3. Magic Number and Rule of 40… Helpful, For Now

Financial ratios (link) are partially helpful in allowing entrepreneurs and executives to benchmark SaaS companies by which to shape their own company’s growth. However, one size does not fit all given differences in market, product and go-to market motion.

Instead, there are a host of various different metrics that are used to assess the company’s broader growth and efficiency — with the better known ones being the Magic Number and Rule of 40. There are good reasons to use these metrics —there are many resources available online that go into these in detail — strong performance of these numbers are typically correlated with stronger valuation multiples, as they are today.

However, this hasn’t always been the case over time, as shown in this analysis.

Burn Productivity — is much better correlated over time.

We discuss these two metrics below relative to:

1. Current trading multiples, and
2. Certain company stages in their growth lifecycle

Feel free to drop me a note if you have any questions or thoughts.

1Q 2020 Valuation Multiples vs. Growth and Efficiency Metrics

When looking at SaaS valuation multiples post-1Q 2020 earnings, and apportioning these 60 companies across quartiles ranking by NTM Revenue valuation, the top quartile of companies (i.e. average 23.0x NTM revenue vs. an overall sample median of 11.7x) had significantly better metrics relative to those outside of the top quartile:

• Magic number of 1.1x, vs. a median 0.6x
• Rule of 40 of 36%, vs. a median 22%

For completeness, this analysis was also extended to analyse other metrics such as Payback Periods and ARR/Opex per FTE. While payback periods were directionally solid with companies featuring higher valuation multiples, ARR/Opex per FTE was less conclusive.

A key caveat to this however is that correlation does not equal causality — i.e. there will be companies with low Magic Numbers and Rule of 40, but not necessarily have premium revenue multiples.

How Useful Have These Metrics Been Over Time?

The above analysis indicates that there is a strong correlation between Valuation and Magic Number / Rule of 40 — however, this has not always been the case.

Over the last 4 quarters to the end of 1Q 2020, Magic Number and Rule of 40 had an R Square correlation with NTM revenue multiple of 31% and 24% respectively (statistically significant with P<0.05).

However, prior to 2015 and during 2018, these correlations fell to below 10% — interestingly, no other statistically significant correlations arose during this period.

Can These Metrics Differentiate Great Companies From Good? … Not Really

Looking back in time to when SaaS companies hit $250M in ARR (i.e. the median ARR at IPO for SaaS companies), this next analysis looks at each company’s relative valuation at this point in time, and the Magic Number / Rule of 40 the company possessed.

Relative Valuation (“RV”) in this sense, using an example, means that when Zscaler was trading at 17.7x NTM Revenue at the end of 3Q 2018 (at $253M ARR) vs. the SaaS median at the time of 9.1x, Zscaler would have had a RV multiple of 2.0x. This puts it squarely into the top quartile of RV for all companies that reached $250M in ARR. At this time, Zscaler also had a Magic Number of 0.8x. Conversely, LogMeIn reached $250M ARR in 2Q 2015 and traded on 4.9x NTM revenue, vs. 6.8x for the median, i.e. 0.7x RV multiple, and placing it in the bottom quartile.

See below for an example of the top and bottom-5 companies as measured by RV at the time they hit $250M ARR, alongside their Magic Number at the time.

Comparing the Magic Number to RVs across various ARR profiles reveals that there is not a strong correlation between the two metrics. Comparing all companies at $150M ARR through to $600M ARR (at which point there is still a meaningful enough sample size) — their RV quartiles to Magic Number — shows that the 2nd RV quartile often has a stronger Magic Number than the top RV quartile.

Similarly, when running this analysis with the Rule of 40 — a similar pattern emerges; oftentimes the 2nd RV quartile has a stronger Rule of 40 than the top RV quartile.

So What? Magic Number and Rule of 40 Are Helpful, For Now

As of 1Q 2020, a higher valuation is generally correlated with a higher Magic Number and Rule of 40, but this relationship has not necessarily held strongly over time nor as companies scale.

Next, we show how ‘a broader ’Burn Productivity’ has been more tightly correlated to Valuation over time: 4. ‘Burn Productivity’… A Consistently Better Signaler of SaaS Valuation

Other topics in the series:

Introduction — SaaS ‘Burn Productivity’… Better Than Magic Number and Rule of 40?

Background:

1. SaaS Financial Benchmarking… One Size Doesn’t Fit All, and Focusing on Gross Profit — benchmarking growth, margins and opex items
2. What Financial Ratios Should You Go Public With?… And What Should They Look Like Longer Term? — P&L ratios at various stages of their growth curve, from pre-IPO through to large scale, and why there is no ‘one size fits all’
3. Magic Number and Rule of 40… Helpful, For Now — Showing that these metrics haven’t always been correlated to higher valuations

Burn Productivity:

4. ‘Burn Productivity’… A Consistently Better Signaler of SaaS Valuation — Defining Burn Productivity and its stronger correlation with valuation owing to its capturing of product-led growth

5. How Does Burn Productivity Drive Profitability and SaaS Valuation? — A Practical Example — Valuation and its stronger relationship to Burn Productivity via a first-principles look at the drivers of valuation