Software as a Service (SaaS)
Software as a Service (SaaS) delivery is all the rage, and so Iíve read about rules of thumb for SaaS economics. (As an aside, I feel sorry for SAS since their company name got homonymed out in my mind. I used to think of them, now I think of cloud-based software providers.)
A client provided me with this website where Josh James discusses his ďMagic NumberĒ theory. It holds that you measure Y1 Revenue for a new customer and divide that by the customer acquisition cost. If the number is greater than 75% youíre a success and should acquire customers with alacrity.
I like a good rule of thumb, it saves time. But isnít this just a substitute for NPV? Weíre looking for a go/no-go decision and basing it on factors that include cash flows over time. So I did my analysis and used NPV because, well, no reason to resort to the Intelligent Design tool when evolution is sitting on the workbench. In any case, I thought to test how well the SaaS Magic Number rule performs.
What I found was not encouraging. The Magic Number gives both false negatives (declaring a good deal bad) and false positives (declaring a bad deal to be good). Consider when Customer Acquisition Cost (CAC) is $150 per customer and COS is 20% of revenue. When price is $9 and $10, the Magic Number gives results that donít match NPV:
Why does this happen? Well, Magic Number doesnít take timing of cash flows into account because it ignores the discount rate. The other big missing factor is that one of the keys to SaaS economics is the churn rate, which measures how quickly customers leave. A low churn rate means that customers keep paying you for a long time. NPV takes both of these into account. So in the case of a $9 price, the Magic Number is under 75%, and youíre supposed to move cautiously or work to correct your system. But if your service is sticky and customers stay with you for a relatively long time, then you make up that $1 per month shortfall through longevity. Combined with a low discount rate, and you have a money machine. On the other hand, when the price is $10, Magic Number says to go forward in every case. But if churn is high and your money is expecting venture level returns, the NPV can still be negative.
Oh, well. Rules were made to be broken.
The spreadsheet used for this analysis can be found here.