Magic Number

What is the magic number?

Magic number is the ratio between the net annual recurring revenue added in a quarter and the sales and marketing costs of the previous quarter. The metric measures sales efficiency, and in the software sector it is also called the SaaS magic number. It shows how much additional annual revenue one euro of sales and marketing spend has generated. A value of 0.8 means that EUR 1 of spend produced EUR 0.80 of new annual recurring revenue. The name is pure convention and does not stand for any special method of calculation.

The metric comes from the practice of US venture capital investors and is also used in Germany for subscription software (SaaS). Unlike the LTV/CAC ratio and the CAC payback period, it requires no allocation of costs to individual customers, only quarterly figures from the KPI report and the bookkeeping. Investors use it above all in growth financings (growth capital) when a company wants to channel additional capital into expanding sales and marketing.

Calculating the magic number: formula and variants

Formula: Magic number = (ARR at the end of the quarter minus ARR at the start of the quarter) / sales and marketing costs of the previous quarter

The numerator is the net new ARR of the quarter, that is, new business plus expansions minus cancellations and downgrades. Anyone who does not report ARR calculates with quarterly revenue: (revenue of the quarter minus revenue of the previous quarter) × 4 / sales and marketing costs of the previous quarter. Multiplying by four extrapolates the increase in quarterly revenue to a full year.

The ARR, by contrast, is already an annual figure. If its increase is additionally multiplied by four, the extrapolation is applied twice and the magic number is four times too high. The costs of the previous quarter are used because sales and marketing work takes effect with a delay. With long sales cycles, some companies calculate with an offset of two quarters or over a rolling four quarters.

A further variant multiplies the metric by the gross margin, because only the gross profit of the new revenue contributes to covering the sales costs. The gross-margin-adjusted magic number can be converted approximately into a payback period: CAC payback period in months = around 12 / (magic number × gross margin). Because the net new ARR also contains expansions and cancellations, the result is a plausibility check and not an exact payback calculation.

Benchmarks: when a magic number is good

As a rule of thumb, the following reading applies, based on the ARR variant without gross margin adjustment:

• Below 0.5: Additional sales and marketing spend generates little new revenue. Common causes are an unclear target group, long sales cycles or high churn.
• 0.5 to 0.75: Growth is reasonably efficient; a higher budget presupposes improvements in sales.
• Above 0.75: regarded as a sign that additional sales and marketing spend is justified.
• Well above 1: very efficient or distorted by special effects, such as a large order, a price increase or a low budget in the previous quarter.

These thresholds are more generous than the common benchmark for the payback period. At a gross margin of 80%, a magic number of 0.75 corresponds to a payback period of 12 / (0.75 × 0.8) = 20 months. For a payback period of twelve months, a magic number of 1.25 is needed at this margin.

The magic number in a funding round

The magic number shows how much recurring revenue arises from additional sales and marketing budget, and thus whether the planned use of proceeds can work. Particularly useful is the implied magic number of the growth plan, which results from planned net new ARR and the planned sales and marketing costs of the respective previous quarter. If it is well above the historical value, the plan assumes an efficiency gain that has to be justified, for example by a new channel, higher prices or better close rates.

The metric has limits. With recurring revenue of only a few hundred thousand euros, individual deals determine the result. Seasonal patterns, such as strong year-end business with corporate customers, distort individual quarters. Companies with a high share of project or usage-based revenue can use the ARR variant only to a limited extent.

Recalculation in due diligence

For the review, investors request an ARR bridge by quarter from customer-level data. In addition come the sales and marketing costs by quarter from the bookkeeping, with personnel costs allocated by function. Investors recalculate the metric over several quarters and compare the trend with the development of new business and churn.

The delimitation concerns numerator and denominator at the same time. In the numerator, it must be clarified whether ARR comprises only invoiced contracts or also signed contracts that have not yet started, and how usage-based revenue is treated. Multi-year contracts enter with their annual value, not with the total contract value (TCV). In the denominator, it must be determined whether customer support, partner commissions and a share of overheads count as sales and marketing costs.

Because it rests on observed quarterly values, the magic number is regarded as harder to manipulate than metrics based on LTV. There is still room for manoeuvre. Order intake can be counted as ARR before the customer is invoiced, sales engineers and marketing staff can be booked under product development, and the sales work of the management is often missing from the denominator. The time offset also has an effect: if the budget rises, referring to the lower costs of the previous quarter raises the metric.

Worked example: magic number of a SaaS provider for energy suppliers

A software company for energy suppliers raises its ARR in one quarter from EUR 6,000,000 to EUR 6,600,000. The increase consists of EUR 540,000 of new business and EUR 210,000 of expansions, less EUR 150,000 of cancellations and downgrades. In the previous quarter, sales and marketing costs were EUR 750,000, and the gross margin is 75%.

• Net new ARR: 540,000 + 210,000 minus 150,000 = EUR 600,000, corresponding to 6,600,000 minus 6,000,000.
• Magic number: 600,000 / 750,000 = 0.8.
• Incorrect, with a fourfold extrapolation of ARR: 600,000 × 4 / 750,000 = 3.2.
• Gross-margin-adjusted: 0.8 × 0.75 = 0.6, approximate payback period 12 / 0.6 = 20 months.
• Without cancellations and downgrades: 750,000 / 750,000 = 1.0.
• Plan for the following year: EUR 1,200,000 of sales and marketing costs per quarter and EUR 1,500,000 of net new ARR per quarter, implied magic number 1,500,000 / 1,200,000 = 1.25.

At 0.8, the company is just above the rule-of-thumb threshold of 0.75, but on a gross margin basis it needs around 20 months until the sales costs are earned back. It therefore clearly misses the benchmark of a payback period under twelve months. Churn costs 0.2 points of the metric. The plan assumes an efficiency gain of more than half, although the budget rises by 60%. Without a documented justification, investors generally do not adopt such a plan but recalculate with the historical magic number.

Distinctions: magic number and other sales efficiency metrics

• CAC payback period: calculates at the level of the individual new customer and only with new business. The magic number includes the entire net new ARR, including expansions and churn.
• LTV/CAC ratio: values the entire future customer relationship and rests on assumptions about customer lifetime. The magic number uses only observed quarterly figures.
• Retention rate: shows what share of recurring revenue in the customer base is retained or added over twelve months. A high net revenue retention raises the magic number, because expansions are contained in the net new ARR.
• Burn multiple: net burn of a period divided by the net new ARR of the same period. This metric includes all cash outflows, not only sales and marketing.

Common mistakes

• ARR increase times four. ARR is already an annual figure. The additional extrapolation quadruples the metric.
• Order intake instead of ARR. Signed contracts whose invoicing only begins after an onboarding phase raise the numerator too early.
• One-off revenue in the numerator. In the revenue-based variant, implementation projects and consulting services raise quarterly revenue without being recurring.
• Incomplete costs. If sales engineers, partner commissions or the sales work of the management are missing, sales appears more efficient than it is.
• A single quarter assessed. Large orders and seasonal fluctuations distort individual values. The trend over several quarters is what is meaningful.
• Inconsistent time offset. If the calculation switches between costs of the same quarter and of the previous quarter, the values are not comparable.

Frequently asked questions

At what company size is the magic number meaningful?

In practice often from annual recurring revenue in the low single-digit millions. Below that, individual deals determine the result, so the metric is observed rather than used for steering.

Is a magic number above 1 always a good sign?

Not necessarily. It can rest on a large order, a price increase or a temporarily reduced budget in the previous quarter. If it holds over several quarters, it more likely indicates that the company could invest more in sales and marketing.

How is the magic number calculated for annual contracts with prepayment?

With ARR, not with cash received. A prepayment does not change the annual value of a contract. If the cash receipts of a quarter are used as revenue growth, liquidity and revenue are mixed.

Do expansions among existing customers belong in the numerator?

Yes. The numerator is the net new ARR and contains new business, expansions, cancellations and downgrades. Anyone who uses only new business measures a different figure, which is closer to customer acquisition costs.

The Roemer Capital view

We calculate the magic number on a rolling four-quarter basis and place it next to the CAC payback period. If the two metrics diverge significantly, this is often due to the delimitation of sales costs or to high expansions. We clarify the cause before investors ask about it.

In the financial model, we test the implied magic number of the growth plan against the history. If the plan assumes a significantly higher sales efficiency than achieved so far, it needs a documented justification. If it is missing, we adjust the planning together with the management. A plan that survives the recalculation in due diligence supports the valuation better than an ambitious one that fails at it.