There’s been much chatter about the Rule of 40 in recent years, and for good reason. As a quick, simple metric used by investors to value software businesses, it’s no surprise that SaaS (Software as a Service) leaders are drawn to testing their own businesses against the rule and discussing its benefits and shortcomings.
Understanding the rule of 40
The Rule of 40 provides a high-level view of a SaaS, or any software, business’s health. Put simply, if your percentages of growth rate and profit margin total at least 40 when added together, then your business is in great health and could double in valuation.
This rule suggests that a business with low or even negative profits can still be highly valued if it has a large enough growth rate as a counterbalance.
This situation is very common in rapid-growth startups looking to maximize customer acquisition and establish leadership in their niche.
The opposite can also be true for late-stage companies: slowed growth can signify valuable maturity if profits are high enough to satisfy the rule.
Which “percentages of growth rate and profit margin” should one use? While each business is unique, most thought leaders agree on using Monthly Recurring Revenue (MRR) or Annual Recurring Revenue (ARR) for growth rate. Combine the growth rate from either of those with the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) margin for the same time period, and see if the product is at least 40.
Some businesses may find that using their free cash flow (FCF) margin or operating income instead of EBITDA margin works better for their situation.
Businesses may choose not to use EBITDA for a variety of reasons. In one common scenario, a business that is hosting their own software has to factor in the cost of equipment purchase, financing debt, or lease expenses to do so—using EBITDA margins would not be a good fit in this case. However, a business using a cloud infrastructure can expect its cost of goods sold to scale along with the business, so using EBITDA works just fine.
Once you know which values are right for you, simply add these two percentages together and, voilà, you’ll know whether or not you’ve reached or surpassed the magical number 40. The calculation will look something like this:
Growth% + Profit% = x
If x is greater than 40, you’ve beat the Rule of 40.
Small SaaS startups that are doing well tend to blow the Rule of 40 out of the water. This is because they are experiencing exponential growth early on, which will lead to later stabilization and success. Because of this, many in the SaaS industry have formed opinions about when it’s appropriate to start using the Rule of 40 as a metric—and that’s not the only topic being discussed.
Rule of 40 debates seem to center around four main areas:
- When to start measuring
- What time period to measure
- How to “beat” the rule
- The actual value of the Rule of 40.
When to start measuring
The Rule of 40 hit the SaaS industry’s radar when Brad Feld, investor and founder of Techstars, published The Rule of 40% for a Healthy SaaS Company.
In his post, Feld shared the “rule” as described by a late stage company investor. The rule was only used for software and SaaS companies with at least $50 million in revenue, but Feld argued that it worked just as well once a business hit $1 million.
Opinions differ on this point. For example, Tomasz Tunguz quickly responded to Feld’s article with some data crunching in The Data Behind the Rule of 40%. In it, he suggested that in the early days of a new business, applying the Rule of 40 formula may yield confusing results higher than 100%—even 189% in the case of Workday in 2010.
Tunguz implied that waiting until year 5 or 6, when a business is more likely to have reached $50 million in revenue, may be more prudent.
David Cohen, co-CEO at Techstars, agrees that using the Rule of 40 too early will yield unsustainable results, but also thinks that waiting to reach $50 million isn’t necessary. He suggests starting once around the $15-$20 million in revenue run bracket. Still others recommend waiting until your business has built out all the necessary departments for growth: research and development, sales and marketing, customer support, etc.
A final common recommendation is for startups to focus on the T2D3 approach before looking into the Rule of 40. Under T2D3, a business triples its revenue for two years in a row, then doubles it for three years in a row. After taking five years to achieve this, businesses should be ready to look at the Rule of 40 seriously.
Taking these many opinions into consideration, the consensus is clear: relying on the Rule of 40 too early can create misunderstanding around company value.
Waiting until a business’s fifth year, after departmental build-out and reaching tens of millions in revenue, will yield a more accurate representation of potential for high valuation.
What time period to measure
Once a business starts using the Rule of 40, another common question is what time period to measure. For many, the standard practice is to measure quarterly or year-to-date, but other methods have cropped up over time.
Cohen points out, for example, that while investors often give credit forward 12 months when evaluating a business with consistency, someone looking to acquire a business may only be interested in the previous 12 months. Because of this, when calculating your business’s position within the Rule of 40 for a buyer, it is more prudent to measure the last 12 months of revenue. Do not use Rule of 40 as a predictor for future valuation.
Opinions differ on whether to use the Rule of 40 to create year-over-year (YoY) comparisons. While achieving a measure of 40 or above in a single year is not uncommon for successful businesses, maintaining the metric for multiple consecutive years has proven to be a rare feat, even for large companies. Fluctuations in the results of the formula can be due to any number of things, including business changes that will be positive long-term. If you do choose to create YoY comparisons of your Rule of 40 results, be sure to interpret the result along with other metrics and indicators—never alone.
How to “beat 40”
Of course, as soon as the Rule of 40 (R40) became well-known in the SaaS world, industry leaders wanted to know how to “beat” it.
This worries technology executive and investor Dave Kellogg. As he explains in “An Update on the SaaS Rule of 40”:
“My instinct at this point is that many companies target R40 compliance too early, sacrifice growth in the process, and hurt their valuations because they fail to deliver high growth and don’t get the assumed customer acquisition cost efficiencies built in the financial models, which end up, as one friend called them, spreadsheet-induced hallucinations.”
A post by the SaaS Capital blog agrees, pointing out that this metric isn’t right for everyone, and pushing to reach it “might not even be that productive if the market opportunity is not there.” Because every business is unique, the Rule of 40 could discourage startups from focusing on the large customer acquisition necessary to corner a market, or push others into rushed product development that alienates their niche audience.
Startup investor Greg Sands takes a similar stance in his piece, “What the ‘Rule of 40’ Means at the Early Stage.” In his post, he reminds business owners that what good investors really value is an owner’s understanding of unit economics, the ability to analyze their business and explain tradeoffs, and the ability to be profitable.
Still, those who have passed the early business stages are persistent in their desire to learn how to make the Rule of 40 work for them. Fortunately, Bain & Company has a well-written breakdown of different scenarios that allow for the conquering of Rule 40 as a startup matures. These can be summarized as:
- Keep revenue growth above 30%. This means that profit margins hover around 10% or lower, as long as the sum of the two is still 40% or more. This works best for startups trying to acquire customers at a rapid pace and disrupt their industry; immediate profits are sacrificed for expedited growth that claims a large portion of the market.
- Keep revenue growth between 10%-30%. This requires profit margins of also at least 10%-30%, again, as long as the sum of the two values is 40% or more. It works better for large, established companies with a presence in adjacent markets and a history of adaptability. The balance of growth and revenue is a sign that a business is both profitable but also still growing at a sustainable pace.
- Keep revenue growth below 10%. This is another approach that works better for established companies. In this situation, profit margins are consistently high (30% or more) thanks to pricing power, leveraging scale, cross-selling, and/or expanding the customer base, etc. Beating the Rule of 40 in this situation is simply a matter of remaining a giant in your field.
How useful is the Rule of 40, really?
With so many investors and experts expressing concern about putting too much focus on the Rule of 40, it’s understandable that some ask where the boundaries of its usefulness lie.
After all, most SaaS companies who beat the Rule of 40 are larger and well-known, and investors know this. They may be more likely to see a startup business as having promise if it invests more energy and value in tracking customer acquisition, lifetime value, churn, and renewal rates.
Due to the nature of SaaS, the need to sacrifice profit for growth early on makes sense for many. As long as attention is on creating the “monopoly” required to expand into enterprise-level operations, revenue growth is the priority. For most startups, this means that the Rule of 40 takes a backseat to focusing on more important things, like the acquisition, lifetime value, churn, and renewal rates listed above.
This doesn’t completely remove the Rule of 40 as a tool for startups, however. Thierry Depeyrot and Simon Heap of Bain & Company point out that the rule can be used in the early stages of business to assess the performance of business units or product families within an organization. Building the goal into business planning and performance assessments can be a great way to get started.
Getting in the habit of using the rule early on may lay a blueprint for success down the line when the metric really matters.
In an interesting expansion on using the Rule of 40, Jeremy Krasner at Stout came up with a Modified Rule of 40. In this rule, you include Research & Development (R&D) and Sales & Marketing (S&M) costs as a percentage of revenue in your Rule of 40 calculation. This allows for a tighter view and correlation to revenue multiples. Thus, the formula expands to look like:
Revenue Growth% + Profit% + S&M% + R&D% = x
The same number applies here: 40 and over is good, while under 40 means there may be room for improvement. In this new version, however, a business is more likely to reach 40 with the newly added values. This version of the rule may be more appropriate for businesses which aren’t (yet) giants in their field and are trying to understand their value—since it’s currently rare for lesser-known names in the industry to beat the rule.
As with anything else, the Rule of 40 is just one metric for measuring a business’s health. To oversimplify and use it as a sole measure would be unwise, but it’s certainly a great tool to have as you determine where your business stands as it grows. It is a “rule” of thumb, a predictor—not a catch-all measurement. Use it as needed, but remember that the health and success of your business are never measured by just one metric.