📂 Reverse engineer a budget from a revenue goal, or a revenue goal from a budget

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📖 The following is an excerpt from my work-in-progress book, Founding Marketing. It's a (very) rough draft of thoughts, notes, and research... so feel free to reply with your feedback on what I should expand more on and what needs to be clarified. Enjoy!

Something about trying to come up with a marketing budget for a SaaS startup just never sat right with me in the past.

How much cash are we operating with? What’s our burn rate or profit margin? What’s the revenue goal for the next year? What about plans to hire or delegate to freelancers or agencies? Are we raising a round of funding anytime soon?

If you’re anything like me, you were essentially pulling numbers out of a hat to come up with a marketing budget.

You don’t want to ask for too little, so you ask for “enough,” but you also don’t want to ask for too much and risk getting bombarded with questions, so you write a number down that hopefully doesn’t inspire too much investigation.

When I’d try to get some context before proposing a budget, I’d hear: “We can find the budget for the right opportunities as long as the ROI is there.”

Okay… so we’re working with an unlimited amount of money? Of course not.

It’s a lazy and unacceptable excuse.

Budgeting on a project-by-project basis slows down progress, discourages experimentation, and boxes you into thinking too small and conservatively.

The truth is that 99% of SaaS startups have no idea how marketing expenses relate to revenue growth.

And without understanding that relationship, there’s no scientific way of coming up with a marketing budget.

There’s gotta be a better way than pulling a number out of thin air, right?

There are two easy and trustworthy methods I’ve come up with to create a marketing budget for your SaaS startup.

Let’s go over each and run through a few examples.

Method #1: 5-40% of annual revenue

With this method, you start with the budget and then end with the revenue goal.

The budget is essentially determined by how much money can be devoted to marketing comfortably, and set a goal depending on how much revenue you can forecast that budget to generate.

Unlike other methods, the goal is the last piece of the puzzle and is largely determined for you.

If a business is already established and focused on profits, it may only want to devote a conservative 5% of revenue to marketing to preserve enough profit to distribute to shareholders.

For example, if your business is doing $1M ARR, the annual marketing budget would then be $50,000. And if the cost of acquiring a customer (CAC) is $100 on average, then you can expect to acquire 500 new customers. And if the average monthly revenue per customer (ARPC) is $50, then you can expect to add $300k to ARR for an end-of-year ARR goal of $1.3M ARR.

If you want to account for churn, and if the churn rate is 15% annually, then you can expect to add 85% of $300k, which is $255k, and a final end-of-year goal of $1.255M ARR.

Now, if you’ve done a round of fundraising and you’ve got ambitious goals you need to hit, you might spend as much as 40% of ARR to aggressively deploy the funds you’ve raised.

For example, if your business is doing $1M ARR, the annual marketing budget would then be $400,000. And if the cost of acquiring a customer (CAC) is $100 on average, then you can expect to acquire 4,000 new customers. And if the average monthly revenue per customer (ARPC) is $50, then you can expect to add $2.4M to ARR for an end-of-year ARR goal of $3.4M ARR.

We’re using some nice round numbers for the sake of example but the math holds up.

You can’t be afraid to aggressively invest capital toward marketing when you need to hit your goal.

I remember talking with a sales leader at a previous startup about how we were going to hit our revenue goal that we were behind on.

“We need to figure out how to spend a million dollars this quarter.”

I laughed, thinking he was joking. He was not joking.

My mindset forever changed after that moment.

Looking back on past Zoom investor reports show that they’ve allocated as little as 20% and as much as 55% of revenue to sales and marketing. You’ll see a similar trend across other public SaaS companies and private startups if you had access to crunch the numbers from their balance sheet.

There are two keys to making this approach work:

  1. Knowing your CAC
  2. Matching your ambition with the percentage to allocate to marketing‍

If you don’t have any past data on CAC, use a baseline of one-year customer revenue of your smallest paid plan. Then, as you deploy the budget, you can compare the baseline against real data as it comes in, and establish a new benchmark to use going forward.

And you don’t need to run ads to be able to generate customer acquisition costs. CAC should be blended to include salaries, advertising costs, technology, content creation costs… everything related to acquiring new customers. Add up all those costs and divide by the number of new customers you acquired in the last year — that’s your CAC.

It’s important to be objective about CAC. You can work on reducing it later. For now, you need a real number to work with.

In fact, it’s actually better to start with an inflated CAC because it gives you more room for error.

Once you’ve established CAC, then you can forecast how many new customers you can acquire with your budget and determine if that’s enough.

Simply slide the scale up and down from 5% to 40% until you agree on how aggressive you want to be and how much money you have to deploy from the start.

If you’re challenged to increase the revenue goal, challenge them to increase the marketing budget along with it.

It’s a symbiotic relationship.

But what if you’ve already been given a revenue goal and are asked to propose a marketing budget to achieve it?

Method #2: [(New ARR / (ARPC x 12)) x CAC] / annual retention rate

With this method, you start with the revenue goal and end with the budget.

The budget is essentially determined by reverse-engineering the relationship between the goal and the customer acquisition unit economics.

The formula took quite a few iterations and a lot of Excel to come up with, but it’s a foolproof way to propose a budget that you can be confident talking about how you came to that number.

This method is best for when your SaaS is just starting up or anticipating outside sources of capital, where you need to find the money to hit ambitious goals.

It’s also great for when you have access to revenue-based financing or non-dilutive capital like Pipe, Capchase, or Founderpath.

Once you’ve reached $1M ARR, VCs will generally want to see you triple revenue for two consecutive years and then double revenue for at least three consecutive years.

Some call it the “3 3 2 2 2 Rule.”

For example, if you’ve just raised a Series A at $1M ARR, here are your goals laid out for you:

  • Year 0: $1M ARR
  • +1 Year: $3M ARR
  • +2 Year: $9M ARR
  • +3 Year: $18M ARR
  • +4 Year: $36M ARR
  • +5 Year: $72M ARR
  • +6 Year: $144M ARR
  • +7 Year: $288M ARR

But to each their own. You may want to grow by 50% or 5,000%. It doesn’t matter to the formula.

Let’s break down the formula piece by piece and use the example of doubling from $1M ARR to $2M ARR.

[(New ARR / (ARPC x 12)) x CAC] / annual retention rate [(1,000,000** / (ARPC x 12)) x CAC] / annual retention rate

Next, you have to calculate how much ARR each new customer represents on average.

To do so, you would multiply the average monthly revenue per customer by 12 to get the first-year revenue of each customer. Let’s assume ARPC is $50, generating $600 in ARR.

[(1,000,000 / (ARPC x 12)) x CAC] / annual retention rate → [(1,000,000 / 600) x CAC] / annual retention rate

Now we know that you need to acquire 1,667 additional customers.

Next, multiply it by the average cost of acquiring each customer. Let’s assume CAC is $100.

[1,667 x CAC] / annual retention rate → [1,667 x 100] / annual retention rate

This effectively gives you the marketing budget since you know how much it’s likely going to cost to acquire the number of additional customers you need to add $1M ARR.

But you also need to account for churn and the extra bit of customers you need to make up for so that you don’t fall short.

So you divide by the annual retention rate. Let’s assume retention is 85%.

166,700 / annual retention rate → 166,700 / .85 = ~196,118

Now you have a final marketing budget of ~$196k which can be rounded up to $200k or whatever the nearest additional increment is.

When someone asks how you got to this number, you can simply walk them step-by-step through this formula to explain your thinking.

The key to this approach is building in a buffer to your CAC estimations.

CAC is the main dependency. If CAC is 50% higher than originally estimated, it’ll have cascading effects and you’ll be at risk of missing your revenue goal. Yikes!

It’s far better to overestimate CAC than to underestimate.

Plus, you need room to experiment, be wrong, and still have enough budget to make up the difference in other experiments that get you to your goal. As a good rule of thumb, tack on an additional 10-20% to your marketing budget and label it “experimental budget.”

I know that’s a lot to digest, but it’s simpler than it sounds.

The two main methods are:

  • 5-40% of annual revenue
  • [(New ARR / (ARPC x 12)) x CAC] / annual retention rate

I find talking it through to be helpful to understand it from first principles.

Spending Benchmarks for Private B2B SaaS Companies - SaaS Capital

—Corey

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