The Rule of 40 – an introduction
Most fast-growth tech and SaaS businesses are loss making. They’re loss making because they’re typically growing fast. Faster growth typically means greater losses. The Rule of 40 aggregates both growth and loss metrics together for a combined net growth/loss rate. This combined metric helps VCs to benchmark their portfolio better.
What is the Rule of 40 in SaaS?
Fast-growth SaaS businesses are loss-making for a while, sometimes many years depending on their strategy. This is typically because product development and customer acquisition costs are front-loaded for most SaaS businesses, with recurring revenues paid over the customer lifetime.
Given the fact profit isn’t the focus in the early stage of a business, it can be difficult to judge what the right level of spend is when planning growth. Benchmarking is a great way to know whether you’re moving in the right (or wrong) direction. But with fast-growth companies using different strategies, investments and revenue growth, it's not always easy to benchmark.
The Rule of 40 combines two important metrics to measure performance in SaaS businesses: growth rate and EBITDA margin. In other words, it balances greater growth investment (and thus higher EBITDA losses) with higher revenue growth, and vice versa.
Why is the Rule of 40 so important?
The Rule of 40 is important because it helps SaaS companies and investors evaluate the overall health and potential of a business. High growth rates are important for a SaaS company because they indicate that the business is acquiring new customers and generating more revenue. However, high growth rates alone don’t guarantee success or sustainability. Your company must also balance growth with EBTIDA losses to demonstrate sustainable growth.
The Rule of 40 provides a way for companies and investors to quickly evaluate the balance of growth and profitability. A company with a high Rule of 40 score is likely to be in a good position for long-term success, as it is growing quickly and generating enough profit to sustain that growth. On the other hand, a company with a low Rule of 40 score may be facing challenges, such as high expenses that are eating into its profits.
SaaS companies are often valued based on their revenue multiples, which are directly influenced by growth rate. By considering the profitability of the company as well, the Rule of 40 can help in determining a more accurate valuation.
It's important to note that the Rule of 40 is not a substitute for a more detailed analysis of a company's financials and operations, but it can be a useful starting point for evaluating the overall health of your SaaS business.
Why does the Rule of 40 matter?
The Rule of 40 is a useful metric for assessing the overall health and potential of a SaaS business because it takes into account two critical factors: growth and profitability.
A balance between a strong growth rate and a not so high EBITDA loss percentage is important for a number of reasons:
- Strong growth indicates that the business is acquiring new customers and generating more revenue, which can lead to increased market share and long-term success.
- High EBITDA percentage indicates that the company is generating enough profit to sustain that growth, which is important for its sustainability in the long run.
- A high Rule of 40 score can make a company more attractive to potential investors, which can help it raise capital to fund its growth. Although, too high can indicate you’re not investing enough into growth.
For investors, evaluating a company's growth and profitability is important when determining whether to invest in a business. The Rule of 40 provides a quick and easy way to evaluate these factors and make a more informed investment decision.
It's important to note that the Rule of 40 is not a guarantee of success and shouldn't be used as the only metric to evaluate a business. However, it can be a useful tool when evaluating the overall health of a SaaS business and determine the potential and attractiveness of an investment opportunity.
How to calculate the Rule of 40?
While the Rule of 40 needs to be determined across a specified time period, that time period needs to be reflective of growth and profit margins. One month could be too short to be reflective, but you could apply a trailing 12-month period to continually get an up-to-date number.
The formula to calculate the Rule of 40 is:
Rule of 40 number = Revenue growth rate % + EBITDA %
Where:
- Revenue growth rate % = (Current year revenue – Prior year revenue) / Prior year revenue
- EBITDA % = EBITDA / Revenue
The Rule of 40 worked example
The examples below show a simple way to calculate the Rule of 40. You can see there are different ways for businesses to achieve the same Rule of 40 number. Example 1 shows a much greater focus on revenue growth, whereas example 2 shows half the growth, but with a much smaller EBITDA loss. Both return the same Rule of 40 number.
Example 1.
Example 2.
Conclusion
The Rule of 40 is a commonly used metric that helps evaluate the performance of a SaaS business by adding a company's growth rate and EBITDA percentage. The idea behind the rule is that for a SaaS business to be successful, it must have a balance of both strong growth and profitability, hence a combined score of at least 40% is considered a healthy number.
The rule is important for companies and investors because it provides a quick and easy way to evaluate the balance of growth and profitability. It can be used to make more informed investment decisions or to evaluate the overall health and potential of a SaaS business.
However, it's important to note that the rule of 40 is not a guarantee of success and shouldn't be used as the only metric used to evaluate a business.
