Certain numbers have magical symbolism attached to them. Friday the 13th is ingrained in popular culture as ominous and foreboding. Pythagoras, the discoverer of pi, believed numbers were more than mere mathematical symbols. For investors in software-as-a-service (SaaS) companies, the magic number is the Rule of 40.
The Rule of 40 SaaS takes into consideration two metrics of company health: growth rate and profitability. In layman’s terms, the Rule of 40 asserts that a SaaS company’s growth rate plus profit margin should add up to 40%.
In essence, Rule of 40 = revenue growth + profit (EBITDA) margin
But there’s more to it than meets the eye. In simple terms, the Rule of 40 means a SaaS company’s profit margin and growth rate should add up to more than 40%. This article provides insights into what the Rule of 40 is made of and how businesses can use it to their advantage.
What is the Rule of 40?
The SaaS Rule of 40 is a rule of thumb used to gauge the health and vitality of a SaaS company.
Despite the popular perception of SaaS companies as engines of hypergrowth, most of them barely sustain growth rates above 30%. According to McKinsey, the average growth rate of public SaaS companies in the US was only 22% in 2021. And the difficulty to generate growth and shareholders gets steeper as their business or market matures.
What’s more, the Rule of 40 acts as a normalizing factor and shows the tradeoffs that are often made between profitability and growth. For instance, if a SaaS company has a revenue growth rate of 20%, it should be generating a profit of 20% (or 20% EBITDA margin). In the same vein, if a company has 0% profit, it should maintain a 40% growth rate. Likewise, 50% growth means you can lose 10% in profits.
In essence, it’s awesome if you’re doing better than the SaaS 40% rule.
SaaS growth rate
Measuring SaaS growth rate is relatively straightforward. The timeline is usually YoY (year over year) based on monthly recurring revenue (MRR). The MRR metric is especially important for subscription-based business models, but it poses challenges due to retention and churn.
On the other hand, profit is a bit more multilayered because it could be measured in several different ways. However, one of the most commonly used and successful profit metrics for startups and SaaS is EBITDA.
EBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization. The appeal of EBITDA is that it provides a means to measure profits without thinking about other elements like financing costs, accounting practices, and tax tables. Because it strips out these extraneous factors, EBITDA represents the best indicator of profitability for the Rule of 40 SaaS calculation.
The weighted Rule of 40
The Rule of 40 is an operating performance marker. The challenge it presents is how to manage the competing priorities between increased profitability and rapid growth. However, the Rule of 40 doesn’t provide any guidance on the tradeoff between growth and profitability. Therefore, businesses have to figure this out for themselves, based on their strategic goals and targets.
Some have the consensus that pursuing growth should be more important for smaller SaaS firms; thus, a weighted preference towards growth over profitability exists.
Therefore, when it is weighted towards growth, it’s calculated like this:
Weighted Rule of 40 = (1.33 * revenue growth) + (0.67 * EBITDA margin)
The flexibility of the Rule of 40 allows a company to reach 40% in many ways. As a result, the Rule of 40 provides clarity to your business projections.
This allows companies to decide, for instance, to sacrifice profitability for growth and still understand how to “fudge” the numbers to attain the 40% threshold. Likewise, they can decide to be highly profitable but forgo investing in growth areas like sales and marketing.
Who should follow this rule?
An important question is whether the Rule of 40 is only the exclusive purview of subscription-based software companies. Well, the answer is yes, for several reasons.
First, software companies tend to have much higher profit margins than other traditional businesses. For instance, it isn’t inconceivable for a SaaS company to have profit margins of up to 80% or 90%. But you would be hard-pressed to find a subscription business selling, say, wine or furniture that has equivalent profit margins.
The Rule of 40 is a beneficial guide because it provides a sense of how much a startup or business should invest in growth before it starts to pursue profits. Therefore, it provides these companies with a goal, in addition to fostering the operational discipline required to achieve the desired target.
Companies that successfully follow the Rule of 40 don’t necessarily adhere to a set of rigid practices. Rather, they often set revenue or profit targets that can be organically achieved based on their existing portfolio.
The value proposition of the Rule of 40
The basic guiding principle behind the Rule of 40 is that combining a SaaS company’s profit margin and growth rate should exceed 40%. Moreover, the Rule of 40 is used as a guide by later-stage investors to gauge the viability of a startup.
You need a reliable tech partner to help achieve the minimum threshold of the Rule of 40. At VeryCreatives, we help startups, innovators, and SaaS companies bring their ideas to life by optimizing their existing resources.
Book a call today to learn how we can help and discuss next steps.