What is the Rule of 40 and How to Calculate It?

What is the Rule of 40 and How to Calculate It?

Measuring metrics is crucial for any business trying to excel in the SaaS industry. Without benchmarks, companies wouldn’t be able to make informed decisions about what to do next, especially in the early stages.

The goal is to make the appropriate internal changes and make the right comparisons between companies, which is particularly useful for potential clients and investors assessing their options.

The SaaS world has become extremely competitive in recent years, which makes your benchmarking, strategies, and forecasting that much more important. However, the benchmark that works for you depends entirely on your organization and the businesses you’ll need to compare yourself to — among other things.

Of course, the one thing that all SaaS companies have in common is that revenue growth and profitability are at the top of the list when it comes to measuring benchmarks. That’s where the Rule of 40 comes into play.

What Exactly Is the Rule of 40?

The Rule of 40 is a financial concept commonly applied within a SaaS business model expressing that a company should have a combined revenue growth rate and profit margin equal to or exceeding 40%. The idea behind this principle is that SaaS companies operating above 40% are seeing a sustainable revenue growth rate while SaaS companies below 40% are looking at issues with free cash flow or liquidity.

It should be noted that the Rule of 40 only applies to SaaS businesses. This is because software companies that leverage their services to other businesses are known to manage higher margins between 70% and 90%. However, this rule of thumb can still be applied as a useful benchmark for other subscription companies.

When it comes to determining these SaaS metrics, the company must understand both its revenue growth and profitability margin. This is because the primary purpose of these metrics is to make it easier to compare SaaS companies with varied operating structures or that are at different phases of their business cycle or are just generally difficult to make comparisons to.

Calculating the Rule of 40 For SaaS Companies

The Rule of 40 is calculated by adding a company's Revenue Growth Rate (%) to its EBITDA Margin (%)

Revenue Growth Rate represents the percentage increase in a company's revenue over a specific period, typically a year. It shows how quickly the company is growing its top line.

EBITDA (earnings before interest, taxes, depreciation and amortization) Margin is a measure of a company's operating profitability, indicating how much money it generates from its core business operations before considering non-operating expenses.

EBITDA Margin is calculated as EBITDA divided by Revenue and multiplied by 100 to express it as a percentage. It reflects the company's ability to generate profits from its operations.

Here’s an example of how to use the Rule of 40:

Let’s say there’s a company within the SaaS industry that generated $10 million in 2020 and then another $12 million the following year. That’s a $2 million difference, so you would divide that 2 million by 10 million and multiply it by 100% — which equates to a year-over-year revenue growth of 20%.

Now, if that same company had an EBITDA of $3 million in 2021, its EBITDA margin (3 million / 10 million x 100) would be 30%.

The revenue growth rate plus the EBITDA margin adds up to 50% — which means they’ve exceeded the Rule of 40 and are a healthy SaaS company.

Why Use the Rule of 40?

Setting up benchmarks and metrics for balancing profitability and a company’s growth is key. This is how you inform your long-term and short-term decisions so you can grow more profitable over time.

Here are a few reasons why you should use the Rule of 40 to maintain a healthy business.

It Can Help You Figure Out Which Trade Offs You Can Afford

After doing your Rule of 40 calculations, if you find that your company has exceeded or matched that 40% (20%+ growth rate and 20%+ profit margin) you can still operate with losses.

If your growth and profitability fall below the 40%, you’ll need to check your other KPIs to identify where the potential issues are. This will help you figure out if you’re looking at an increased cost of goods sold (COGS), higher Customer Acquisition Costs (CAC), high churn rates, and so on.

It Can Help You Evaluate Your Investment Abilities

When your profitability and growth rates exceed 40%, you’ll know that you have room to go after rapid growth — or hypergrowth — and attract new customers and retain more of your customer base. This can help you sustain your company’s performance over a longer period of time without having to worry about sacrificing profits.

Adversely, operating below 40% can prove challenging as it can keep you from scaling for a long period of time. In a competitive market, you need to corner the largest possible share right away to nail down your targeted market for sustainability.

Investors Use the Rule of 40 to Assess Investment Opportunities

Venture capitalists are the ones who came up with the Rule of 40 and they use it to quantify the potential valuation of SaaS companies.

It’s easy for SaaS companies to reach higher-than-average valuations, but many investors like to consider valuations for short-term planning. They’re also aware that a SaaS company’s value can be destroyed despite an increasing annual recurring revenue.

However, valuation isn’t determined using the Rule of 40 as the metric’s primary focus is measuring sustained value creation instead — this is what investors are really looking for in a venture capital opportunity.

It Can Be Used to Determine When to Maximize Growth and Profitability

In the SaaS industry, startups and small businesses focus on growing their revenue, whether they make a profit or not. However, this doesn’t justify runaway growth as you still need to be able to generate profits even when your growth rate has slowed down.

Then there are the more mature companies that have already cornered their target market and need to shift their focus to more profit margin rather than market expansion.

Regardless of whether you’re a startup or a mature SaaS company, the Rule of 40 can be used to shine a light on your marketing and sales tactics. It can help you determine whether or not they’re effective at attracting and retaining customers while producing high enough growth margins to keep your investors satisfied.

When Should You Use the Rule of 40?

The Rule of 40 used to apply to SaaS companies exceeding an annual revenue of $50 million. Brad Feld was the individual who established the rule and also recommended that it be applied to your company after reaching $1 million in annual recurring revenue (ARR).

However, according to a recent survey, most SaaS companies take about five years to reach $1 million ARR. While this may not be what you want to hear if you’re a younger SaaS company, assessing a period of 12 to 18 months can help you determine your growth curve or monthly recurring revenue (MRR).

Conversely, you can also wait until all of your departments are in the right place and have your product-market fit nailed down as well as fix any cash flow issues.

The most important thing to keep in mind when applying the Rule of 40 is that it’s not the only metric you should be using. It’s simply part of an overall company health assessment, which means while you can use it monthly or YoY, it should also be used in combination with other value metrics.

To get the full picture of your company's health, download our SaaS Metrics Template and track everything in one place.

Final Thoughts

Ultimately, the Rule of 40 is a very simple benchmark that can help you gain useful insights for your SaaS company. The main thing you want to keep in mind is that maintaining a balance between revenue growth and profitability is the key to maximizing long-term stability. Then, once you hit and exceed the 40% mark, you’ll have a better chance at getting attention from investors and cornering your share of the market.

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