You cannot improve what you do not measure.
The Rule of 40 is a good high-level benchmark of performance for software companies and SaaS management teams. It's gained a lot of momentum in the areas of venture capital and growth equity.
Importance of benchmarking as companies grow
Benchmarking is essential for any company that wants to succeed, regardless of whether they're a SaaS company. It can be challenging if a company doesn't know whether it is on the right path without benchmarks, especially at an early stage.
Businesses can use benchmarking to measure themselves against internal progress and the external environment. At the same time, benchmarks are also quite useful for investors and potential customers when evaluating the value of a company.
With cloud-based SaaS businesses flooding the market, it is essential to know where your software company stands, how much value it holds and whether customers and investors prefer it. However, the traditional GAAP accounting method is not as helpful for valuing SaaS companies as it is for companies in other industries.
That's mainly because annual revenue is different in the SaaS industry. As you may already know, the SaaS business model is a subscription-based model, which determines that the sales cost are expensed in advance. At the same time, revenue is recognized equally over the lifetime of customers.
Therefore, we need to use different financial metrics to evaluate a SaaS company's performance.
Generally, profitability and growth are two critical metrics in SaaS businesses. Most SaaS companies will seek high profitability and growth if all other things are equal.
But how does a SaaS business owner know if the company can grow and make profits at a sustainable rate? How do they evaluate whether this is a healthy business? That's where Rule of 40 comes in.
What is the Rule of 40 SaaS
Rule of 40 states that your revenue growth rate plus profitability margin should equal 40% if you are a venture-backed SaaS business. It is a rule of thumb for investors (e.g., venture capitalists, private equity investors) and possible buyers. They usually do not invest in a company if they do not have the Rule of 40.
This rule was initially popularised in the SaaS industry when Brad Feld, author of the popular blog Feld Thoughts, announced this community baseline in The Rule of 40% For a healthy SaaS company in 2015:
"I was at a board meeting recently and heard something I've not heard before from a late-stage investor. He described what his firm called the 40% rule for a healthy software company, including business SaaS companies. These are for SaaS companies at scale – assume at least $50 million in revenue – but my Illusion of Product/Market Fit for SaaS Companies correlates nicely with it once you hit about $1m of MRR."
- If you are growing at 20%, your profit margin should be 20%;
- If you are growing at 40%, your profit margin can be 0%
- If you are growing at 50%, you can lose 10% in profit
How to calculate the Rule of 40
The calculation of the Rule of 40 included two standard financial metrics for SaaS businesses: the company's revenue growth rate and profitability margins.
The formula is to add these two metrics together. If it is over 40%, it indicates that you have an excellent healthy SaaS business and your SaaS company is ready for more customers and hyper-growth opportunities. However, if it is below 40, that doesn't necessarily mean your business is in bad condition. You need to evaluate other metrics to identify potential issues, such as Cost of goods sold (COGS), customer acquisition cost (CAC), churn, and others.
Calculating the revenue growth rate
ARR Growth Rate is the growth in annual recurring revenue in a specific period, usually for 12 months, which indicates the growth rate of your business. It is one of the vital factors that impact the valuation of SaaS companies at an early stage, and it is essential to monitor the metric when preparing for funding.
You can find out more about how to calculate these two benchmarks in the following articles:
Calculating the profitability margin
We usually use earnings before interest, taxes, depreciation, and amortization (EBITDA) to calculate profitability margin. EBITDA margin also called the operating income as a % of revenue, removes differences in interest expense, tax treatment, amortization, and depreciation, making it the best indicator of profitability when comparing the SaaS business.
But some SaaS businesses may find it works better for their situation when using cash flow or free cash flow margin and net income instead of EBITDA margins. Some may also change the revenue growth indicator to gross margins.
Therefore, there are three commonly used formulas:
- Revenue Growth (ARR growth rate or MRR growth rate) + EBITDA margin/ Operating income margin
- Revenue growth + net income margin
- Gross margins + free cash flow margin
In addition, a SaaS company can also use growth rate and profit margin as separate key metrics to track the company's financial health.
Why is the Rule of 40 crucial for the SaaS business
There is no denying that the Rule of 40 is becoming a popular metric for measuring the performance of software companies. But why is the Rule of 40 becoming increasingly important for SaaS businesses? Here are three crucial benefits.
Better chance of raising funds
As mentioned above, venture capitalists came up with the idea of the Rule of 40. Therefore, if you want them to invest in your company, you must show them what they're looking for. That means you have to quantify your SaaS business's performance when trying to convince them to bet on you. That means you must show them that you have achieved or you have a plan to achieve the Rule of 40.
An indicator of return on investment
Put yourself in the shoes of a venture capital investor for a minute. Think about what kind of SaaS company you might be looking for as an investor. Think about the competitive market is where companies rise and fall. Even if a business experiences rapid growth in their first few years of operation, that is not a guarantee that you will get a return on your investment.
SaaS businesses are often valued high, and sometimes too high. You want the investment to give you a healthy return. But when investors consider valuations for short-term plans, they realize that the value of some SaaS companies declines as average annual revenues grow.
The Rule of 40 gives investors a clear picture of a company's ability to achieve sustainable growth. Therefore, prepare the report of your Rule of 40 for the next meeting and convince those investors to fund you.
Strike a healthy balance between future growth and profit
It is challenging for a company to maintain a high level of profit and growth. As a company grows, it must balance its growth and its increased profitability.
Some companies may sacrifice growth in pursuit of higher profits, while others may trade profits for higher growth. The Rule of 40 gives business owners a complete understanding of the trade-offs between the two. They can measure profitability and growth ability using this Rule and therefore make decisions for sustainable business growth.
Make business strategies for different stages of growth
In business, it's not always a smooth ride, and companies can't always maintain a high growth rate. Usually, after rapid growth, companies reach a plateau, where they may see lower growth rates or even negative growth rates as the demand for products or services decreases.
Founders should set different goals and build business strategies accordingly at different stages. It would help if you decided whether improving profitability margin should be the priority or increasing growth rates is the primary focus, depending on the stage of the business.
The Rule of 40 helps mature companies with the bulk of the market share focus more on margin growth without worrying about expansion. Meanwhile, SaaS businesses at early stages in the industry can also use this metric to improve marketing and sales strategies that attract new customers and increase customer retention.
When should you use the Rule of 40
However, as useful a tool as the Rule of 40 can be, it can only misdirect you if your company does not meet specific criteria.
The Rule of 40 is primarily for mature SaaS businesses. And according to Bred Feld, "mature" means at least $50 million in total revenue or when your company hits $1m of MRR. In other words, early-stage SaaS companies with a small number of existing customers should pay more attention to other indicators such as profit margin, growth rate, and gross margin.
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