In the last post on this topic, I said that a simple calculation of sales efficiency, which we called the Magic Number, is a great predictor of future success for subscription based business (saas or open source). Can I prove it? I have taken twelve, publicly traded, software as a service companies and looked at a three year period for each of them, starting where the data was available, in the first quarter after annual revenue was greater than $ 20 MM. I then simply calculated three numbers, the revenue growth over the next three years, the average magic number for those three years and the average ratio of sales and marketing expense to total revenue. The table below shows all twelve companies ranked by three year revenue growth.
CompanyAnnualized
Revenue First QuarterAnnualized
Revenue 12 Quarters Later3 Year
Revenue Growth MultipleAverage
Magic NumberSales
Expenses as % RevenueSalesforce $47.5 $287.86.11.157%Omniture $22.3 $126.05.71.647%SuccessFactors$26.4$147.85.60.791%NetSuite$22.8$126.95.60.784%Constant_Contact$21.7$112.55.21.156%LogMeIn$22.4$80.93.60.961%Vocus$20.3$56.32.80.751%Rightnow$34.5$90.22.60.652%AthenaHealth$69.3$177.72.61.817%Concur$34.3$76.92.20.625%Salary.com$21.9$45.2210.551%Demandtec$41.8$79.21.90.926%
At first glance the data does not tell you a lot. Some high growth companies like Salesforce and Omniture have great magic numbers, but some high growth companies like Success Factors and NetSuite do not. Equally some companies with lower growth rates like Athena Health have really high magic numbers, reflecting a strong return on sales and marketing expense while most low growth (sub 3x in three years, which is still pretty good), have MN’s in the .7x range. It seems somewhat random.
CompanyAnnualized
Revenue First QuarterAnnualized
Revenue 12 Quarters Later3 Year
Revenue Growth MultipleAverage
Magic NumberSales
Expenses as % RevenueSalesforce $47.5 $287.86.11.157%Omniture $22.3 $126.05.71.647%Constant_Contact$21.7$112.55.21.156% SuccessFactors$26.4$147.85.60.791%NetSuite$22.8$126.95.60.784% AthenaHealth$69.3$177.72.61.817% LogMeIn$22.4$80.93.60.961%Demandtec$41.8$79.21.90.926%Vocus$20.3$56.32.80.751%Concur$34.3$76.92.20.625%Rightnow$34.5$90.22.60.652%Salary.com$21.9$45.2210.551%
Three of the companies (Omniture, Salesforce and Constant Contact) have high magic numbers (>1x) and high three year growth rates (5x). All three also have what I would describe as a high but reasonable ratio of sales and marketing expense to revenue, which is a good proxy for overall burn in a software company (because R&D and G&A tend to be relatively fixed expenses at scale while sales and marketing has to ramp to drive revenues). They spend around 50% of revenues per annum on sales and marketing.
Two of the companies (SuccessFactors and NetSuite) have lower magic numbers but still were able to grow greater than 5x in three years. However it took a lot of cash to get there. The ratio of sales and marketing expense to revenue was noticeably higher than for the first group, spending around 90% of revenues per annum to grow at roughly the same rate. I know all five companies reasonably well, and I want to be clear on two points. First a lower MN for the second group almost certainly does not indicate weaker execution, rather it indicates that in those markets (ERP and Talent Management) , the sales cycle, and the velocity of customer adoption, was not as compelling or fast as it was for CRM, web analytics (Omniture) or email marketing (Constant Conctact). Second, because both NetSuite, and SuccessFactors were able to access capital at relatively attractive rates, growing aggressively and spending aggressively, was almost certainly the right decision. It just took cash to bludgeon their way through.
One of the companies, AthenaHealth is in an interesting category of having a high MN but only reasonable growth at 2.6x in three years but as a result was able to spend relatively little on sales and marketing (17% of revenue) and was consistently profitable throughout this period with operating margins of 18% by the end of the third year. The company is focused only on the Healthcare vertical and as is typical in verticals, once you get to critical mass, you have to spend less on sales and marketing, as referral marketing takes over.
Six of the companies had magic numbers below 1x and growth rates in the 2x to 3x for the time period. This represents solid growth (40% per annum) and all of them have manageable sales and marketing expenses, and thus manageable cash burns. None spent the kind of capital that SuccessFactors or Netsuite did to get to scale and all generated a good return for their shareholders but (with the exception of Concur which was already at scale and has since accelerated even more), they have not yet created the kind of market capitalization that has been created by the six in the other three categories.
This analysis shows a couple of things:
First the ratio of sales and marketing expense to revenue is a useless metric to measure sales efficiency for a subscription revenue business. Salesforce, Constant Contact, Rightnow and Salary,com were all in the same rough range for this entire period of time, but have dramatically different revenue growth rates and are dramatically different businesses. What this ratio does measure pretty well is the level of investment, and thus the level of cash burn, in a software company. A high sales and marketing to revenue ratio, is a direct proxy for the amount of investment the Company is making. The key question then is, is the investment good or not.
The Magic Number is a good measure of sales efficiency and thus a good measure of return on sales investment. A business with a high MN > 1x, has a fundamentally profitable model. The company can choose to invest aggressively in that model (Salesforce, Constant Contact, Omniture) or achieve high profitability while still growing strongly, (AthenaHealth). Even with a decision to invest aggressively, the business will probably not require excessive amounts of capital because investing 50% of revenue in sales and marketing can generate 5x revenue growth in three years. A business with a decent (.6x to 1x) MN has to make choices. It can almost certainly grow in the 25% to 40% range (2x to 3x in three years) while investing only 50% of revenue in sales and marketing, but to grow at a faster rate will require significant capital, and is thus dependent on the price of that capital and the size of the overall opportunity.
Finally business with above $ 20 MM in revenues and a MN <.6x do not in general make it public. We have financed them as venture investors, and lived to regret it. Revenue grows, but at such a slow rate, that the capital required, to build a business that matters is not available at a realistic price. An interesting question, and one for a later post, is can a business that is sub scale ie below $ 20 MM in revenue, start with a lower MN and drive it up, as efficiencies improve. We finance a lot of business doing $ 4 MM in annual revenues. The quick answer is yes but only sometimes, the long answer will have to wait (or send us your business plan and we will tell you).
