearer picture emerges.
The Magic Number
This is our starting point for further investigation and uses the same magic number as the example in the previous article.
Sales Efficiency Ratio (Magic Number) = (ARR current quarter - ARR prior quarter) x 4 / Sales & Marketing Spend prior quarter
0.89 = ($1,500,000 - $1,000,000) x 4 / $2,250,000
The magic number based on the calculation is 0.89.
This can be interpreted as not breaking even in the first year, as for every $1 spent on sales & marketing, we have $0.89 returned in annualized revenue. At face value, this suggests inefficiency. However, as we'll see from the supporting metrics, this interpretation is incomplete.
With this in mind, before we examine the supporting metrics, it is important to understand that we are tracking different cohorts across different timeframes. The Magic Number reflects how Q1's $2,500,000 in sales & marketing spend generated $500,000 in new ARR by Q2. The CAC shows our cost efficiency in each quarter. The LTV represents the projected lifetime value of customers acquired in recent quarters, while churn reflects the retention of our existing customer base. Together, these metrics paint a complete picture of both acquisition efficiency and long-term customer value. Now let's examine the supporting metrics that reveal whether the magic number is actually a problem.
CAC
I mentioned in a previous article that CAC measures how efficient we are in acquiring new customers.
Combining this with the new ARR, you want either scenario to be true about your business:
- CAC is declining, and ARR is holding steady or increasing
- CAC is flat, and ARR is increasing
What this demonstrates is that we are improving our sales and marketing efficiency faster than the magic number reflects, as the magic number is a lagged metric, but the present/forward-looking unit economics are improving relative to what the Magic Number says.
In this example, we see the cost to acquire a new customer falls as we scale spend. The declining CAC is encouraging, but we also need to understand if the customers we're acquiring are valuable enough to justify the investment.
LTV
LTV, as I have explained in a previous article, is the total revenue value of a customer over their "lifetime" as a customer (typically evaluated as one year of revenue). A high or expanding LTV is a positive sign that the $1 of new ARR that is calculated in the magic number, which represents just the immediate value of that acquired customer, carries more value in the long term.
This is really important to understand because a 0.89 magic number undervalues the long-term value of the customer that could significantly offset the up-front cost to acquire that customer and mean that you have more room to spend more on sales and marketing, since you know that the value over the long run is more significant than what the magic number indicates.
In this example, we see a growing LTV and a good sign that while the short-term revenue from the customers is not breaking even on the investment we make, the long-term prospect is much more promising, and that we are even acquiring higher-value customers in the recent quarter. Making it reasonable to have a sub-1.0 magic number. Now, let's combine LTV and CAC, two critical metrics, to understand our true return on acquisition spend.
LTV:CAC
Combining the previous two metrics together creates a powerful understanding of the relationship between sales & marketing spend and its relationship to the long-term value of the customer acquired.
It reflects the return on every dollar spent to acquire a customer. A healthy industry benchmark you should be aiming for is >=3:1 or a return of $3 in revenue per customer for every $1 spent to acquire them.
Using this example, if our magic number is 0.89, but the LTV:CAC is at 5.33x, then it is a good sign that we are acquiring high-value customers, whose revenue compounds over the first-year ARR, and that we should be spending more on sales & marketing as we have the opportunity to grow more with spend.
When comparing the magic number to LTV:CAC, you should think of the magic number as the speed to ARR, while LTV:CAC is the total return. The strong LTV:CAC ratio depends on one critical assumption: that customers actually stick around. That's where churn becomes essential.
Gross Churn Rate
Finally, we should understand gross churn rate, or the rate at which we lose each new customer over a specific time period. It is used as an input in LTV and a crucial metric to understand and monitor, which will let us understand how much ARR we lose over time. A healthy monthly churn rate is <5% and an annual churn rate is <10%.
Using this example, we can see that customers are sticking around longer, which means ARR compounds for longer and the revenue is stickier.
The Full Picture
I hope you can see how impactful using the magic number as a lead into supporting metrics helps fully interpret both the short-term and long-term efficiency of sales and marketing spend on annual recurring revenue. While the magic number is an easy ratio to comprehend for the whole organization, it only tells part of the story, which is why supportive metrics like the examples I used above are required to give you the full story.