What is the Rule of 40 and How to Calculate it and Use it for SaaS?

Success is a pretty abstract notion.

Success for a football player could depend on the goals they score each season. Or, for someone like me, it could be associated with the notion of a  good career. It all depends on personal ambitions and the requirements of the industry.

What is the indicator of success for something that cannot have its own ambitions and goals, though? What makes a business, something originating from a collective goal of accomplishment successful?

Growth, of course!

But at the end of the day, pure growth cannot be enough to feed the ambitions of the people behind that business. So let me tell you right away: growth does not equal success.

Then, what tells us that our business is thriving and we are also reaching our goals as founders and business owners? 

The answer is a quite simple yet effective metric called the Rule of 40.

So today, let me walk you through the way to understanding the Rule of 40 and how you can calculate the success of your SaaS business with the help of the Rule of 40.

Don't have the time? Here's the quick video guide ⬇️

What is the Rule of 40?

Rule of 40 is a high-level metric for software company success that has been getting more and more popular, especially in the realms of venture capital and growth equity.

The success indicator is generally concerned with two very important KPIs for SaaS businesses, growth rate, and profit margin.

According to the Rule of 40, if the combination of a SaaS business' growth rate and profit margin is greater than 40%, the business is viable and on the right track to becoming a mature company.

Beating the Rule of 40 in a single year is not unusual for bigger businesses. In reality, the top quintile of tech companies reaches a gross profit ratio of 50% in such a short time.

Software firms that can outperform the Rule of 40 by balancing growth and profitability have valuations that are twice as high as those that fell “off the mark,” and they generate returns that are up to 15% more than the S&P 500.

Activist buyers and private equity acquirers also threaten companies whose growth has slowed, and performance has not improved.

So TL;DR, the Rule of 40 is a great rule of thumb to assess the health and attractiveness of your business. The higher it is, the better.

How did the Rule of 40 come to be, though? Let's take a look. 

The Rule of 40: A Brief History

Executives in the tech industry are increasingly using the Rule of 40 as a key criterion for assessing the tradeoffs involved in managing growth and profitability. Yet it hasn't been long since the original Rule has become a common metric to keep growth and profitability at a sustainable rate.

Let's roll back to 2015.

The story we've all heard originated from Brad Feld's personal blog, on a post about how he's heard some private equity investors talk about a "rule of 40".

Then we came to know this brilliant rule that was not only great for investors but also for founders and business owners.

But as you might have realized, Brad Feld wasn't the corner of the term.

The Rule of 40 was created by venture capitalists as a simple way to measure the success of small, fast-growing businesses. And naturally, it took a while to fully establish. In fact, there were discussions about what metrics or data to use to measure.

For example, analysts have disagreed about the profitability metric to use—the majority choose EBITDA, but others have suggested free cash flow, EBIT, or net profits as alternatives.

Back to today, whatever metric you choose to use for Ro40, it's a great rule of thumb for any SaaS business.

But is it really a rule of thumb? Is Rule of 40 really among the key metrics to opt for when designing a market strategy? What makes profitability margins and growth rate so special?

The truth is that starting, growing, and profiting from a business is hard work as is. When it is SaaS, it becomes even harder. But of course, the rewards for the successful ones are plenty. And in keeping your revenue growth rate high, customer acquisition cost low, and profit to a maximum, there is much to gain.

The question is: How are you measuring what you gain? 

Why Is Rule of 40 Important (and Effective)?

There is no discussion that the Rule of 40 is becoming a more and more popular metric, slowly but surely, just like how you're supposed to achieve that 40%.

But of course, there is quite some discussion about whether it is the ultimate metric that will decide your financial health - whether you are a profitable business in the long term or not.

Now, I'm not saying Rule of 40 should be the go-to determiner of a healthy business. But for some, this is the case. And there are 3 reasons why:

1- Speaking the Investor's Language

When in talks with investors or other people who might take an interest in the inner mechanisms and future growth of your company, just common metrics won't do.

You could talk about how much you have grown YoY or how great customer retention has been recently, but more often than not, it won't mean much for an investor. What you need to put on the table is more substance.

Luckily, Rule of 40 has all that, and it is not even a complicated metric.

So, the next time you are meeting with your potential investors or anyone else who has a say in your investment strategy, you know what to whip up and serve them.

2- Pushes for a Healthy Balance of Growth and Profit

As companies start to pay greater attention to the tradeoff between growth and profitability, one thing is revealed.

We shouldn't need to choose growth over profitability or vice versa.

So, with Rule of 40, we are leaning more toward creating sustainable growth and a decent amount of profit, in a balanced sense - or aspiring to be in a balance. 

And what is a balance between profitability and growth good for?

You guessed it: sustainability.

Maybe it'll take a slower growth period and a little less profit than you'd hoped for, but in the end, you will be reducing the chances of failing your business.

3- Gets You Serious in a Competitive Market

It is easy enough to consider all the measures of profitability and common metrics that will give you great results. But at the end of the day, a healthy business cannot stay healthy without proper diagnosis.

If something's wrong with your business, the best way to solve it is to recognize the problem.

The Rule of 40 gives businesses the discipline to take things seriously, regardless of the market fit or size.

Once you have the courage to see for yourself what your company excels at and what its weaknesses are, you will be even more willing to adopt Rule of 40 as your primary business health metric.

 Already willing? Let's take a look at how you can start with Ro40 right away:

The Rule of 40: How to Work It Out

Let me get one thing straight.

As much as there are different criteria to consider, the only two inputs needed for the rule of 40 calculation are growth rate and profit margin.

Simply add the two, and there you have your percentage. If it's:

👉 Below 40% - If you are in your early startup stage, there isn't much to worry about. In fact, it might not be a good call to measure this rule as a startup pre-team structuralization. But if you are past that and are a growing company, you might want to take the matter more seriously. 

👉 40% - You made it there, but it is no time to stop. Hitting the 40 percent mark only means you are eligible to be attractive as a business. Keep moving.

👉 Above 40% - Congratulations, you are an attractive business for investors. Anything above 40-45% means you are a profitable and growing company. However, you might want to make sure your profits and growth rate are in a proper balance. If not, this might be a fluke or a short-term success.

Here's a real-life situation.

Let's say your revenue growth rate is around 15%, and your profit margin is 20%. Then, your rule of 40 number is 35% (15 + 20%), which is less than the 40% mark.

How to Calculate Growth Rate

Calculating your growth rate is quite easy. Here's the formula:

Basically, whether it is your MRR or ARR growth you are calculating, just set a time period, take the value from the end of the period, subtract the value from the start of the period, and lastly, divide the value at hand by the start of the period value.

Of course, there are some decisions to make when calculating. For example, when adding in your revenue growth rate, you might want to exclude extra revenue that's not coming from subscriptions, but if your revenue pool is mixed, you might just want to take it all into account. 

Then there is the profit margin bit.

How to Calculate Profit Margin

EBITDA margins are commonly used to calculate profit margins. In the SaaS universe, EBITDA is a popular financial metric that is very significant. EBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization.

Your SaaS company is always priced in terms of ARR multiples, but when it comes to exiting on a broader scale or from a private equity holding, EBITDA reigns supreme. EBITDA is a rough approximation of the SaaS company’s cash balance.

The capital and organization arrangements of each corporation vary, as do the accounting rules applied to the capitalization of fixed and intangible assets.

But what EBITDA does basically is that it attempts to level the playing field by excluding interest from debt, as well as disparities in taxes and accounting practices, to estimate operational cash flow.

Profit vs. Growth

I know by now that we are on the same page about one thing: The rule of 40 is based on the never-ending struggle to strike a balance between growth and profit.

Let's be honest, it’s difficult to get both a high profit and a high growth rate. There’s a trade-off, and you’ll need to figure out where you fit into it.

Since you are likely spending aggressively on advertising and marketing, you are unlikely to have strong margins if your turnover is increasing rapidly. On the other hand, if your growth is slow, you’ll need to generate a lot of cash flow and EBITDA margins to appeal to your lenders, advertisers, and future acquirers.

It’s just fine to be one or the other. Only be aware of your role in the tradeoff. This approach aids you in quantifying the profit-growth tradeoff.

But again, the target is to have a profit margin plus a growth rate of more than 40%.

When Can the Rule of 40 Be Used?

To use the Rule of 40 as a decision-making mechanism, you have to make sure that certain criteria are met. Otherwise, you might find yourself making wrong assumptions about your company which might be fatal.

The main criterion is to have a mature business.

But what defines a mature business?  

First and foremost, startups that are just getting their very first customers should steer clear of the Ro40.

According to Brad Feld, a good time to start measuring Ro40 is when you reach $1 million MRR. Yet still, that might not be the best time either unless you have clearly separated and functioning departments like customer care, resources, CSM, R&D, distribution, and marketing.

With the majority of divisions in place, the focus should be on gross margins, operational productivity, sales growth, EBITDA, and other metrics.

It would be a clear extension to the monthly reporting kit to calculate the rule of 40. Of course, it’s not the only metric to consider, and you shouldn’t overlook other SaaS metrics like CAC.

Ways to Go Over and Beyond (with Examples)

Now, you know what the Rule of 40 is and how to calculate it.

You also know that I said the best way to preserve long-term sustainability is to balance profit and growth.

There are some big-ballers who agree with me, while there are others representing the edges of the spectrum.

Let's take a look at how businesses go over and beyond the 40%.

Exceptional Growth Does the Trick 🔼

One-third of the firms that outperform the Rule of 40 over five years do so with sales growth of more than 30%.

Splunk, Wix, and Workday, for example, are modestly profitable when investing in hypergrowth to create a massive installed base, displace legacy vendors, and achieve the holy grail of platform status.

Beyond $1 billion in sales, tech companies must adapt their operating model and process sophistication to address various client groups’ challenges across many countries and with multiple products.

When market growth slows, advanced tech firms search for opportunities to maximize sales from current clients while still being competitive in order to boost profit margins and retain profitability that exceeds the Rule of 40.

It's all a Matter of Balance ⚖️

Half of the firms that regularly outperform the Rule of 40 do so with sales increases of 10% to 30%.

VMWare, Adobe, and Salesforce, for example, have successfully created new technologies for markets beyond their core competencies and navigated technological or business model changes (for example, to SaaS and subscription models) to continue to grow.

They must reorient their approach to hit the next step after climbing the S-curve. Any business that has become used to exponential growth finds it difficult to adapt.

R&D expenditures, for example, may reflect the fact that recent waves of innovation may not be as valuable as the earlier breakthroughs in terms of the company size and that the mix of the investment may need to change to renew the original infrastructure.

Portfolio management and investment decisions that are disciplined and data-driven are becoming increasingly relevant.

Profit for Life 💰

We have discovered that 18% of businesses with annual organic sales growth below 10% beat the Rule of 40.

Oracle, SAP, and Trend Micro, for example, have big, lucrative flagship businesses.

Companies focus on being more competitive and sustainable as the growth rate is below 10%—exacting pricing leverage, exploiting the size and reach of massive salesforces, cross-selling and expanding installed base consumers, testing new market models, increasing renewals, and moderating R&D expenditure.

But hey, that's how they do it. Let's talk about how you can go over and beyond the rule of 40.

How You Can Outpace the Rule of 40

Let me just say this once: it is impossible to outperform the Rule of 40 on a stable and long-term basis.

Across products and offerings, engineering reliability and effectiveness, go-to-market competitiveness, and consumer life cycle management, each organization faces its own set of profitability challenges. 

However, most competitive businesses follow a few traditional trends. Here are some for you:

1- Concentrate on the installed foundation

A mature tech company’s most valuable asset is its customers.

So naturally, the focus shifts to retaining the customer base and the value added to it.

Take it from me, customer satisfaction is as critical as investing in customer-centric technologies, designing larger and deeper solutions techniques, and incorporating pricing strategies and discipline.

So, when marketing investments move from “hunting” to “farming,” customer data will help offer insights into the right ways to produce. They must develop more effective methods of marketing to existing clients, such as using inside sales instead of costly field forces and paying channel partners depending on the value they contribute.

2- Productivity in engineering

When a company grows, engineering teams face new challenges.

Technology groups must align the demands of producing new features with those of product maintenance, all while grappling with the technical debt that sometimes slows them down, in addition to being directed by wise portfolio investment decisions.

Clarity on goals is crucial, as it is an insight into how sprawling engineering departments spend time dealing with those priorities.

Roles can be streamlined, leader developers can be supported, and site strategy can be clarified to refocus the right tools on creating what’s necessary in the most cost-effective way.

3- Performance in operations

Complexity is also the enemy of productivity in mature businesses.

As new technologies, customers, and countries are introduced to the market mix, so are new acquisitions, processes, and structures.

When this is the situation, we turn to streamlining and process integration to help increase productivity over time. This will reduce the number of SKUs and price meters, streamline the number of legal entities and channel forms, clarify organizational staff responsibilities, avoid overlap, and replace management layers.

Conclusion

The Rule of 40 is a pretty simple, easy-to-figure-out KPI.

What's not so easy is to determine whether your business is fit to consider using it and if you are, how you are going to make it increase.

Focusing on profit like Oracle or on growth like Wix are both valid options, but it is always best to keep it balanced for maximum long-term sustainability.

Whatever you choose to do, just get over that 40% mark, and there come your investors.