Last week, software and SaaS names have gone through a roller coaster following an elevated inflation expectation, strong dollar, and uncertainties around Powell’s nomination. While we still believe the inflation expectation is transitory, caused mainly by supply chain disruption, we think it is a good time for the market to catch its breath in chasing high–flyers and stay more focused on the quality of growth. So here we go, the first part of a series of work where we want to discuss different perspectives of a high-quality software business. We kick off the series with “sales efficiency.”
Definition: there is no universal way to define the efficacy of sales, but the most common approach is to track “magic number,” where we take the Net New ARR divided by the Non-GAAP S&M expense. There are some variations, depending on the business model and sales velocity. For example: for companies that are not 100% subscription-based, we can use net new revenue instead. At a high level, it tells us, “for every dollar you spent, how much new ARR did you generate.”Ideally, we focus on ARR from new customers only vs. existing customers captured by Net Dollar Retention (NDR).
Other helpful metrics to track sales efficiency include:
Customer acquisition cost (CAC) where we take S&M in prior period / new customers in the current period.
Gross margin adjusted fully burdened CAC payback period: Gross Margin % * MRR / Non-GAAP S&M.
Why it matters: sales efficiency is one of the few crucial factors to ensure quality growth. It means the company has more levers to pull to achieve productivity because it takes “less” to achieve growth. Like how brick-and-mortar businesses achieve cost efficiency at scale after their initial investment in factories, a highly efficient sales team and a strong product help a software company achieve more new ARR with less investment in sales and marketing. As we go into a more mature phase of the economic cycle, investors want to see a clearer path to profitability (average SaaS benchmarking 20% operating margin). However, there is only so much you can cut back in R&D for high-growth tech companies. G&A reduction takes time and scale to realize. As such, S&M becomes a key source of operating leverage. What is a good magic number? Average sales efficiency across the SaaS industry is ~0.8x. Zoom achieved one of the highest numbers we have ever seen during COVID: jaw-dropping 6-7x. In other words, the Zoom sales team doesn’t have to do much work to keep sales numbers going up. This is the perfect example where the market demand is extremely strong. Watch out how the company reports sales commission, some of them might be capitalized or buried in other lines like COGS. Make sure your capture everything when you do the math.
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