What’s rule #1 about running a SaaS business?
You don’t talk about SaaS businesses.
This isn’t Fight Club.
However, when it comes to SaaS, there’s one rule you do need to know: the Rule of 40.
The Rule of 40 is an essential benchmark that investors use during SaaS valuations to assess the growth and profitability of a SaaS business.
Actively tracking the Rule of 40 metric can benefit your SaaS business in many ways — from boosting operational efficiency to ensuring optimum financial health.
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This Article Contains
- What Is the Rule of 40 in SaaS?
- How to Calculate the Rule of 40
- How to Evaluate Your Rule of 40 Results
- When Should You Use the Rule of 40?
- 3 Reasons You Should Use the Rule of 40
- How to Balance Growth and Profitability
Let’s get started.
What Is the Rule of 40 in SaaS?
The Rule of 40 is a principle that states that the combined revenue growth rate and profit margin of your SaaS company should exceed 40%.
Why is the Rule of 40 metric important?
The metric indicates how well a company balances its growth with profitability margins.
This way, it’s not sacrificing cost efficiency for the sake of growth.
SaaS companies that meet the rule of 40 generate profit sustainably, whereas those pulling numbers under 40 may have cash flow or liquidity issues.
What type of company is the Rule of 40 applicable for?
The Rule of 40 is a SaaS-specific benchmark introduced in 2015 by two venture capitalist investors — Brad Feld and Fred Wilson.
Why is it exclusive to SaaS companies?
It’s largely because the SaaS sector typically follows a recurring revenue model — making it easier for companies to predict their future cash flow and attract investors.
Moreover, SaaS companies tend to generate high cash flow (with profit margins around 70%-80%), which could be reinvested for growth or returned to the shareholders.
Hence, it’s vital for SaaS companies to have a system that ensures a healthy balance between cash flow and growth.
But how do you measure this SaaS metric?
How to Calculate the Rule of 40
You’ll need to determine your total revenue growth and profitability margin to measure your standing in the Rule of 40.
Let us explain.
Follow these steps to find out your Rule of 40 standing:
- Calculate your growth percentage (ARR or MRR growth).
- Then calculate your profit margin percentage.
- Add your growth percentage to the profit percentage.
- The result would indicate where your SaaS business is regarding the Rule of 40.
Here’s the formula:
|Rule of 40 total = (Growth % + Profit %)|
And as for the growth rate and profit %, use these formulas:
|Growth Rate = (MRR/ARR at end period – MRR/ARR at start period) / (MRR/ARR at start period)|
|Profit % = Net income + Interest + Taxes + Depreciation + Amortization|
Don’t break your brain trying to crunch the numbers.
It might seem confusing, but it’ll all make sense as we discuss the individual components in the formula. Let’s take a closer look:
A. The Growth Input Metric
When calculating your growth, you can use your Monthly Recurring Revenue (MRR) or Annual Recurring Revenue (ARR).
B. The Profit Input Metric
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a standard for measuring cash flow generated by your SaaS business.
EBITDA is an accurate measure of profitability for SaaS businesses as it excludes non-cash expenses, like depreciation and amortization. Given that SaaS is typically run over the cloud, you don’t have to deal with hardware purchases and asset depreciation.
Here’s an example:
Let’s say your SaaS company has generated $10 million in 2021 and $15 million in 2022. You’ll then take that $5 million difference, divide it by the base ARR of $10 million and multiply the result by 100 — giving you a revenue growth rate of 50%.
To calculate your company’s profitability, let’s say the EBITDA for 2021 was $2 million.
You’d divide the $2 million by $10 million, equating to 20%.
Using the two inputs, your Rule of 40 would add up to 70%.
Yay! Your company’s rule has exceeded the 40% benchmark, good job. 👍
How often should you measure the Rule of 40?
You should evaluate your company’s Rule of 40 based on what properly reflects your growth and profit margins.
So if you’re using MRR growth rate as your growth input, you should calculate your Rule of 40 monthly, and if you’re using annual recurring revenue, calculate it annually.
Need help interpreting your Rule of 40 results?
How to Evaluate Your Rule of 40 Results
Here’s what the three possible ‘Rule of 40’ scenarios tell about your SaaS business’s health.
When it’s below 40%😐: Your business likely has cash flow or liquidity issues. You’ll need to check other KPIs to establish what the problem is. These metrics will help confirm if you’re dealing with an increased cost of goods sold (COGS), pricey customer acquisition cost (CAC), high churn rates, etc.
When it’s at 40%🤓: You made it there, but there’s no time to stop. Hitting the 40 percent mark means your business is just about attractive to investors. So keep aiming to improve. One way to improve your margins is to focus on customer retention efforts.
When it’s above 40% 😎: Yay! Your business stands out to investors during SaaS valuation. Anything above 40-45% means your company is profitable and growing. However, to ensure it isn’t a fluke or something temporary, you must balance your profits and MRR growth rate.
We know what you’re thinking:
‘No way any large public SaaS companies are achieving more than 40%.’
Zoom, Twilo, and Datadog are all examples of public SaaS companies beating the Rule of 40!
It’s the early-stage startups that might have difficulty hitting that mark:
When Should You Use the Rule of 40?
Early-stage startups or smaller companies (those in the pre-structuralization phase) should usually avoid prioritizing the SaaS Rule of 40.
Experts believe that early-stage startups should ideally focus on cash flow and product/market fit. Measuring the Rule of 40 could trap them into making fatal assumptions about the company. Focus on growth at this stage – profitability will come later!
Mature businesses, however, can use the Rule of 40 as a decision-making mechanism.
But what is a mature business exactly?
A mature business is one that’s well-established within its niche and typically has an MRR over $1 million.
Here’s the truth:
The Rule of 40 shouldn’t be the only metric your business focuses on.
Instead, it can be an extension of your monthly reporting kit, including other key valuation indicators like YOY growth, customer acquisition cost, etc.
However, there’s a variation of the rule of 40 that might be worth looking at:
What is the Weighted Rule of 40 for SaaS Companies?
The weighted Rule of 40 gives more ‘weight’ to the total revenue growth.
Companies still finding their footing and trying to scale up should use the weighted rule.
It provides a realistic look into the financial health of such companies by prioritizing the rapid growth rates they’re currently benefiting from.
But what’s wrong with using the original Rule of 40 SaaS?
The longer a company exists, the more likely it is that its growth rate will decrease and eventually stabilize.
As these companies are in a stage where they’re experiencing stable growth, measuring sustainable profit margins becomes paramount for investors — something the rule of 40 SaaS does well.
So far, so good, right?
The weighted rule of 40 caters to companies with high growth margins (like startups focusing on scaling up) but might not be making a steady enough overall profit.
The extra focus on growth will ensure the startup has a high valuation based on its potential to become profitable as it grows.
|Weighted rule of 40 = 1.33 * Revenue Growth + 0.6 * EBITDA|
Still trying to understand why the Rule of 40 is essential?
3 Reasons You Should Use the Rule of 40
Here are three reasons why you should implement using the Rule of 40 for your SaaS business:
1. Appeal to Your Investors
When meeting with investors (like a venture capitalist firm or angel investor), presenting standard financial metrics won’t suffice.
The rule of 40 will allow your investors to assess the future growth prospects of your SaaS company, and whether it has the potential to offer them sustained value, even if it’s still growing.
2. Promotes a Healthy Balance of Growth and Profit
Your business shouldn’t have to prioritize growth over profitability or profitability over growth. Focusing on just one aspect might cause the downfall of the other and, eventually, your entire business.
The Rule of 40 aims to balance sustainable growth and profit.
Nurturing sustainability will ensure every aspect of your business thrives and cement long-term prosperity.
3. Gets You Disciplined in a Competitive Market
Tracking the Rule of 40 can give your SaaS business the much-needed discipline to achieve high operational efficiency and performance transparency.
By knowing which problem areas to focus on and which well-performing areas to boost.
Once you know your company’s strengths and weaknesses, you’ll be ready to use the Rule of 40 as your primary business metric!
Now let’s look at four strategies you can implement to help achieve a good Rule of 40.
How to Balance Growth and Profitability
So what’s the deal with the whole balancing act between growth and profitability?
Let’s take an example of two different SaaS companies:
Company A has a high growth rate but might not generate enough revenue to cover all associated growth costs. By emphasizing growth, company A could possibly experience cash flow problems which could lead to bankruptcy.
Company B is focusing on profitability and in turn sacrificing growth. By sacrificing growth, company B won’t be bringing in new customers. This company could stagnate and eventually fade out.
Steady growth brings steady profits and vice versa, but a high growth rate or just focusing on profitability might put your business at risk.
Here’s what you can focus on to promote balance:
- Customer satisfaction 😁: Constantly monitor and improve your customer service levels to ensure your existing customers are happy with your products or services.
But what balance does it bring?
Happy customers become loyal customers and reduce customer churn. Aside from ensuring a steady stream of operating income, they can also act as marketing sources by bringing in new customers through referrals and free publicity.
- Finances 💲: This might seem obvious, but carefully managing your finances can help you achieve a healthy growth-profitability balance.
Good financial management includes:
- Carefully planning and monitoring your income and expenditure
- Keeping track of your business’s financial performance
Improved financial behavior lets you make informed decisions about where to invest your money to maximize growth and profitability.
- Patience 🧘: As a business owner, it’s important to remember that your business needs time to grow. 🌱
While having ambitious growth plans is fine, you still need to be realistic about what you can achieve in the short term.
Forcing rapid growth can lead to financial problems and ultimately damage your business in the long run.
Ready to Rule the SaaS Industry?
The Rule of 40 is a crucial SaaS metric you should measure to get your business on the right track.
Which track exactly?
The track to success!
Start tracking the SaaS Rule of 40 today to build a strategy that allows you to achieve sustainable growth and impressive profit margins.