When you're new to a place and trying to find your way around, what do you do? You'd probably use a GPS!
That’s exactly how the Rule of 40 works for SaaS companies. It serves as a modern compass for these companies, guiding them in maintaining a balance between expansion and financial viability. If a SaaS company's revenue growth and profit margin sum up to 40% or more, it's in the sweet spot of being financially healthy and attractive to investors.
So, how does this rule work? Well, it helps a company to gauge if they are pacing growth just right and steer the business in the fast lane without sacrificing profits. In essence, the Rule of 40 suggests that, as businesses expand, the cumulative value of their revenue growth rate and profit margin should surpass 40% for optimal health in the SaaS industry.
What is the Mechanism Behind the Rule of 40?
The Rule of 40 helps evaluate the financial health and viability of growth-focused SaaS companies. It provides a single metric to gauge a company's commitment to boosting growth and profitability.
Moreover, the Rule of 40 aids SaaS founders in determining whether their balance between profitability and growth is optimal. For example, a company might prioritize growth over profitability and still be an attractive investment opportunity.
SaaS company's Rule of 40 could be assessed as follows:
<40 – Regarded as “poor” if your company has undergone Series A or later funding rounds;
40+ – A SaaS business with 40% or higher is appealing and higher than 40% is preferred;
and if your number nears 40, efforts should be made to raise this percentage.
It's important to know that achieving a number above 40 can be approached in various ways. A Venture Capitalist’s (VC) investment decision is influenced by their inclination toward growth or profitability, and a number exceeding 40 does not assure a high valuation multiple.
The Rule of 40 Computation
Before we begin trying to solve the formula, there are some metrics to help you determine if your company is meeting the Rule of 40.
Determine Your Revenue Growth Metric
Begin by selecting a revenue growth metric. You can opt for either annual recurring revenue (ARR) or total revenue. The key is to choose the type that best represents the majority share of your overall growth.
If most of your revenue comes from subscriptions, ARR is the most accurate metric;
If your revenue mainly comes from non-subscription products, total revenue is the better choice.
Select Your Profit Metric
Next, choose a profit metric. Earnings before interest, taxes, depreciation, and amortization (EBITDA) margins work best because they provide a standardized definition that companies of any size can use. EBITDA is a relatively simple way to measure cash flow without needing deep analysis, offering a quick way to see if you're on the right track.
The Rule of 40 serves as a guideline to evaluate the health of a SaaS business in terms of its recurring revenue growth rate and profit margin. The baseline figure of 40% indicates that a company is in good shape. If the percentage exceeds 40%, the business is likely well-positioned for long-term growth and profitability.
Usually, MRR or ARR serves as the revenue metric since GAAP metrics frequently do not fully reflect the actual performance of SaaS companies. The Rule of 40 is simply calculated by adding the recurring revenue growth rate to the EBITDA margin for a specific period.
Rule of 40 (%) = Revenue Growth Rate (%) + EBITDA Margin (%)
Let’s apply this computation to a company called TMP Inc.,
Where:
Revenue Growth Rate (%) = 25%
EBITDA Margin (%) = 18%
Therefore:
Rule of 40(%) = 25% + 18%
Rule of 40 (%) = 43%
In this example, TMP Inc. has a 43% Rule of 40 percentage which is above the benchmark of 40%. This indicates that the company is performing well according to this metric.
Finding the Balance Using the Rule of 40
The Rule of 40 serves as an important tool for analyzing SaaS growth and is key to the success of growing SaaS companies. It simplifies investor viability by offering a straightforward metric for investors to assess the attractiveness of a SaaS company. This clarity makes it easier for investors to make informed decisions. Also, it aids young SaaS companies, which often grapple with balancing growth and profitability. By regularly calculating the Rule of 40, these companies can determine which aspect—growth or profit—to prioritize at any given time.
The Rule of 40 offers a unified metric that aligns performance and growth plans, enhancing financial planning and analysis (FP&A) efforts and helping in identifying areas for improvement within the company. A company's position on the Rule of 40 can influence decision-making processes and highlight specific areas that require attention and refinement.
Primarily, the Rule of 40 is most reliable for mature SaaS companies surpassing mid-stage. When it comes to early-stage startups, their Rule of 40 figures can be all over the place, which makes it trickier to understand because their business models are still evolving.
Over time, as a SaaS company matures, it's natural to see a drop in MRR and ARR growth. Therefore, finding a balance between growth and profitability must be achieved. The Rule of 40 can guide when should a SaaS startup shift gears and aim for profitability over growth.
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