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The Rule of 40: A Metric for Benchmarking Healthy SaaS Companies

Steven Groccia
Posted on
April 20, 2021
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While 40 isn’t necessarily the magic number for SaaS companies, it might be an important benchmark for you. The Rule of 40 can be a great way to think about your balance between growth and profitability. Learn what the Rule of 40 is, how to calculate it, and why you should care about it.

There’s a method to the madness behind sacrificing profitability in the name of massive growth for a SaaS business. If you can grow rapidly and define a new market, the long-term benefits could far outweigh the short-term losses. It’s one reason why venture capitalists are happy to funnel millions of dollars into early stage SaaS companies at high revenue multiples.

But sacrificing profits for growth doesn’t mean taking on an unsustainable growth-at-all-costs strategy. The Rule of 40 can help you maintain a sustainable balance.

Understanding how to calculate and track the Rule of 40 can help you measure the health of your SaaS business and maximize its valuation.

What Is the Rule of 40?

The Rule of 40 is a SaaS metric that uses revenue growth and profit margins to provide visibility into the performance of your business. Popularized by Techstars Co-founder Brad Feld in 2015, the Rule of 40 states that a healthy SaaS company’s growth rate and profit margin combined should equal 40% or more.

The simple definition accounts for the fact that an unprofitable software company can be healthy if it is generating enough revenue growth as a tradeoff. You could lose 20% over the course of a quarter or a year and still have strong performance if you have a 60%+ revenue growth rate.

The Rule of 40 can be a great benchmark for SaaS health. The 40% rule of thumb highlights an optimal balance between growth and profitability that is challenging (but not impossible) to maintain. But it’s not always entirely reliable for every SaaS business.

Generally speaking, the Rule of 40 is more reliable for mature companies. According to Feld, “mature” means hitting at least $1 million in monthly recurring revenue (MRR). For his Techstars Co-founder David Cohen, it means having annual recurring revenue (ARR) of $15-$20 million. And for others, it means having closer to $50 million in annual revenue.

Focusing too heavily on the Rule of 40 in the early stages of your SaaS business can lead to strategic missteps. According to experienced SaaS executive and investor Dave Kellogg, “many companies target R40 compliance too early, sacrifice growth in the process, and hurt their valuations because they fail to deliver high growth.”

The Rule of 40 may not be a perfect metric. But it’s a widely accepted benchmark that any startup leader can benefit from tracking on a quarterly and annual basis—especially when they’re gearing up for a new round of venture capital funding.

How Do You Calculate the Rule of 40 in a SaaS Business?

The actual calculation for the Rule of 40 is simple. Just add revenue growth percentage to profit margin for a given time period.

But if you want an accurate calculation, you need to make sure you’re using the right inputs for growth and profit.

Find the Right Revenue Growth Input

Monthly recurring revenue is typically the best growth metric for the Rule of 40 calculation because the vast majority of SaaS revenue comes from subscription pricing models.

The SaaS business model generally requires a focus on accruals in financial statements. Amortization extends MRR across a full 12 months, giving you a more standardized baseline for quarterly Rule of 40 calculations. If you’ve already taken the time to establish these financial fundamentals for your SaaS business, you should be able to pull MRR straight from profit and loss (P&L) statements for your calculation.

Another option for the growth input is to use total revenue instead of recurring revenue. According to Ben Murray, “The SaaS CFO,” total revenue growth may make more sense if subscription revenue accounts for less than 80% of your total. For example, if professional services make up a significant chunk of your revenue, limiting your Rule of 40 calculation to MRR or ARR could lead to inaccuracies.

Choose an Accurate Profit Measurement

The right profit measurement for the Rule of 40 will depend on your SaaS business model. But your EBITDA margin is usually the best option.

EBITDA is a non-GAAP (generally accepted accounting principles) metric that stands for earnings before interest, taxes, depreciation, and amortization. It’s a great way to measure profitability for SaaS companies leveraging cloud services to deliver their products. When you use a service like AWS or Azure to deliver your SaaS product, your cost of goods sold (COGS) increases alongside your revenue. That means you can use EBITDA because you don’t need to account for something like hardware asset depreciation in your profit margin.

But if you aren’t using cloud services to deliver your products, there are other ways you can measure profit for the Rule of 40. You could use EBIT (earnings before interest and taxes), free cash flow, net income, or operating income—whichever makes the most sense for your business model.

Why Should You Care About the Rule of 40?

The Rule of 40, for all its limitations, remains a common benchmark for investors as they evaluate SaaS businesses. Showing investors that you can consistently meet or exceed the Rule of 40 can significantly increase the valuation of your business for funding rounds or an eventual IPO.

A study from the Software Equity Group found a clear correlation between a company’s valuation and its ability to adhere to the 40% rule of thumb. It highlighted public SaaS companies like Zoom, Twilio, and Datadog as examples of companies that beat the Rule of 40 and saw significantly higher valuations because of it. The graph below shows what a major difference exceeding the Rule of 40 can make in terms of valuation.

Image Source: Software Equity Group

This graph shows that companies meeting or exceeding the Rule of 40 are typically valued at much higher revenue multiples than those that fall short. Even a slight dip under 40% could result in a 5x multiple difference in your company’s valuation.

There’s a lot more that goes into maximizing your company’s valuation than just complying with the Rule of 40. However, showing investors that you have a strong balance between growth and profitability is a great way to earn trust and earn greater revenue multiples in your valuation.

An Easier Way to Track the Rule of 40 and Benchmark Business Health

Startups run into trouble with the Rule of 40 when they rely on it too heavily as a framework for success. You also need a strong handle on your unit economicscustomer acquisition cost (CAC), lifetime value (LTV), churn, cash flow, etc.—to plot a path of sustainable growth and profitability.

Mosaic automates your Rule of 40 calculation to help you track the health of your SaaS business in real time. Instead of trying to decide whether to calculate on a quarterly or annual basis, you can start tracking the Rule of 40 alongside all of your other critical financial metrics. Our platform pulls data directly from your most important business systems, unlocking real-time visibility into your numbers and driving strategic business decision-making.

In Mosaic, you can pull different levers in your forecasts with just a few clicks and see how they’ll impact your balance between growth and profitability. And you can model different scenarios to solve complicated strategic challenges.

The health of your SaaS business is too important to only track with a quarterly or annual Rule of 40 calculation. Get a free demo of Mosaic to learn how to get a more comprehensive overview of business health and chart a path to balancing growth and profitability.

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