Don't get fooled: Applying the Rule of 40 in SaaS Companies

In Software as a Service (SaaS) companies a simple yet powerful metric has emerged to assess their health and potential: the Rule of 40. This rule serves as a litmus test, balancing growth rates and profitability to gauge a company's overall performance and sustainability.

Understanding the Rule of 40

The Rule of 40 essentially suggests that the sum of a company's revenue growth rate and profitability margin (measured as EBITDA margin or operating margin) should ideally be equal to or greater than 40%. It's a straightforward equation that encapsulates two critical aspects of a SaaS business: growth and profitability.

For instance, if a SaaS company is growing at a rate of 30% annually, it should aim to have a profitability margin of at least 10% to meet the Rule of 40 (30% growth + 10% profitability = 40%). Alternatively, if a company is experiencing rapid growth at 50%, it can afford a lower profitability margin of around -10% and still comply with the Rule of 40 (50% growth - 10% profitability = 40%).

Why It Matters

The Rule of 40 matters for several reasons:

1. Balance between Growth and Profitability: It ensures that companies are not solely focused on hyper-growth at the expense of profitability or vice versa. Striking the right balance is crucial for sustainable long-term success.
2. Investor Confidence: Investors often use the Rule of 40 as a benchmark to evaluate SaaS companies. Meeting or exceeding this rule signals to investors that a company is effectively managing its growth trajectory while maintaining a healthy bottom line. Growth at all cost which dominated the mindset of VCs and founders in the SaaS industry pre and during the pandemic has now been replaced by the mantra of profitable growth.
3. Operational Efficiency: Companies that adhere to the Rule of 40 are typically more operationally efficient. They are adept at scaling their operations without sacrificing profitability, showcasing effective resource utilization and management. They also have a tendency to always look for ways to increase efficiency by slashing costs not only when desperately needed, but rather as an ongoing task to ensure operational efficiency.
4. Risk Mitigation: By considering both growth and profitability, the Rule of 40 helps mitigate risks associated with overextending resources or neglecting profitability, ensuring a more sustainable business model.

Example

Let's consider a hypothetical SaaS company, XYZ Inc.:

• Annual Revenue Growth Rate: 25%
• EBITDA Margin: 20%

Using the Rule of 40 equation:

25% (growth) + 20% (profitability) = 45%

XYZ Inc. comfortably exceeds the Rule of 40, indicating a healthy balance between growth and profitability.

Don’t get fooled when comparing Rule of 40

So, can you compare your Rule of 40 to industry benchmarks? Well, that depends on what definition of Rule of 40 has been applied. See, like for many other metrics, there are different ways of calculating the metric which shows kind of the same thing but not really.

If a SaaS company has multiple revenue streams, such as license revenue, consulting revenue, etc. the Rule of 40 can be misleading if total revenue growth is used. If Company A has 30 % revenue growth and 10 % EBITDA margin in a financial year, sure, they’ve hit the Rule of 40 target that year. However, if 50 % of the revenue growth stems from consultancy this may give the CFO a false sense of security. If the markets changes rapidly (or slowly for that sake) due to, say, a global pandemic (Covid-19 anyone?), consultancy revenue might vanish overnight having a serious impact on both growth and profitability.

Hence, although it makes sense to track the Rule of 40, measuring the Rule of 40 using total revenue growth can be misleading if you do not consider the revenue stream robustness. Therefore, we suggest you track the metric both on a top level, but also by splitting up the revenue streams using Annual Recurring Revenue (ARR) growth to increase granularity and get a more detailed view on the financial health of your company.

What about organic VS in-organic growth?

Another pitfall you want to overstep is uncritically comparing Rule of 40 year over year, and between companies.

Let's revert to our prior example, however, we mix up the assumptions a bit. Last year Company A achieved 40% revenue growth and 0% EBITDA margin, hence, a Rule of 40 of exactly 40%.

As business goes well and markets looks solid you would expect to repeat those numbers. However, what the Rule of 40 metric does not tell us is that the company acquired a competitor called Target B last year which brought in 50 % of the growth meaning half of the revenue growth came from in-organic growth.

On top of that, nearly 80 % of Target B's growth came from price increases, which was a one-off event. This will make hitting the 40% growth target a way bigger challenge this year, and also suggest you take Rule of 40 benchmark numbers with a trailer load of salt unless you know what definition of the metric has been used in the reported numbers. Summing up, be considerate when comparing the metric between companies and even your own company's historical financial years. 

Impacting the Rule of 40

Achieving or improving the Rule of 40 requires a strategic approach. Here are some tactics:

1. Optimize Pricing Strategy: Evaluate pricing models to maximize revenue without hindering customer acquisition or retention. Remember, pricing is not something that is done once and left alone, but should be continuously monitored and adjusted.
2. Focus on Customer Lifetime Value (CLV): Enhance CLV by improving customer satisfaction, retention, price increases and upselling strategies.
3. Cost Optimization: Continuously assess and optimize operational expenses to improve profitability margins. Tip for a quick-win: In our experience most SaaS companies have multiple software licenses they don’t use!
4. Expand Market Reach: Explore new markets or verticals to fuel growth opportunities while maintaining profitability.
5. Invest in Scalable Infrastructure: Ensure your infrastructure can support growth efficiently without significant increases in costs.
6. Product Innovation: Continuously innovate to add value to your offerings and differentiate yourself in the market, potentially commanding premium pricing. Don’t try to be your competitor as this will make your product a commodity (they are the same). If you have a commodity, the only real difference will be the price of the product meaning your market size will implode due to a price war.

Conclusion

In conclusion, the Rule of 40 serves as a guiding principle for SaaS companies, emphasizing the importance of balancing growth and profitability. However, beware the pitfalls by tracking Rule of 40 including all (and very different) revenue streams when calculating the growth rate. By understanding, applying, and strategically impacting this rule, SaaS businesses can enhance their performance, attract investor confidence, and chart a path towards sustainable growth and success in a competitive landscape.

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