The Rule of 40. It may sound like some ancient code, but it is actually the formula that helps SaaS companies understand their growth and scalability. The term rule of 40 was coined by two venture capitalists, Fred Wilson and Brad Feld, in 2015. It has continued to be used by organizations looking to analyze both profit and loss statements and balance sheets for quick insight into how well a company is doing.
The Science Behind 40
The Rule of 40 is a rule of thumb that predicts the growth of a SaaS company based on the number of customers it has.
The Rule of 40 was first introduced by Fred Wilson and Brad Feld in 2015 in their blog posts “The Rule of 40% For a Healthy SaaS Company” and “the 40% rule”. In the article, Fred described that the 40% rule states that your growth rate plus profit should add up to 40%. For example, if you’re growing at 20 percent, you should be generating a profit of 20 percent.
While it is true that you can lose money if your business is growing faster than 40% annually, at least that growth can generate a minimum level of happiness.
Let’s do some math and apply the rule!
Example of the Rule of 40
The Rule of 40 is not hard and fast. It’s simply an approximate ratio that you can use to understand your revenue breakdown. Here’s how it works:
- 40% of your revenue comes from 20% of your customers
- 20% of your customers account for 80% of your revenue
- 80% of your customers account for 20% of your revenue
Calculating the Rule of 40
The formula for calculating the rule of 40 is based on two inputs: percentage growth and gross margin. Simply add these two numbers together to get your answer.
For example, if your sales growth is 10% and your profit margin is 25%, your break-even point (the point at which revenues equal expenses) is 35% (15 + 20%), which is less than 40. Your percentage must be 40% or more to be considered an attractive business.
You can increase income by either growing sales or increasing revenue. Suppose subscription revenues account for 80% or more of your total revenue. In that case, you may be inclined to focus on recurring sales growth.
Six Reasons Why the Rule of 40 Matters
The Rule of 40 is a way to help you identify your company’s potential for growth, traffic, and scalability.
Why does the Rule of 40 matter? Because it gives you a baseline for what’s possible with your business. Once you know where the line is drawn, you can figure out if you’re on track or not.
If your SaaS business makes more than 40%, then congratulations! You’ve reached that goal and are now ready to scale up. If it doesn’t get as much traffic as this number (or if it never reaches this point at all), then there are probably some things holding back its success—and those weaknesses should be addressed immediately, so they don’t hinder future growth prospects.
Following are the reasons why the Rule of 40 matters:
- A Company Can Use This Metric to Decide When to Prioritize Growth or Profitability at Any Specific Stage of the Business’s Development
Early-stage SaaS companies should be able to prove that they can easily generate profits if they slow down their growth—and this is best measured by the RO40.
For small businesses, marketing strategy is both an art and a science. By using advanced analytics to track the effectiveness of their sales and marketing efforts, they can fine-tune their spending to attract more customers while maintaining high enough returns to attract investors.
Additionally, it helps established companies with high market shares to focus on increasing margins rather than increasing revenue. This is because growth rates tend to fall as a company approaches maturity.
- It Outlines What Trade-Offs a SaaS Business is willing to make
A 15% loss should be acceptable if your profits are expected to increase by 55% over the next year. However, if the score is less than 40%, you should look at other SaaS metrics like customer acquisition cost and customer retention.
- Using This Metric, Investors Can Decide Which Software as a Service Companies to Invest In
Venture capitalists have established the rule of 40 as a way to gauge the viability of a company’s product. Therefore, it makes sense to use the Rule of 40 to decide whether to invest in a SaaS company or not.
The RO40 metric provides an investor with an important benchmark for assessing the quality of their investment opportunities.
Benchmarks for the Rule of 40
1. Below 40%
In this case, businesses must reevaluate their strategies and determine whether they should seek growth or profits, depending on their business stage.
This is the minimum level of performance necessary to attract investors.
3. Above 40%
This is the right time to seek high investment because your business has a high potential for growth while maintaining profitability.
How to Raise Your Rule of 40 Score
If you want to increase your Rule of 40 score, you need to:
- Increase your monthly recurring revenue.
- Increase your average customer lifetime value.
- Decrease your customer acquisition cost.
- Increase the number of customers who come back and buy again (the “customer acquisition rate”).
When Can the Rule of 40 Be Used?
The Rule of 40 can be used for SaaS companies looking to grow their revenue, scale their business, and increase their customer base. It is a useful tool to have in your SaaS growth arsenal because it helps you determine how long it will take for your business to reach certain milestones based on your current usage rates.
- Let’s say that you’re a SaaS company with 10 customers and an average monthly recurring revenue (MRR) per user of $100/month. You want to know how long it will take for this number to double—and then double again—to reach 40 users at $200/month MRR each ($80K total). The answer: 14 months and 6 months, respectively.
- Another example: Let’s say that you’re a SaaS company with 100 customers right now and an average MRR per user of $100/month each ($10K total). You want to know how long it will take before those same 100 customers generate 200% more revenue thanks to the introduction of new features or new pricing tiers (another $20K). The answer: 42 months!
Who Should Follow This Rule?
After reading the original post by Brad, we wondered whether that rule applied only to software companies or if it had other applications. And yes, it applies only to software because of the way it is developed.
The margins of software companies tend to be very high, reaching as much as 80 or 90 percent in some cases, while other kinds of subscription businesses, such as news subscription services, have much lower margins because they have so much in their COGS, such as buying paper, paying for printing, delivering the paper, etc.
We hope this article has shed some light on the Rule of 40. It’s a straightforward way to evaluate your company’s performance, and it can be used by private, public, or venture-backed companies. We encourage you to do some mathematics of your own and see how your company stacks up!