What is Rule of 40? A Comprehensive Guide for SaaS Companies

The Rule of 40 is a vital metric in SaaS, requiring a company’s revenue growth rate and profitability margin to sum up to at least 40%. It provides key insights into a company’s financial health and performance, helping SaaS businesses strike a balance between growth and profitability for long-term success.

Investors, stakeholders, and industry experts utilize this guiding principle to assess a company’s potential, making it essential for building credibility, attracting investment, and comprehending the Rule of 40’s significance in the SaaS industry.

What is the Rule of 40?

The Rule of 40 helps SaaS companies balance growth and profitability, with the goal of revenue growth rate plus profitability margin totaling 40% or more. This metric guides decision-making, optimization, and long-term success in the competitive SaaS industry.

i. Rule of 40 Calculation

The rule of 40 is a metric to assess a company’s performance. Add its growth percentage and profit margin together to get the rule of 40 value. A higher value indicates a healthier company.

ii. Rule of 40 Formula

Rule of 40 = Growth Percentage + Profit Margin Percentage

Growth Percentage is the annual growth rate of the company’s revenue (or other relevant metric) expressed as a percentage.
Profit Margin Percentage is the company’s profit margin (Net Income / Revenue) expressed as a percentage.
Simply add these two percentages together to calculate the Rule of 40 value for the company.

Example:

Last year A company grew their revenue by 30%. At the same time, they made a profit margin of 15% (that’s how much they earned after expenses).

Now, let’s calculate their Rule of 40! We just add their growth percentage (30%) to their profit margin percentage (15%):

Rule of 40 = 30% (growth) + 15% (profit margin) Rule of 40 = 45%

Company Rule of 40 is 45%. Since this value is above 40%, it means they’re doing a great job balancing growth and profits. Investors will find them pretty attractive.

So, the Rule of 40 helps you see how well a company manages its growth and profits.

History of Rule 40

The Rule of 40 was born out of the tech and startup scene, where companies were growing rapidly, but investors wanted to ensure they were making wise choices. It started gaining traction around the late 2010s as the SaaS industry was booming.

Investors realized that simply looking at revenue growth or profitability in isolation wasn’t enough to gauge a company’s overall health. They needed a single metric that combined both factors to get a clearer picture.

Why Does the Rule of 40 Matter?

The Rule of 40 benefits SaaS operators by bringing financial discipline and balancing growth with profitability in decision-making. For investors, it’s a simple way to gauge a SaaS business’s attractiveness, aiding in investment decisions.

Rule of 40”s key Drivers: Growth and Profitability

i. Growth Percentage

When calculating the Rule of 40, the easiest and widely used method is using year-over-year growth % based on GAAP revenue. While mature SaaS companies prefer GAAP revenue, early-stage ones may use MRR or ARR growth.

Just remember, using different metrics might lead to inconsistent comparisons, so sticking to GAAP revenue ensures a reliable and comparable Rule of 40 measurement.

ii. Profit Margin Percentage

Absolutely, my friend! Calculating profitability for the Rule of 40 can get a little tricky since there’s no one perfect measure. You’ve got options like Unlevered Free Cash Flow, Cash from Operations, Net Change In Cash, Operating Income, and EBITDA – all legit contenders. Plus, the debate on whether to include stock-based compensation (SBC) costs adds to the complexity.

Remember, there’s no “correct” answer here, but for simplicity and comparability, many go with EBITDA excluding SBC costs. Just know that each choice can yield different results, so pick what works best for your situation.

When to Use the Rule of 40

The Rule of 40 is great for comparing SaaS companies. It looks at both growth and profits together, making it a fair way to evaluate targets for investors and buyers. Some companies focus on growth, while others are super profitable but not big on marketing. The Rule of 40 helps balance it all, making it a friendly metric for the exciting SaaS world.

10% revenue growth + 30% EBITDA margin = 40%
30% revenue growth + 10% EBITDA margin = 40%

In this scenario, the company achieves a Rule of 40 result by balancing moderate revenue growth with a healthy EBITDA margin. Remember, there are various combinations that can add up to 40%, offering flexibility for companies to find their optimal balance between growth and profitability.

Benefits of tracking Rule of 40

Lets explore the benefits of rule of 40 :

1. Balancing Growth and Profitability

The Rule of 40 helps businesses strike a healthy balance between growth and profitability. By measuring the combined growth rate and profit margin, it ensures that a company is not growing too fast at the expense of its financial health.

2. Attracting Investors

Tracking the Rule of 40 demonstrates your company’s ability to manage both growth and profitability, making it more attractive to potential investors.

3. Clear Performance Indicator

The Rule of 40 provides a simple and understandable metric to assess your company’s overall health and performance.

4. Investor Confidence

Investors often look at the Rule of 40 to assess a company’s overall performance and potential. When a company meets or exceeds the Rule of 40 threshold, it signals to investors that the business is efficiently managing its resources and is likely to be a good investment.

5. Competitive Analysis

Comparing a company’s Rule of 40 performance with its competitors can provide valuable insights into its market position. It allows businesses to gauge how they stack up against industry peers in terms of growth and profitability.

Why You Should Use the Rule of 40

Explore the reasons why SaaS companies use rule of 40. Here are some points :

a. Calculating the Sustainability

The Rule of 40 is a cool metric for SaaS companies to gauge their financial performance and appeal to investors. It combines profit margins and revenue growth, giving a complete picture of their sustainability.

Imagine a SaaS company with a 30% growth rate and a 10% profit margin. They decide to invest in marketing and product development, causing their profit margin to decrease to 5%.

However, with these strategic investments, their growth rate shoots up to 40%. As a result, the company not only meets but exceeds the Rule of 40, showcasing their potential for sustainable growth and investor appeal.

b. Investment Standard Comparisons

The Rule of 40 is a useful tool for investors to compare investment options. It focuses on value-creating growth, which means both revenue and total shareholder return (TSR) should increase. Investors typically look for at least 2% revenue growth and around 7% TSR.

If a company has high TSR but no revenue growth or vice versa, it raises concerns. Ideally, investors prefer businesses with strong revenue growth and high returns. While a combined percentage exceeding 40% is preferred, falling slightly below isn’t a deal-breaker, as other factors are also considered by investors.

c. Increasing Development and Profitability

When seeking funding in the SaaS market, businesses aim for a Rule of 40 close to 40% for a balanced growth and profitability. To achieve higher growth rates, they invest in research and development (R&D) and improve user experience. For increased profitability, focus on existing customers with upsells, cross-sales, and pricing adjustments for better recurring revenue.

The Rule of 40 is a common metric used by investors to assess SaaS companies for funding, but they also consider other key metrics for a comprehensive view. Presenting a well-rounded financial picture can attract potential investors successfully.

Final Words - Rule of 40

Finally, the Rule of 40 is a vital metric for SaaS companies, combining revenue growth and profitability. It helps strike a balance between expansion and financial health, making businesses attractive to investors.

By tracking this metric, SaaS companies can ensure sustainability, compare investment options, and drive development and profitability for long-term success.