Software companies can manage margins higher than other industries such as those dealing in physical goods (up to 90 percent). The Rule of 40 was popularized by venture capitalist Brad Feld and ties the trade-off between profit margins and growth in order to prevent people from over-focusing on just one indicator. The Rule of 40 generally applies to SaaS companies at scale and is a simple and effective rule of thumb for evaluating financial long-term performance of SaaS businesses.
What is the Rule of 40?
The Rule of 40 implies that early-stage SaaS businesses generating low or even negative profits can still be valued reasonably if their growth rate is high. It takes both growth rate and profit margin into account. The simple yet effective rule of thumb balances growth and profit margins and helps determine the overall financial attractiveness of a SaaS company.
According to the rule of 40, the sum of growth (in percentage) and profit margin (in percentage) should hit the baseline figure of 40% for a healthy company. The higher the number, the more likely a SaaS business is to achieve long-term profitability and growth. Although the rule is just a generalized representation, it has gained credibility and popularity among investors. Opinions still differ about its reliability and in which funding stage or sub-industry should we apply this rule. But its simplicity and accuracy are the two main reasons behind its popularity. The rule of 40 implies many things, including the following:
- SaaS businesses lacking growth need to maintain 40% profitability
- Businesses growing at a rate of 40% can afford to have 0% profitability
- Businesses growing at a rate of 50% can afford to lose 10% in terms of profitability (50% growth rate is rare and very hard to achieve in the real world)
- A SaaS company growing at a rate of 20% should generate profitability at 20% and vice versa
SaaS businesses tend to burn a lot of cash in the initial growth period and have to grow at a certain rate to stay attractive to investors. Investors typically expect up to 3X return on their investment over a period of 10-15 years. Investors expect big wins on their investment and want a high threshold on their prospective investments. They want businesses to grow fast and understand that CAC (Customer Acquisition Costs) are high in the beginning until the payback time comes in the future. The rule mostly applies to SaaS companies funded by venture capitalists that need growth at a certain rate.
Although EBITDA is widely used when calculating profitability, you might also want to consider other metrics to define profit more accurately, including net income, operating income and cash flow. SaaS companies running their own infrastructure or involved in R&D also need to consider fixed costs otherwise, free cash flow, operating income and EBITDA will not match up.
How to Calculate the Rule of 40?
Calculating the rule of 40 requires only two inputs i.e. revenue growth rate and profit margin. Investors can use both total revenue growth and recurring revenue growth, but if 80 percent or more of the total revenue comes from subscription revenue, it’s better to use recurring revenue growth. Although the calculation is pretty straight forward, revenue generated through one-time payments should be excluded to get a clearer picture of the recurring revenue (e.g. consultation, installation and other one-time fees).
For profitability or profit margin, EBITDA is widely used because it’s a common financial metric and gives a clear picture of how much cash flow is being generated by a SaaS business. If a SaaS company is running and managing its own infrastructure, investors can also use other metrics such as net income or operating income.
Rule of 40 can be simply calculated as:
The Rule of 40 = Year-on-Year Growth in percentage + EBITDA (earnings before interest, taxes, depreciation and amortization) in Percentage
It can also be calculated by adding the MRR growth rate percentage with the EBITDA margin percentage for any given time period.
For example, a business experiencing a year-on-year growth rate of 20% and a profit margin of just 10% will have a rule of 40 number of 30%, which is below the target number of 40%. The number implies that either the business should increase its profit margin or achieve a higher growth rate to meet the minimum criteria for rule of 40.
The Importance of Rule of 40
One of the main reasons behind the popularity of the rule of 40 is that it’s hard to gauge the financial performance only based on the GAAP metrics. When evaluating performance of SaaS businesses, the rule of 40% comes in handy for late-stage investors and works reliably for established and mature companies, and startups having low profit margins, but experiencing a high growth rate.
The ARR/MRR usually declines as a business matures and only considering these metrics does not provide a clear picture of its overall financial standing. The 40% rule strikes a balance between growth rate and profit margin, helping investors make a more informed decision.
It’s not uncommon to see tech startups lose money when growing at a rapid rate. The rule of 40 points to the minimum ‘point of happiness’ by going beyond just the annual or MRR growth rate.
For example, a business in the garment industry has to pay up front costs to buy a factory, machinery, raw materials and pay employees to get the business running. In order to be profitable, every garment it sells has to be sold at a price that is above the total cost of producing it. The business grows as it makes more sales and generates profit on each sale.
Things are a little different for SaaS businesses because the higher the growth rate, the more likely they are to incur losses. SaaS businesses only aiming for profitability tend to grow too slow, which means the competition will capture the market pretty soon. That’s where the rule of 40 can help businesses find the sweet spot between growth and profitability.
Benefits of the Rule of 40
Provides a Benchmark
The rule of 40 helps identify healthy SaaS companies and provides a benchmark or baseline. Meeting the baseline of 40% indicates that the company has maintained a balance between profitability and growth and can be considered a sustainable business.
Helps Evaluate Growth Potential and Scalability
SaaS businesses consistently meeting the 40% baseline indicates that the business model is scalable, and well-positioned on a growth trajectory. It also shows the ability of a company to increase its market share by expanding its customer base and generating sustainable revenue in the future.
Helps Compare with the Competition
The simple rule of thumb helps potential investors quickly compare performance of different companies and assess them based on a standardized rule, which takes into account both profitability and growth. Companies meeting or exceeding the baseline are more likely to get the attention of investors. Meeting the baseline demonstrates the ability of a company to manage growth effectively or deliver strong financial performance.
Focuses on Long-term Sustainability
Instead of focusing only on short-term profitability, the rule of 40 encourages businesses to strike the right balance between long-term sustainability and profits. It encourages them to build a resilient company able to deal with economic uncertainties and market fluctuations.
Challenges and Limitations of the Rule of 40
Over-Reliance and Misinterpretation
The rule of 40% is a simplified metric that gives a high-level assessment or a broader picture of the financial health of a SaaS company. Relying solely on the rule can result in reaching incorrect conclusions or misinterpretation. Investors also need to take into account other key metrics, including but not limited to CAC, CLTV (Customer Lifetime Value) and churn rates.
Variations across SaaS Sub-industries
The rule of 40 has its own limitations and challenges because it cannot be universally applied to all SaaS sub-industries. It may not provide a comprehensive view of the financial performance of certain SaaS sub-industries as they can have unique growth patterns and dynamics, including healthcare, e-commerce and finance. Other factors such as the competition, customer behavior and regulatory requirements can impact the applicability of the rule of 40 in these industries.
Market Conditions and External Factors
Achieving the rule of 40 might not be possible in certain conditions such as economic downturns or sudden changes in market trends. Other external factors such as increased competition or change in customer behavior can impact profitability and disrupt revenue growth, making it difficult to maintain the desired balance between growth and profitability.
Evolving Dynamics of the Software Industry
The software industry in general and the SaaS sector in particular is always evolving with new business models and technologies emerging over time. The rule of 40 alone cannot reflect the true picture of performance of a company in such situations. For example, the recent popularity of AI and platforms like ChatGPT have changed the way we access information and will have long-term impact on how information is processed and distributed.
Measuring Profitability can be Tricky
There are various ways to measure profitability, including EBITDA, net income and operating income. Although EBITDA is widely used to calculate the rule of 40, it does not work well in all situations, especially when dealing with high infrastructure costs. Some businesses might prioritize future growth over short-term profitability by investing heavily in infrastructure expansion and customer acquisition. These businesses might not be able to satisfy the rule of 40, but are building a strong foundation for profitability in the future.
Conclusion
The sum of profit margin and growth rate, which should be 40% or more, helps investors quickly identify how well a SaaS company is operating. The baseline annual growth metric helps companies focus their key strategies either on increasing profits while sacrificing growth or increasing growth while sacrificing profit margins.
The rule of 40 neatly represents the operating performance of a SaaS company into one number. It works best when calculated over longer time horizons, minimizing the impact of short-term fluctuations. The simple framework helps SaaS companies discipline their decision-making process and helps investors evaluate the attractiveness of a company. It helps attract new investors, serves as a health metric for the management and aids them in both short-term and long-term budget allocation and funding for R&D.