The Rule of 40 has become a standard among venture capitalists and stock market watchers since it was first introduced in 2015. It quickly determines whether a SaaS company’s business model is effective.
The Rule of 40 is a mathematical expression of a well-known argument featured in Brad Feld’s original post: “We can become profitable right away if we slow our growth rate.” The point is that in a SaaS company, you can easily trade growth for profitability.
As the economy slows, interest rates rise and investors focus more on cash flows, the Rule of 40 is facing its first real test. Instead of growing aggressively and losing money, maintaining a healthy balance between growth and profitability is now critical.
This article examines the Rule of 40, its calculation, when to apply it, and whether it is relevant in the current economic environment.
- The Rule of 40 is a simple way to assess the performance of a SaaS company. This rule states that a SaaS company is healthy if the sum of its revenue growth and profitability margin (EBITDA, EBIT, or free cash flow) is higher than 40%.
- However, the Rule of 40 should only be applied to companies employing SaaS/software subscription-based business models. It’s not suitable for analyzing marketplaces, e-commerce, or other non-software companies.
- Inflation can make passing the Rule of 40 easier for companies that perform well on cost pass-through using simple price hikes.
- With the global economy slowing down and rising interest rates, companies are now prioritizing profitability over revenue growth. The 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?
The Rule of 40 is a metric used to assess the performance of a SaaS company. According to it, for a SaaS company to be healthy, the sum of its revenue growth rate and profitability margin should exceed 40%. The rule implies a trade-off between growth and profitability, and that the former can be traded for the latter.
In essence, if a company’s revenues grow at 30% year-on-year, it should have a profitability margin of at least 10%.
On the other hand, if a company’s growth is 60% year-on-year, it can have a profit margin of negative 20%, i.e. a loss.
Introduced initially as a quick way of assessing the health of a company, the Rule of 40 has now become a common way of assessing the performance of listed SaaS companies. In this context, one might assume that the company with a higher number is more effective.
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 year-over-year change in MRR (monthly recurring revenue) or ARR (annual recurring revenue). It is the most fitting for a SaaS business as it primarily only includes recurring revenues.
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 subscriptions). This metric may not be accurate if the company has a significant share of non-recurring revenues.
Companies often have different accounting policies. As a result, revenue recognition may be based on cash billings for many small companies (revenue is recognized at the moment of the sale). To correctly calculate the Rule of 40, you must use accrual accounting and recognize the revenue throughout the contract’s lifetime with clients. This method gives a more accurate picture of when the company earns its revenue.
There are various methods to determine a company’s profitability margin. The most commonly used measures are the EBITDA margin, the operating profit margin (EBIT margin), and the free cash flow margin (FCF margin).
The EBITDA margin is a commonly available profitability metric that measures a company’s profitability. However, the EBITDA margin should be used cautiously, as the company may be aggressively capitalizing its development costs, resulting in an increase in depreciation add-back. In these situations, we may use EBIT margin instead of EBITDA.
Additionally, we must decide whether to factor in share-based compensation (SBC) when using EBITDA or EBIT.
An argument can be made that it’s a cashless expense and should be treated the same way as depreciation and amortization. However, there is a hidden expense to all the other shareholders, who are the company owners and are “diluted” – left with a smaller fraction of ownership after the new shares are issued. If the company wants to avoid diluting existing shareholders, it will have to use cash to buy back shares on the open market.
Analysts tend not to adjust for SBC when it is significant and recurring. However, both approaches are appropriate; the key is to maintain consistency.
Another way to measure a company’s profitability is using the FCF margin. This is calculated by dividing a company’s free cash flow by its sales for a period. It’s essential to be consistent in calculating FCF, as there are various ways to do this.
Typically, analysts will adjust the EBITDA for capital expenditure, share-based compensation, and net working capital when using the FCF formula.
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 considers CAPEX, so capitalization of development costs is irrelevant. The inclusion of net working capital accounts for the fact that SaaS companies sell long-term subscriptions, receiving cash in advance and recognizing it as revenue over time.
However, the FCF margin may not be suitable for firms that extensively compensate their employees with shares (options or restricted stock units) – also called stock-based compensation. SBC is included in the calculation of free cash flow as an add-back – a non-cash charge for the company. Though the payment is non-cash, SBC remains an expense recorded on the P&L statement and can significantly impact the Rule of 40 assessment.
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 the 51% FCF and the -47% EBITDA margin. This large difference is the result of adding back the $560M in stock-based compensation to FCF, but not to EBITDA. Again, since Okta has a significant stock-based compensation that eventually will turn into an expense for the company, it’s not adjusted for in EBITDA.
There is no one correct answer to what profitability margin should be used, and for most SaaS and software companies these metrics will be similar, especially when using adjusted figures. The key is to decide on the most relevant method for your business/industry and compare metrics consistently.
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. It’s best to use with companies that have a subscription-based business model.
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. Either focus on turning profitable now and spend less on customer acquisition, but this will dampen your future growth prospects. Or “compromise” current profitability by spending heavily on growth initiatives and customer acquisition, hoping your business will eventually become profitable.
When such a trade-off between current profitability and future growth exists, the Rule of 40 can clearly show how profitability is temporarily sacrificed for growth. If it’s a loss-generating business with no prospects of becoming profitable, analyzing how it performs on the Rule of 40 test adds little value
Company size and phase of the business cycle
In his original post, Brad Feld writes that the Rule of 40 is best used for companies at scale with $50M in ARR. In general, this revenue target is met by well-established mature companies. However, the Rule of 40 could be a useful SaaS metric for any company with $10M in ARR. Therefore, instead of focusing on size, it’s better to look at which stage of the company’s business life cycle is in.
Notably, Rule of 40 is irrelevant for early-stage companies experiencing rapid growth from a smaller base with hundreds of percent growth rate. These companies should focus on product-market fit, generating their first revenue, and serving existing customers. The Rule of 40 may be a good guideline for more established companies, but it does not apply to start-ups at the early stages of development.
At the same time, the Rule of 40 can be well applied to mature businesses. For example, Salesforce, one of the pioneers of the SaaS business model, has delivered high growth at around 25% with 10-15% EBITDA margins, despite reaching a significant scale. At the same time, the caveat is the significant number of acquisitions that the company did, so a large part of the growth is inorganic
When not to use the Rule of 40?
The Rule of 40 was initially created for analyzing SaaS companies as it works best with subscription-based companies. However, now it’s used for all kinds of business models, often to point at 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 selling lower-margin third-party manufactured goods and services, not the sale of proprietary software. Over the long term, they can typically only achieve a low-single-digit EBITDA margin, requiring these companies to grow above 30% in perpetuity to be considered healthy. Additionally, lower customer retention and LTV in eCommerce purchases make a trade-off between growth and profitability much less obvious.
How does Rule of 40 influences valuation?
The Rule of 40 has a substantial impact on the valuations of companies in the Software as a Service (SaaS) sector, primarily because it serves as a crucial indicator of a company’s operational efficiency and growth potential.
In the realm of SaaS businesses, the revenue multiple is among the most widely employed valuation metrics. In our analysis, we took a look at how Rule of 40 correlates with the revenue multiple for the 70+ companies from our SaaS Index.
As a rule of thumb, a 10% increase in the Rule of 40 score tends to correspond to approximately a 0.8x growth in the revenue multiple. In simpler terms, when a SaaS company demonstrates the ability to balance growth and profitability by exceeding the Rule of 40 threshold, investors are more likely to assign a higher valuation, based on the expectation of sustained growth and operational efficiency.
A deeper analysis, indicated that it is the growth element of the Rule of 40 is primarily responsible for the difference in revenue multiple for listed companies.
Is Rule of 40 still relevant?
The first test of the 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 a customer base. Many companies were efficient on a Rule of 40 basis primarily due to extraordinary sales growth rate.
Software companies with solid profitability margins were more common among names founded in 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 the 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 profitability margin?
As MRR growth declines, SaaS companies are expected to reap the benefits of past exponential growth and transform it into solid profitability 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 achieve 20-30% profitability margins to be considered efficient. The next few years will show whether exchanging growth rates for profit is as easy in reality as it is in a spreadsheet.
Inflation and the Rule of 40
Inflation can have a significant impact on the Rule of 40. If inflation is high, companies will need to adjust their prices upwards to maintain their profitability margins. Many countries report inflation close to 10%, while some emerging markets have price growth above 20%.
Companies that can effectively pass through higher costs to consumers (protect margins), will find it easier to hit the 40% target through simple price hikes. Therefore, if CPI remains at around 10%, 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, future cash flows become less valuable for investors as its discounted at a higher rate. This has major implications for SaaS strategies that usually have a large upfront investment to acquire customers and are expected to generate cash years down the line. With a higher discount rate, the present value of future customers is lower, and therefore the time needed to become profitable is extended.
At the same time, some of the elements of SaaS businesses are becoming less attractive. For example, long-term contracts 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, the Rule of 40 may become overly lax to companies growing rapidly but with low-profitability margins or high churn.
One way to improve the analysis is to apply a Weighted Rule of 40 when profitability is more important than growth: to give more weight to profitability margin than to a company’s growth rate. For example, using a 1.33 weight for profitability 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 must 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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