Ellen Glasgow said, “All change is not growth, as all movement is not forward."
I would take it even one step further: in business, not all growth is enough growth, and this is where the Rule of 40 has the ultimate word. This metric has been around for less than a decade but is already shaping the SaaS business world by providing a clear starting point to evaluate revenue growth rate and cash flow, as well as how they come together in the end.
In this article, I will explain what the SaaS Rule of 40 is, why operators in SaaS need to be paying attention to it, and how to get your Rule of 40 calculation without perpetrating the most common mistakes.
What Is The Rule Of 40?
First, what exactly is the Rule of 40? At its core, the Rule of 40 is a core metric that combines a SaaS company's revenue growth rate and profit margin to evaluate its overall performance. It was popularized in 2015 by Brad Feld, with the publication of his article titled “The Rule of 40% For a Healthy SaaS Company”, where he explained the ins and outs of the metric.
The Rule of 40 has evolved in recent years, and it has reached a clear status that makes it essential for any operators in the SaaS business world, even though some studies suggest its standard can be unsustainable in the long-term. This metric provides a valuable benchmark for both SaaS companies and venture capitalists, offering a common language and framework for assessing performance and determining the potential for long-term success. It serves as a way to balance the tradeoffs between revenue and profit, ensuring that software companies find the right equilibrium to sustain growth while maintaining profitability.
As Brad illustrates in his article, growth and profitability maintain a close relationship that should behave according to certain standards.
If you're growing at 20%, you should be generating a profit of 20%.
If you are growing at 40%, you should be generating a 0% profit.
If you are growing at 50%, you can lose 10%.
If you are doing better than the 40% rule, that’s awesome.- Brad feld
Not only is the Rule of 40 a vital metric for SaaS companies to balance growth and profitability, but it also holds a significant influence on investor perception. Investors recognize the value of a balanced approach, where sustainable growth is prioritized alongside profitability. SaaS companies that adhere to the Rule of 40 and demonstrate this balance position themselves as attractive investment opportunities. By meeting the Rule of 40 criteria, you can increase your chances of securing funding at higher enterprise valuations.
Calculating The Rule Of 40
The Rule of 40 calculation is a relatively straightforward process. All you need to have is:
- The revenue growth input
- The profit margin input
And the formula looks like this:
Revenue Growth Rate + Profit Margin = Rule of 40.
The primary objective of this formula is to define the equilibrium between growth and profitability for businesses, then benchmark against it.
Even though the formula can look like a simple calculation, there are some factors within each of these inputs that add a degree of complexity.
Revenue Growth Input
As you’d expect, revenue growth refers to the increase in your company's total sales or revenue over a specific period of time.
When calculating the revenue growth rate, you need to choose specific parameters to ensure accuracy. Choose a consistent timeframe, such as quarterly or annually, then evaluate revenue gain in those specific periods. Comparing annual recurring revenue (ARR), for example, captures the change in your total sales or revenue over a year, providing a comprehensive view of your performance and trajectory.
On the other hand, monthly recurring revenue (MRR) growth focuses on the predictable and recurring revenue generated on a monthly basis, which may be more useful to newer companies or organizations undergoing critical changes (such as a change in your pricing strategy). This metric offers a more detailed perspective, enabling you to monitor short-term trends, identify seasonality patterns, and assess the effectiveness of customer retention efforts and new customer acquisition.
The main element to consider in your Rule of 40 calculation is consistency: you should choose one timeframe and stick to it, as this is the only way to get accurate data that reflects progress.
Profit Margin Input
When calculating the profit margin input, it's important to use EBITDA as a starting point.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization, and it provides a clearer idea of gross margin. This alternative measures a company’s profitability by looking at the operational profit generated by a company's operations. By focusing on the EBITDA margin, you can assess your firm’s financial performance accurately and avoid distortions caused by non-operational factors.
High Growth, Low Profit
When a company experiences rapid growth but struggles with low profitability, it can be both an exciting opportunity and a cause for concern. In early stages or industries with high potential for disruption, like green-field tech startups, prioritizing growth over immediate profitability is a wise long-term choice.
By rapidly expanding market share, acquiring new customers, and fostering innovation, these companies aim to lay a solid foundation for future profitability. However, when low-profit margins persist even when hypergrowth leaves, there’s something that needs to change.
This specific scenario could indicate many inconsistencies, from an unsustainable business model and operational inefficiencies to increasing churn and weak customer engagement. In this case, profitability should become a problem to solve in order to ensure long-term sustainability.
Low Growth and High Profit
On the flip side, a company with low growth but healthy profit margins may appear stable and financially sound. Established businesses in mature industries often prioritize profitability over rapid expansion, particularly when their markets are saturated or their customer base is well-established. By focusing on operational efficiency, cost management, and maximizing returns from existing customers, these companies can generate solid profits.
However, relying solely on high-profit margins without pursuing the company’s growth opportunities can be risky. It may leave companies vulnerable to disruptive competitors or changes in the market landscape. Industries undergoing transformation, technological advancements, or shifting consumer preferences demand strategic agility and adaptability. Therefore, while low growth and high-profit margins provide stability, evaluating the long-term sustainability and growth potential is crucial in such situations.
Time Period To Measure
When coming up with a Rule of 40 calculation, selecting the appropriate time period becomes a big decision. The optimal duration varies based on the nature of the business, industry dynamics, and the competitive landscape. Shorter time frames, such as quarterly or annual reports, may suit agile startups in rapidly evolving sectors, where performance can change swiftly. Established businesses in stable industries might benefit from longer time frames, such as three to five years, for a more accurate assessment.
Additionally, considering the competitive context is important. Comparing a company's performance against industry peers offers valuable insights. However, the time period chosen should align with typical industry cycles and competitive dynamics. For instance, in industries with seasonal variations, adjusting the measurement window to account for seasonality ensures a more accurate evaluation.
Common Mistakes in the Rule Of 40 Calculation
Now that you know what the Rule of 40 is and how you can use it as an essential metric to understand your business growth, it’s time to share some disclaimers. There are different mistakes that can lead to non-accurate results when calculating the Rule of 40, and the best way to avoid them is to understand what they are about.
Let’s talk about the “dont’s” for this metric.
Mistake #1: Overlooking the Impact of Non-GAAP Adjustments on Profit Margin
One prevalent mistake is failing to recognize the significance of incorporating non-GAAP (Generally Accepted Accounting Principles) adjustments when assessing the Rule of 40 for a SaaS business.
The Rule of 40 acknowledges that in hypergrowth scenarios, companies often prioritize investing in growth initiatives, which may temporarily impact profitability. Considering non-GAAP adjustments will help you get a clearer picture of the company's true profitability and growth potential.
Mistake #2: Neglecting the Impact of Capital Expenditures
CapEx represents the investments you make in assets that support the long-term growth and maintenance of your operations. These investments will include different activities such as developing infrastructure, conducting research and development to understand your product-market fit, or acquiring new equipment.
So how’s this related to the Rule of 40?
The relationship between CapEx and the Rule of 40 lies in understanding its impact on your profitability. By including CapEx in the profitability component, you ensure that the returns generated from these investments are accounted for. This acknowledges your ability to generate returns on your capital investments and sustain growth while maintaining profitability.
Mistake #3: Failing to Discern the Quality of Revenue Growth
Remember, not all revenue growth is created equal. When navigating the Rule of 40, one of the main mistakes is overlooking the distinction between sustainable, organic growth vs short-term growth, driven by factors that might fade without advance notice. It's crucial to carefully scrutinize the sources of revenue and evaluate whether it's durable and aligned with the company's long-term strategy.
Don't get swept away by superficial gains; dig deep and seek out the substantial ones.
The Rule Of 40: One (Important) Pixel In A Bigger Image
The Rule of 40 provides a snapshot of the situation that your current business model is going through but should be complemented by a broader analysis of market conditions, competitive landscape, and long-term growth strategy. Taking a holistic approach will provide a more comprehensive understanding of your company's prospects.
Whether you are in the early stages of your business journey or you’re managing a mature company with a clear path, there’s a lot to learn about the numbers behind your business. If you want to stay updated on the latest insights and strategies about financial metrics, KPIs, and any rules of thumb, you should be receiving The CFO Club’s newsletter in your inbox, weekly.
Our newsletter offers exclusive content, expert advice, and actionable tips to help you grasp all the financial concepts you need to excel in your business journey.