The Rule of 40 is an often known and well-used metric for measuring a SaaS company’s performance. For a software as a service company (SaaS), reaching the Rule of 40 is about measuring growth and profitability. The Rule of 40 assesses that the company’s growth rate and profitability numbers reach or exceed a combined total of 40%. Rule of 40 is used by investors and companies alike as a gauge for success and sustainability.

The Rule of 40 is a valuable metric for investors and companies alike. For investors, it shows the base numbers without sacrificing one metric for another. Because companies often have to sacrifice growth for profit or profit for growth, this quick test helps to see if the path forward is healthy and productive. For investors, this shows the potential of the company. For a company, it shows that they are matching industry standards and profitability.

Calculating the Rule of 40

There are two inputs for the Rule of 40: growth and profit margin. Usually, growth and profit are at odds with each other, especially in the early stages of a company.

To be attractive to investors and financial lenders, the growth and profit margin number should be above 40%. If the number is too low, either growth or profit margin must be increased to reach 40. This often about finding the right mix and can often be tricky to balance.

Many nuances can affect the margins and numbers of both growth and profitability. Younger companies tend to be growth forward, and the numbers may lead to misleading interpretations. Rule of 40 is better suited to larger, more established SaaS companies.

Growth Rate Input

For SaaS companies who depend heavily on subscription revenue, recurring revenue is the essential formula for calculating growth rate. A year-over-year evaluation of monthly MRR (monthly recurring revenue) will yield the growth rate. Though total revenue is an option, using MMR calculations makes sure that you are compliant with GAAP (Generally Accepted Accounting Practices). MRR is the cleanest, most straightforward way to establish the baseline of growth and provide a consistent basis for comparison in the short-term and the long term.

Profit Margin Input

To find profit margins, the EBITDA margin is one of the most commonly used metrics for finding the Rule of 40 in the SaaS world.

EBITDA stands for “earnings before interest, taxes, depreciation, and amortization.” Knowing the EBITDA margin creates a comparison of a company’s performance compared to others in its industry. This margin is calculated by dividing the EBITDA by revenue. The EBITDA margin helps uncover the effectiveness of a company’s efforts of lowering operating expenses and cost-cutting. It is a valuable metric because it removes interest expense and tax treatment out of the equation.

It should be taken into consideration that EBITDA is a non-GAAP financial set of figures. As it is not to GAAP standards, EBITDA numbers can be skewed or manipulated (Investopedia). The EBITDA does not consider debt levels; large interest payments or loan repayments are crucial numbers in a company’s financial numbers. Another consideration is that EBITDA numbers do not always match profit margins. Those with low profitability may emphasize their EBITDA numbers in their favor.

EBITDA attempts to normalize a common playing field by focusing on growth and profit by removing individual company financial decisions, like interest rates, loans, and tax differences, that vary by company. It focuses on the growth numbers comparable across the industry that evaluate the effectiveness of the growth and profit.

Alternative measurements of profitability to use could be net income, cash flow, operating income, or free cash flow to evaluate profit. Though each metric may yield different results, sometimes those differences will bring about valuable comparisons when used in combinations. Some like to use EBITDA as an initial baseline and then back-test using other methods (Feld).

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Profit vs. Growth

In business, there is always a tradeoff between growth and profit. Often business is about finding the balance between keeping both percentages in a healthy range and when to let one rise while the other falls. Usually, in business, one yields to the other, especially for SaaS companies that are young.

It is unusual to have both high profit and high growth. When most companies experience high growth, margins are low because of investments into sales and marketing. When there is low growth, there should be high cash flow and high EBITDA margins. For a SaaS company, knowing where they land in this profit vs. growth tradeoff is the key to having a good Rule of 40 grade.

For investors looking at smaller SaaS companies, growth is considered more important than profitability. The higher the weighted Rule of 40 percentages, the more investors favor a SaaS company because it shows the growth potential and the sustainability of a company’s financial endeavors.

Larger companies may have a more challenging time as they grow to scale to maintain the growth rates of their younger years. This is why the Rule of 40 is a valuable metric as it considers both sides that it takes to have balanced and sustainable finances. Rule of 40 will continue to be a useful metric for maturing companies to continue monitoring operational objectives and having strategic formulas for growth and profit.

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Making the Rule of 40 the Rule

Achieving the weighted Rule of 40 numbers is vital in the SaaS world. Though it does not answer whether a startup in the early stages is on track or is profitable enough, it gives good insight into the balance of profit and growth, which can help prove whether it is a sustainable business model. The Rule of 40 makes a company attractive to investors and proves that growth and profit are on the right track. Taking a hard look at numbers and knowing when and where to make sacrifices to get to the Rule of 40 is the best way to set a SaaS company up for financial success and visibility to investors.

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References:

investopedia.com/terms/e/ebitda-margin.asp
feld.com/archives/2015/02/rule-40-healthy-saas-company.html