Rule of 40

What is the Rule Of 40?

The Rule Of 40 states that a SaaS company’s revenue growth rate and profit margin should add up to at least 40%. Companies that hit the 40% mark are growing at a sustainable rate. Those that don’t might run into cash flow and liquidity problems.

In the Rule Of 40 calculation, there are two parameters: revenue growth rate and profit margin.

• Revenue growth rate equals the year-over-year (YoY) percentage increase in a company’s revenue.
• Profit margin measures the percentage of revenue a company keeps as profits after accounting for all direct and indirect costs.

This principle is important because it helps SaaS companies balance revenue growth and profitability. It adds context to each metric by recognizing that a company can still be sustainable if it’s growing fast, but not yet profitable (or vice versa).

It’s important to note that The Rule Of 40 only applies to software companies. The average SaaS gross margin is between 70% and 85%, making it the most scalable business model (by far).

Ecommerce brands, agencies, and other types of businesses have different considerably lower margins and capital requirements. So, the Rule Of 40 won’t apply to them.

Synonyms

• Rule Of 40 SaaS valuation
• Ro40

Why SaaS Companies Use the Rule Of 40

On their own, neither profitability margin nor YoY revenue growth tell the whole story of a company’s financial health. To correctly value a software company,

SaaS Valuation for Investors

You’ll hear about the Rule Of 40 most often when you’re dealing with fundraising, acquisitions, and publicly traded companies because passing the 40% threshold a telltale sign of an investment-worthy SaaS company.

Investors and VCs love it because it prevents them from falling into the trap of chasing companies with high growth rates, which often come at the expense of cost efficiency. Just because a company is growing fast doesn’t mean it has good unit economics.

The flip side to this is also true, particularly when valuing early-stage companies. Most startups and smaller businesses secure their first rounds of funding, then their R&D and customer acquisition costs cause their burn rate to exceed revenue growth. But, large upfront costs generally precede high profit margins. So, a company that’s losing money but has high margins can still pass the Ro40 test and be considered financially sound.

You’ve probably used several products that were at some point not profitable — Pinterest, Snapchat, Tesla, Uber, and Zillow are all examples. Investors in these companies bet on their future value, which can only be revealed by comparing growth and profit.

Reflects Balance Between Growth and Profits

The Rule Of 40 recognizes that a company with low or net-negative margins can still be valuable when their growth offsets their burn rate. It equally acknowledges that a later-stage company that isn’t growing as quickly can be valuable if its margins make up for it.

As an investor, that’s helpful for the reasons mentioned above. Internally, you can use it to figure out when to invest in scaling your company.

Sustaining 20% profitability and 20% revenue growth is quite challenging as you scale. In a competitive market, you need to invest time and resources into capturing a larger market share as quickly as possible (and reasonable, of course).

If your financial metric and profitability metric balance each other above the 40% threshold, that means you have room to play with. You have room to increase your headcount, do more research, develop new products, and enter new markets. And if you want to pursue an investor for these things, you can show them the excess margin you have to execute your strategies.

Business Health Metric

In SaaS, hypergrowth often comes at the expense of cost efficiency. Without knowing whether you meet the Rule Of 40 requirements, your burn rate might be completely unsustainable. And you might not even realize it.

Understanding how close you are to sustainable growth is important because it tells you how much you can afford to lose (i.e., how much you can afford to invest in growth). You’re running a healthy operation if recurring revenues grow at a rate of 30% and you operate at a 10% margin. If you find a way to grow at 60%, you can afford to operate at a 20% loss.

Knowing this helps you prioritize investments that fall into that window of projected growth vs. margin. You would only burn 20% more than you make if you could grow at least 60% YoY from that investment.

Optimize Company Performance

Either growth or profitability is more important, depending on a company’s growth stage. Using the Rule Of 40, you can make strategic decisions about when to invest in which one.

Many assume startups and small SaaS businesses should focus on growth at all costs, even if they don’t turn a profit. But that isn’t always the case. To justify rapid growth with low margins, you have to know with confidence that slowing down your growth rate would allow you to turn a profit right away.

As a growing company, the Rule Of 40 is also helpful in making investment decisions when it comes to sales and marketing. By investing aggressively enough in these two areas while keeping your margins high enough to appeal to investors, you’ll remain a promising prospect while simultaneously growing sustainably.

Once you’ve captured a significant portion of your attainable market share, you can worry less about expansion and more about efficiency and customer retention (expansion tends to slow as a company reaches maturity, anyway). As you do, your margins will rise as your customer acquisition cost falls.

How to Calculate the Rule Of 40

The Rule Of 40 measures two things:

• Growth rate % — The percentage change in monthly recurring revenue (MRR) or annual recurring revenue (ARR) from one year to the next.
• Profitability margin % — Your business’s income before interest, taxes, depreciation, and amortization (EBITDA) margin.

You should be able to easily locate the amount of ARR/MRR by looking at the revenue column on your latest income statement. Then, all you have to do is subtract your current revenue from last year’s equivalent.

Your profit margin is a bit more subjective — there are multiple different numbers you could use. It’s best to use earnings before interest, tax, depreciation, and amortization (EBITDA) as a measure of profitability.

To determine your margin using EBITDA, measure it as a percentage of total operating revenue.

Rule Of 40 Formula

To calculate the Rule Of 40, use the following formula:

Rule Of 40 = Growth Rate (%) + Profitability Margin (%) ≥ 40%

To fully grasp the formula from strach, let’s break it down.

Growth Rate (%) = (Current ARR/MRR — Last Year's ARR/MRR) / Last Year's ARR/MRR

Profitability Margin (%) = (EBITDA Margin) / (Total Operating Revenue)

Using these two equations, we can see how the Rule Of 40 is fully calculated:

Rule Of 40 = ((Current ARR/MRR - Last Year's ARR/MRR)/Last Year's ARR/MRR) + (EBITDA Margin/Total Operating Revenue)

Example Rule Of 40 Calculation

Let’s look at a real-world example for a hypothetical SaaS company, which we’ll call CloudTech Solutions.

1. Determine ARR

• 2022: $20 million
• 2023: $25 million

2. Calculate Growth Rate

Growth Rate (%) = ((Current Year's ARR - Last Year's ARR)/Last Year's ARR) x 100

Plugging in the given data:

• Growth Rate (%) = (($25 million - $20 million)/$20 million) x 100
• Growth Rate (%) = (5/20) x 100
• Growth Rate (%) = 25%

3. Find EBITDA and Total Operating Revenue

For 2023, let’s assume CloudTech Solutions reported an EBITDA of $5 million.

Assuming the vast majority of their revenue is from their recurring business, but they also have a few additional services they offer (like consulting or set-up services), their total operating revenue might be slightly higher than their ARR. Let’s assume it’s $27 million for 2023.

4. Calculate Profitability

Profitability Margin (%) = (EBITDA/Total Operating Revenue) x 100

Plugging in the data we have:

• Profitability Margin (%) = ($5 million/$27 million) x 100
• Profitability Margin (%) = 18.52% (rounded to two decimal places)

5. Apply the Rule Of 40

Rule Of 40 = Growth Rate (%) + Profitability Margin (%) ≥ 40%

25% + 18.52% = 43.52%

Since 43.52% > 40%, CloudTech Solutions meets the Rule Of 40 requirements in 2023, meaning the organization is generating profit at a sustainable rate.

The Rule Of 40 Tradeoff: Growth vs. Profit

The Rule Of 40 helps SaaS businesses understand the tradeoff between growth and profit. Neither is more important than the other, per se. You need to consider several variables.

• Early-stage SaaS companies normally prioritize growth over profits because they need to bring their product to market and iterate quickly.
• Late-stage companies have established internal systems, a reliable customer base, and a much higher MRR/ARR figure, meaning they’ll grow at a slower rate but operate with more efficiency.
• In both cases, customer retention is the ultimate equalizer — if they’re constantly chasing new customers, they’ll never truly achieve either.

When a company only has a few customers, it’s relatively easy for them to double their customer base. But, for a company like Salesforce to grow 100%, that would be a remarkable feat. You can’t keep growing at a massive rate forever.The true goal every software company should work towards is the ability to create repeatable, scalable systems they can use to generate predictable revenue.

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