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

What is it that makes you think that you are successful in something and how do you find those metrics that actually prove that you are successful in what you do?

You may say that the answer to this question may vary from person to person. However, I can tell you that there are some criteria in most of the things we do that are commonly accepted as success by the majority.

For example, if you are a striker playing football and you exceed the number of goals that you score each year consistently, then you know that you are more and more successful through each year.

Well, it is very similarly like this in the SaaS world!

There are some metrics that are commonly accepted as indicators of success in SaaS.

The rule of 40 is among the strongest indicators that puts forward you are successful as a SaaS company.

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 ruel of 40.

What is the Rule of 40?

how to calculate the rule of 40

In recent years, the Rule of 40—the idea that a software company’s combined growth rate and profit margin should be greater than 40%—has gained traction as a high-level metric for software company success, especially in the realms of venture capital and growth equity. 

Executives in the tech industry are increasingly using the Rule of 40 as a key criterion for assessing the trade-offs involved in managing growth and profitability.

The Rule of 40 was popularized by venture capitalists in 2015 as a high-level health audit for SaaS firms, but it applies to most tech companies. The metric effectively captures the underlying trade-off between short-term viability and investment in growth (including new goods and consumer acquisition).

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. We use EBITDA, a freely accessible profitability index that takes taxation and accounting practices out of the equation.

The Rule of 40 was created by venture capitalists as a simple way to measure the success of small, fast-growing businesses. 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 (measured by the ratio of market capitalization to revenue) 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.

In SaaS, the rule of 40 is a straightforward financial system that combines revenue growth with profit margins. It’s an easy way to assess the health and attraction of your SaaS company.

The Rule of 40: How to Work It Out

how to work the rule of 40 out

Growth and profit margin are the only two inputs needed by the rule of 40 formula. Simply add your percentage growth plus your gross margin to calculate this metric.

For example, if your sales growth is 15% and your profit margin is 20%, your rule of 40 number is 35% (15 + 20%), which is less than the 40% mark.

To be considered “attractive,” you must raise either revenue or benefit by at least 40%.

You may use either recurring sales growth or total revenue growth to increase income. I’m more likely to use recurring sales for growth if subscription revenue accounts for 80% or more of overall revenue.

When you have a lot of recurring revenue, you’re probably focusing on increasing your subscription revenue, because other revenue sources are most likely to support your recurring revenue growth and retention.

For instance, you might have a professional services team that installs and trains consumers on your apps to ensure their performance. While this revenue stream from services generates margins, it is mostly used to fund the ongoing revenue stream.

Profitable Contribution

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 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.

EBITDA 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.

Example of the Rule of 40

Year-to-date (YTD) recurring sales increase is used to calculate my growth rate. You should choose a time frame that accurately reflects your growth and profit margins.

For instance, you might calculate the rule of 40 based on the previous twelve months and then roll the calculation forward on a monthly basis.

Profit vs. Growth

The rule of 40 is based on the never-ending struggle to strike a balance between growth and profit. 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.

Obviously, the target is to have a profit margin plus a growth rate of more than 40%. If you’ve reached the 40%, you’re considered stable and appealing to buyers.

Measurement Time Frame

Over longer time horizons, I measure the rule of 40. When evaluating full-year results, for example, in forecasting P&L, I include it.

This provides a great deal of information to reduce some month-to-month variability that might make shorter calculation times inaccurate.

When Can the Rule of 40 Be Used?

the rule 40 for saas

When you have a more mature business, you can apply the rule of 40. Startups shouldn’t track this because it’s all about a product/market match, go-to-market strategies, and cash flow at that stage.

When you reach $1 million MRR, according to Brad Feld, you will start measuring the rule of 40, but not until you’ve managed to grow your SaaS company and have it divided into different departments.

Customer care, resources, CSM, R&D, distribution, and marketing are only a few examples. These offices will certainly be built out until you reach $1 million MRR.

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.

Duration of Repayment

Simply add your growth percentage and your margin percentage to get the rule of 40 metric. If the percentages add up to 40% or more, you’ve got a thriving SaaS company. Over a representative time span, I use recurring sales growth and EBITDA margins.

Run this fast test to see whether your path forward is safe whether you’re sacrificing growth for wealth or profit for development.

Do you know how to calculate the law of 40? Well, maybe you should.

There are three ways to beat the Rule of 40.

Exceptional growth

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.

Growth that is both balanced and profitable

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 businesses that have become used to exponential growth find 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.

Profitability is essential

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.

How Software Firms Can Outpace the Rule of 40

why is the rule of 40 important for saas

It’s impossible to outperform 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.

Concentrate on the installed foundation

A mature tech company’s most valuable asset is its customers. The focus shifts to retaining the customer base and the value added to it. Consumer satisfaction is as critical as is investing in customer-centric technologies, designing larger and deeper solutions techniques, and incorporating pricing strategies and discipline.

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.

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 technological 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 at creating what’s necessary for the most cost-effective way.

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, as well as new acquisitions, processes, and structures.

Streamlining and process integration can 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.

The Rule of 40 is used by some of the most profitable tech companies to evaluate their results, and many others are striving to accomplish it at different stages of their life cycles.

Furthermore, it should be used to measure the success of business divisions or product families within an organization, not only at the corporate level.

Conclusion

When your SaaS company is more mature, such as when you’ve built out most of the traditional, practical departments, you should calculate the Rule of 40. 

The Rule of 40 is dependent on your company’s stage of development and accounting practices so it’s crucial to equate yourself to comparable businesses, particularly when it comes to accounting policies. 

For example, a company that capitalizes all its production costs and one that spends all on tech development will have a completely different financial picture because the development costs in the second company will be disproportionately large, making it impossible to follow the Rule of 40. 

what is the rule of 40 and how to calculate it for saas

Serhat Erdem

Serhat is the Creative Content Writer of UserGuiding, a code-free product walkthrough software that 2000+ companies trust in their user onboarding.

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