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 is the Rule of 40, how it is calculated, when best used, and whether it is relevant in the current economic environment.
Summary
- Rule of 40 is a quick way to evaluate a SaaS company’s performance. It states that for a healthy SaaS company, the sum of its revenue growth and profitability margin (EBITDA, EBIT, or Free Cash Flow) should be higher than 40%.
- The Rule of 40 should only be used for companies with SaaS/software subscription-based business models. It’s not appropriate to analyze marketplaces, eCommerce, or other non-software companies is not appropriate.
- Inflation can make it easier to pass the Rule of 40 for companies that perform well on cost pass-through through simple price hikes.
- As the global economy slows and interest rates rise, more emphasis is placed on profitability over revenue growth. 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 to evaluate a SaaS company’s operating performance. It states that for a healthy SaaS company, the sum of revenue growth rate and profitability 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-over-year, it should have at least a 10% profitability margin.
- If a company grows at 60% year-over-year, it can afford to have a negative 20% profitability margin, effectively generating a loss.
First utilized as a way to quickly check the company’s health, the Rule of 40 later gained popularity in ranking 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
Revenue growth
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 can 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). However, for the correct calculation of the Rule of 40, one needs to use accrual accounting (recognizing the revenue throughout the contract’s lifetime with the clients), as it gives a more accurate picture of when the company earns income.
Profitability margin
There are multiple ways to calculate the profitability margin. Commonly used metrics include EBITDA margin, operating income (EBIT) margin, or Free Cash Flow (FCF) margin.
The EBITDA margin is a commonly available profitability metric that measures a company’s profitability. 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.
We also need to decide if we want to adjust for share-based compensation (SBC) when using EBITDA or EBIT.
An argument can be made that it’s a cashless expense and, therefore it 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 significant and recurring. However, both approaches are appropriate; the key is to maintain consistency.
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. FCF can be calculated in a number of different ways, the key is to be consistent in your applied method. A common formula used by analysts is adjusting the EBITDA for capital expenditure, share-based compensation, and net working capital.
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. 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.
Yet FCF margin is poorly suited for companies with a large part of employees’ compensation paid in shares (options or restricted stock units), also known as 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 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 a method that is most relevant for your business/industry and to 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. That is, either focus on turning profitable now and spend less on customer acquisition, but this will dampen your future growth prospects. Or “sacrifice” current profitability by spending heavily on growth initiatives and customer acquisition with the hope that eventually your business will become profitable.
When such a trade-off between current profitability and future growth exists, the Rule of 40 can give a clear picture of 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 business life cycle the company is in.
Notably, Rule of 40 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. 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.
Is Rule of 40 still relevant?
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?
Growth slowdown
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 that are growing rapidly but have 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.
About Aventis Advisors
Aventis Advisors is an M&A firm focusing on technology and growth companies. We believe the world would be better off with fewer (but better quality) M&A deals done at the right moment for the company and its owners. Our goal is to provide honest, insight-driven advice, clearly laying out all the options for our clients – including the one to keep the status quo.
Get in touch with us to discuss whether it is the right moment for a deal for your business.
