The Rule of 40 was popularized by Brad Feld [1] and has since evolved into a fundamental metric for evaluating SaaS companies. But what precisely is this number that holds such power?
The Rule of 40 asserts that a SaaS company's total growth rate, when added to its profit margin, should be at least 40%. It’s a straightforward equation that sets a benchmark for business health and draws in investors. For founders, this equates to the potential for higher valuations and enhanced investment interest, forging a path towards sustained growth and stability.
After more than a decade of poring over SaaS financials (eek - dating myself here), I've noticed founders' eyes glaze over when we discuss metrics. But there's one number that consistently cuts through the noise: the Rule of 40. It's elegantly simple - add your growth rate to your profit margin. That's it. While other metrics might have you drowning in spreadsheets, this one gives you a quick pulse check on your company's health.
Here's what I mean: Take your revenue growth (we usually look at MRR or ARR), add your EBITDA margin, and you've got your number. In my experience, this simple calculation often tells me more about a company's trajectory than hours of detailed analysis
Here’s a step-by-step illustration:
Determine Your Revenue Growth Rate: Calculate either the MRR or ARR growth percentage for a specific period.
Calculate Your EBITDA Margin: This involves dividing EBITDA by total revenue to get a percentage.
Add the Two Figures: If your revenue growth rate is 25% and your EBITDA margin is 15%, your Rule of 40 score is 40%—indicating that you've hit a key benchmark!
So what does it mean?
In practical terms, here's what this means for the SaaS companies I work with:
Growing at 50%? You can sustain a 10% loss
Growing at 40%? You should be breaking even
Growing at 20%? You need a 20% profit margin
Think of the Rule of 40 as a health check-up for your business. Just as a thermometer indicates the presence of a fever, a deviation from the 40% mark could signal an imbalance between growth and profitability. Companies hovering around or surpassing this benchmark often exemplify resilience and viability, capturing the attention of astute investors. The metric is particularly crucial for mature companies seeking to maintain competitiveness, as emphasized by Brad Feld, ensuring long-term success. However, for early-stage startups, the focus might initially be on achieving product-market fit before heavily pursuing this metric.
McKinsey's research on the Rule of 40 [2] for SaaS companies reveals that this metric remains a critical indicator of value creation, despite being challenging to achieve and maintain. Analysis of over 200 software companies from 2011 to 2021 showed that only about one-third reach the Rule of 40, with businesses exceeding this benchmark merely 16% of the time. However, those that do meet or surpass the Rule of 40 are rewarded with significantly higher enterprise value to revenue multiples, with top-quartile companies generating nearly triple the multiples of bottom-quartile firms.
The study identified four key metrics highly correlated with EV to revenue multiples: annual recurring revenue (ARR) growth, net retention rate, last 12 months median payback period, and free cash flow percentage for mid-to-large SaaS companies. Top-performing companies excel in setting realistic growth targets, prioritizing net retention (often achieving rates of 120% or more), optimizing go-to-market spend, and rapidly building new businesses. These leaders also emphasize data-driven strategies, efficient resource allocation, and maintaining operational discipline to improve their Rule of 40 performance and create value for stakeholders.
Practical resource allocation can perform wonders. Long-term growth is nurtured by investing in research and development, customer care, and marketing—while maintaining a watchful eye on profitability. Wise management of internal financing ensures sufficient funding for innovation, aligning with growth agendas without undermining financial stability.
Timing is everything. For early-stage companies, prioritizing product-market fit is critical over immediately hitting the Rule of 40. However, as these enterprises progress and hit milestones like $1 million in MRR, the focus should gradually pivot toward attaining a balance between growth and profitability. Mature companies face unique challenges and opportunities, necessitating a flexible approach to financial goals to maintain their competitive edge.
Leverage your strengths—this is more than typical advice; it's a strategic focal point. Identifying the most profitable segments and concentrating efforts on them can exponentially boost growth and profitability.
Innovation should be woven into the very fabric of an organization's culture. Whether through the establishment of innovation labs or nurturing a creative corporate ethos, the objective is to continuously develop novel ideas and business lines that ensure your company remains competitive and relevant. This not only contributes to sustained growth but also bolsters a proactive culture capable of swiftly adapting to changes.
Startups generally aim to carve out their niche in saturated markets. Initially, prioritizing a product-market fit is paramount, potentially taking precedence over immediate Rule of 40 objectives. Yet, as startups mature, balancing growth with profitability becomes critical for sustaining momentum and securing investor confidence.
New trends, such as the rise of AI, cloud computing, and increasingly popular subscription models, are reshaping the SaaS industry landscape. Companies positioned to leverage these advancements can more readily achieve the Rule of 40. Novel technologies and tools provide fresh opportunities to balance growth and profitability, maintaining competitiveness in a rapidly evolving digital world.
While the Rule of 40 is a popular metric for evaluating SaaS companies, there are several alternative metrics and approaches that can provide a more comprehensive view of a company's health and potential.
Here are some alternatives to consider:
This metric measures sales efficiency by dividing new annual recurring revenue (ARR) by sales and marketing spend from the previous quarter. A Magic Number above 1 is generally considered good.
This measures how long it takes to recover the cost of acquiring a new customer. A shorter payback period is better.
This metric shows the percentage of recurring revenue retained from existing customers over time, including expansions, contractions, and churn. An NRR over 100% indicates growth from the existing customer base.
Similar to NRR, but excludes expansions. It focuses solely on how well a company retains its existing revenue base.
This compares the long-term value of a customer to the cost of acquiring them. A higher ratio indicates better unit economics.
This measures a company's ability to grow recurring revenue using its sales efficiency. It's calculated by dividing new and expansion MRR by churned and contraction MRR.
This metric looks at how much cash a company is burning to generate each dollar of ARR growth. A lower burn multiple is better.
Read more about calculating Burn Rate Multiple here.
While not specific to SaaS, this traditional profitability metric can still provide valuable insights, especially for more mature companies.
This measures a company's ability to generate cash from its core business operations.
Measures like Net Promoter Score (NPS) or Customer Satisfaction Score (CSAT) can provide insights into customer happiness and potential for future growth.
These alternatives can provide a more nuanced view of a SaaS company's performance and potential. Many companies use a combination of these metrics alongside the Rule of 40 to get a comprehensive understanding of their business health and growth prospects.
For SaaS founders, understanding and leveraging the Rule of 40 is not a mere nicety—it’s a necessity. It offers clarity and direction, helping navigate the intricate terrain of growth and profitability. Implementing strategies aligned with this principle ensures a company’s relevance in a fiercely competitive market
Are your growth and profitability metrics harmonized with the aspirations set by the Rule of 40? Now is the moment to evaluate and strategize. Consider these steps:
Assess Current Metrics: Conduct a thorough analysis of current revenue growth rates and profit margins.
Identify Core Revenue Drivers: Focus resources on the most profitable segments.
Innovate Relentlessly: Foster an environment of continuous innovation to stay ahead.
Adapt Financial Goals: Modify goals based on the business lifecycle, with milestones like $1 million MRR.
[1] The Rule of 40% For a Healthy SaaS Company
[2] SaaS and the Rule of 40: Keys to the critical value creation metric
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