What is the Rule of 40?

What is the Rule of 40?

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Software companies need to balance profit and growth to survive, thrive and become attractive targets for venture capital firms (VC). One benchmark investors and analysts use to ensure a company is a good investment is a metric called the Rule of 40. This calculation provides a quick way to measure a company’s performance and sustainability. 

The Rule of 40 is the theory that a company’s revenue growth rate and profit margin combined should exceed 40%. Young companies often beat this mark thanks to their early growth. Since young companies grow more quickly, some experts say it’s best to apply the “rule of 40” to companies that have already reached $1M in annual recurring revenue. However, companies at all stages of growth can use the “rule of 40”. 

Software-as-a-service (SaaS) companies are the best targets for the Rule of 40 as they operate based on recurring monthly sales. Adding together profit margins and growth in year-over-year sales for these companies provides a valuable indicator of future performance and financial health. 

 

Why is the Rule of 40 Important?

The “rule of 40” provides a metric for judging a SaaS business’ performance, especially in comparison to other firms. Balancing growth and profitability is key to remaining competitive in the SaaS industry. Grow too quickly, and profit margins and cash flow will suffer. Focus too much on profitability, and the company could miss its chance to expand. 

With the Rule of 40, investors have a reliable metric to apply to SaaS businesses across the board. If the company is below 40%, either growth, profitability, or both are out of balance and could be higher. At 40%, there is a healthy balance between profit and growth. Go too far above it, and the company risks being unsustainable. By using the Rule of 40, investors have a better idea of how a business will perform over time. 

 

How to Calculate the Rule of 40

The formula for calculating the Rule of 40 is:

Revenue growth rate (as a percentage) + profit margin (also as a percentage) = Rule of 40 Total

A company whose revenue growth is 25% and has a profit margin of 15% fits comfortably within the 40% rule. However, a business with a higher growth of 30% but only 2% profitability would fall short. 

The method to calculate the “rule of 40” total depends on how you measure profits and growth.

 

Revenue Growth Rate for the Rule of 40

Recognizing revenue is standardized across organizations thanks to the Generally Accepted Accounting Principles (GAAP). Revenue earned by a business is recorded when its performance obligations are met, for example, when it provides access to its software platform or service. Since SaaS companies often have straightforward pricing models, revenue numbers are generally reliable across different types and sizes of organizations. 

The formula for calculating your monthly revenue growth rate is as follows:

((Revenue for Month 2 – Revenue for Month 1)/ Revenue for Month 1) x 100

For mature companies, measuring year-over-year revenue growth is sometimes more appropriate. Monthly recurring revenue (MRR) provides insight into how a company is growing in the short term. Annual recurring revenue (ARR) is better for taking a big-picture look at how it has expanded over time. Since SaaS companies generally charge a monthly fee, an MRR-based revenue growth rate (shown above) is a good place to start. 

 

Profit Margin for the Rule of 40

Unlike revenue, a profit margin isn’t a standard measurement. While GAAP principles provide the framework for the income statement, many companies will use non-GAAP measures of profitability, such as an ‘adjusted operating income, which adds items like marketing costs into the equation. Other companies might want to base their profit margin on net income, operating income, or cash flow. 

It can be tempting to boost performance numbers as much as possible, especially with early-stage SaaS companies. However, the most reliable way to measure profits for the Rule of 40 is with EBITDA (earnings before interest, taxes, depreciation, and amortization). EBITDA is calculated based on financial statement numbers (GAAP approved!) and indicates a company’s actual cash flow. 

To calculate profit margin, take EBITDA as a percentage of revenue.

(EBITDA / revenue) x 100 = % profit margin

For example, a company that earned $1M ARR in year one and $1.2M ARR in year two would have a growth rate of 20%. If the same company’s EBITDA was $360,000 in year 2, it would have a profit margin of 30%. 

20% Growth rate + 30% Profitability = 50% Rule of 40 Total

In this example, the Rule of 40 would suggest that this is a healthy business with room to invest in more growth for the future. 

 

Ways to Improve Growth and Profitability

If a business falls short of the “rule of 40” target, achieving high performance is still possible. There is always a trade-off when choosing whether to target growth or profitability, but the “rule of 40” gives decision-makers an idea of which area is out of balance. Is the growth rate high and profitability low, or is the opposite true?

If the problem is growth:

  • Expand offerings such as new service lines, platform capabilities, or R&D initiatives to develop or improve products
  • Enter new markets by creating products adjacent to the core business model
  • Increase marketing by making additional hires in marketing and sales, expanding marketing campaigns, or attending events to attract new customers

If profit margins are an issue:

  • Reduce churn by enhancing the user experience, adding customer service features, or collecting feedback to keep existing customers around for longer.
  • Increase your customers’ spend through upsells or changes to your pricing structure. 
  • Leverage existing assets to find efficiencies and scale (simplify your business structure, remove duplication, or automate parts of the process.)
  • Prioritize product maintenance with the development of new features.

Financing options like SR&ED financing and Grant financing can provide businesses with the capital they need to help with the growth part equation. Getting up-front funds for SR&ED tax credits or grants frees up cash flow for sales and marketing spending, R&D initiatives to increase product growth, or acquire technology to make existing assets more efficient. Whether you’re trying to improve margins or expand your customer base, SR&ED and grant financing are easy ways to access the cash you need when you need it.

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