First introduced in 2015, the “Rule of 40” has become a staple of venture capitalists and stock market observers. It is a quick way to establish whether a SaaS company’s business model is effective.
The Rule of 40 has become a mathematical expression of a familiar argument, quoted in the original Brad Feld’s post: “we can get profitable right away if we slow down our growth rate.” The idea is that in a SaaS business, one can easily trade off growth for profitability.
As the economy slows down, interest rates rise, and investors increasingly focus on cash flows, the Rule of 40 is put to its first real test. Suddenly, maintaining a healthy balance between growth and profitability is more important than growing aggressively while losing money.
In this article, we look at what the Rule of 40 is, how it is calculated, when best used. and whether it is relevant in the current economic environment.
Rule of 40 is a quick way to evaluate a SaaS company’s performance.
Rule of 40 states that the sum of a healthy SaaS company’s revenue growth and profit margin should be higher than 40%.
Calculating the Rule of 40 is done as follows:
Take the most recent recurring revenue growth,
Add EBITDA or Free Cash Flow margin, excluding one-offs.
Rule of 40 should only be used for companies with SaaS/software licensing business models.
Rule of 40 should not be used in particular for marketplaces, eCommerce, or other non-software companies.
As the growth slows and interest rates rise, founders and investors are putting more emphasis on profitability rather than on growth rates.
Inflation can make it easier to hit Rule of 40, as some growth can be achieved just by increasing prices.
Rule of 40 can still be relevant as a rule of thumb for the SaaS industry, but now both of its components better be positive.
What is the Rule of 40?
Rule of 40 is a metric used to evaluate a SaaS company’s operating performance. It states that for a healthy SaaS company, the sum of revenue growth rate and profit margin should be higher than 40%. The rule implies a trade-off between growth and profitability and that the former can be exchanged for the latter. In essence:
If a company grows at 30% year on year, then it should have at least a 10% profit margin.
If a company grows at 60% year on year, then it can afford to lose 20% on the bottom line.
First utilized as a way to quickly check the company’s health, the Rule of 40 later gained popularity as a way to rank the performance of public SaaS companies. Here, one would assume that the company with a larger number is more efficient.
Calculating the Rule of 40
There are several different ways to calculate the growth rate of a business. The most common method to calculate the growth rate of a SaaS business is to take the change in MRR (monthly recurring revenue) or ARR (annual recurring revenue). It is the most fitting for a SaaS business as it only includes recurring revenue.
Another way to measure annual revenue growth would be to use total revenue as reported in the financial statements. Total revenue differs from ARR/MRR because it includes income from non-recurring sources (e.g. one-off professional services or lifetime licenses). This metric may not be accurate if the company has a significant share of non-recurring revenue.
Companies may have different accounting policies and revenue recognition may be based on cash billings for many small companies (revenue is recognized at the moment of the sale). Yet, for the correct calculation of Rule of 40, one needs to use accrual accounting (recognizing the revenue over the duration of the contract with the clients), as it gives a more accurate picture of when the company earns income.
There are even more ways to calculate the profit margin. Commonly used metrics include EBITDA margin, operating income (EBIT) margin, or Free Cash Flow (FCF) margin.
EBITDA margin is a commonly available profitability metric, measuring a company’s profitability that excludes non-operational expenses. Yet one should be careful with using EBITDA margin, especially if the company aggressively capitalizes its development costs, resulting in an elevated depreciation add-back. In such scenarios, EBIT margin may also be utilized as an alternative to EBITDA.
Another common way of measuring profitability is to use the FCF margin. It is calculated by computing a company’s free cash flows over a given period and dividing it by revenue over the same period. The argument for using FCF margin is that it provides a good picture of the company’s cash generation potential. Unlike EBITDA, free cash flow takes CAPEX into account, so capitalization of development costs is irrelevant. It also considers that many SaaS companies sell long-term subscriptions, receiving cash in advance and recognizing it as revenue over time.
Yet FCF margin is poorly suited for companies with a large part of employees’ compensation paid in shares (options, RSUs). Stock-based compensation (SBC) is an add-back in free cash flow calculation: a non-cash expense for the company.
While the payment is non-cash, SBC is still an expense recorded on the P&L statement and can significantly affect the Rule of 40 calculation.
For example, Okta paid its staff more than $560M in stock-based compensation in FY2022. Combined with other non-cash expenses and cash received early from customers, there is a staggering difference between 106% and 4% scores calculated using different profitability metrics.
There is no one correct answer to what profit margin should be used for the calculation, and most companies, these metrics will be similar. The key is to compare metrics consistently and ensure there are no interfering effects, e.g. stock compensation, intangible assets capitalization, or one-off charges.
When to use the Rule of 40?
Industry and Business model
The Rule of 40 was initially conceived for SaaS companies but later became a popular rule of thumb for all software companies.
Our view is that the Rule of 40 is a relevant metric when a company’s business model indeed incorporates a trade-off between current profitability and future growth. More specifically, when the product is fundamentally profitable and has strong unit economics (high margins), but requires upfront investments in customer acquisition cost. Only then, the temporary losses will eventually result in increased profitability in the future.
Otherwise, it just justifies making losses without a solid business model.
In his original post, Brad Feld mentioned that he learned that Rule of 40 is best used for companies at scale with $50M in revenue, but it can be a useful SaaS metric for any company with $1M in MRR.
Importantly, this rule of thumb is not relevant for early-stage companies experiencing rapid growth from a smaller base with a growth rate of hundreds of percent. These companies should focus on product-market fit, generating their first revenue and serving existing customers. So while the Rule of 40 may be a good guideline for more established companies, it does not apply to start-ups at the early stages of development.
At the same time, the Rule of 40 seems to be applicable to mature businesses. For example, Salesforce, one of the pioneers of the SaaS business model, has been able to deliver high growth at around 25% with 10-15% EBITDA margins, despite reaching a significant scale.
When not to use the Rule of 40?
While the Rule of 40 was created for SaaS companies, it is now used by many for all kinds of business models. Commonly, using revenue growth as a justification for massive losses.
For example, using the Rule of 40 for eCommerce companies makes little sense as their business model relies on earning (relatively) small margins and selling, not the sale of software. Over the long term, they can typically only achieve a single-digit net income margin, requiring these companies to grow above 30% in perpetuity to be considered healthy. Many eCommerce companies have been some of the fast-growing companies during COVID but losing money and thus valued using revenue multiples. Lower customer retention and LTV in eCommerce purchases make a trade-off between growth and profitability much less obvious.
Is Rule of 40 still relevant?
First test of Rule of 40
Created in 2015, the Rule of 40 came of age in times of unprecedented economic and stock market growth. The venture capital funding for tech companies was ample, allowing companies to invest aggressively in growth and building the customer base. Many companies were efficient on a Rule of 40 basis primarily due to extraordinary growth rate.
Software companies with solid profit margins were mainly players from the past century – Adobe, Salesforce, Intuit, and OpenText – supporting the premise that one needs to wait long enough and profits will come.
With SaaS businesses maturing, the economy slowing, and interest rates rising, the premise of Rule of 40 is put to its first major test. Can the companies indeed choose between profitability and growth? Is 40% profitability at a 0% growth rate as easy to achieve as 40% growth with no profit margin?
As MRR growth declines, SaaS companies are expected to reap the benefits of past exponential growth and transform it into solid profit margins.
Many reported strong SaaS metrics: high LTV/CAC, low churn, and 100%+ net revenue retention, suggesting the growth shall continue even with less investment.
Companies reaching a sustainable growth of 10-20% a year are supposed to reach 20-30% profit margins to be considered efficient. The next few years will show whether exchanging growth rate for profit is as easy in reality as it is in a spreadsheet.
Inflation and the Rule of 40
Inflation can have a big impact on the Rule of 40. If inflation is high, then companies will need to adjust their prices upwards in order to maintain their profit margins. Many countries report inflation close to 10%, while some emerging markets have price growth above 20%.
Inflation makes it easier for businesses to hit the 40% target, as their revenue will grow nominally with price increases.
If CPI remains at its current level, then the rule could be amended to 50% or higher. Either way, it’s important to keep an eye on inflation when assessing a company’s performance using the Rule of 40.
Focus on profitability
With the increase in interest rates, cash flows in the future become less valuable for investors. This has major implications for SaaS strategies. Investing in customer acquisition now to earn cash back in several years becomes much more risky.
At the same time, some of the elements of SaaS businesses are becoming less attractive. For example, long-term contracts with without price indexation are less attractive in times of rapid inflation.
The future of the Rule of 40
A valuable tool to identify a healthy business in times of boom, Rule of 40 may become overly lax to companies that are growing rapidly but low profit margins or high churn.
One way to improve it could be to use a Weighted Rule of 40 when profitability is more important than growth: to give more weight to profit margin than to a company’s growth rate. For example, using a 1.33 weight for profit margin and 0.67 weight for revenue growth.
In any case, balancing growth and profit will remain high on the founders’ agenda. The current environment suggests companies will need to sacrifice growth for a quicker path to profitability. So the Rule of 40 remains one of the critical metrics once both its components are positive. But it becomes increasingly difficult to argue that mature SaaS businesses losing 20% a year are healthy, even while growing revenue by 60% yearly.
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