The Rule of 40
Updated: Oct 30, 2020
There are a lot of different types of companies and business models. One of the most popular these days is SaaS-based solutions that focus on monthly recurring revenue. There are a lot of different metrics to track the performance of these types of companies, but one of the most common these days is what we call The Rule of 40.
What is The Rule of 40?
The Rule of 40 is pretty simple: the revenue growth rate plus the profitability margin should add up to 40 or better. The later a startup company is in their development, the easier this is to calculate - and the more telling the metric becomes. We make a lot of concessions early on when starting a company. But as we ease out of being an early-stage startup The Rule of 40 helps us best determine if a company is ready to scale in a profitable fashion.
The reason we can’t just look at revenue growth is that unlike traditional businesses, venture-backed SaaS companies often focus on growth over profitability. Thus the venture capital. Grow faster and think about profits later. We would of course prefer companies we work with to always be profitable, but certainly understand when there’s a deliberate move to invest heavily into growth at the cost of profits so long as there’s a plan to get to profitability in the near-term. So The Rule of 40 helps understand the balance between customer and revenue acquisition and growth.
Revenue Growth Rate
Luckily, GAAP accounting is pretty standardized. Looking at Revenue Growth Rate allows us to look at year-over-year growth percentages. Here, we put Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR) to the side and look at top line growth. And that’s in terms of recognizing revenue.
Recognized revenue can be calculated monthly, quarterly, or annually. Once plotted, we can look at those numbers and the profitability margin on a graph that shows both in the increments desired. The key is to stay consistent with how data is reported.
The profitability is a bit complicated as companies running on a negative margin factor profitability in terms of Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) or EBITDA excluding Stock Based Compensation (or SBC for short). This is because unlike traditional business, SaaS-based businesses don’t run off a standard cash from operations or cash from income model. Thus the dilution in stock based on investors and the need to report back these numbers to investors.
EBITDA is Net Income plus taxes plus interest expenses plus depreciation and amortization. Because operating without a profit usually means interest, it’s best to account for that in a structured way. This allows companies to take advantage of interest as a tax shield as well as depreciating assets. We see those in the cash flow statement under “cash from operating activities” and as it’s added back on as an expense. This allows us to look at the value of companies that aren’t currently making a profit. Especially when the cost to acquire a customer doesn’t make the customer profitable in a reporting quarter but when we retain the customer they become incredibly profitable over the long run.
Here, we again want to stay consistent and want to report in both when possible, as each investor might have a different metric they prefer but the nice thing about EBITDA as opposed to just EBIT (or operating income) is it’s fairly well accepted accounting practice to calculate and takes into account various factors for multiples.
Once we have the revenue growth rate and profitability margin, it’s fairly straight-forward to addd them up and see if we’re above or below 40. The risk is that we end up over-engineering our accounting practices to come up with synthetic numbers not backed by logic. But it’s become standard in the investment community and there are sound reasons for using these numbers to help track a fund of multiple investments.
The Rule of 40 is a great way to gauge whether a company is moving in the right direction while scaling. The SaaS industry has a wealth of data from companies that have been acquired or gone public that back up the metric. But it isn’t the only indicator that a company is on the right track.
Since all the companies in a portfolio of investments can be tracked with the same numbers, looking at a spreadsheet that includes EBITDA (e.g. in a Discounted Cash Flow) lets us quickly identify when we see huge discrepancies and promote sound practices that lead to an increased intrinsic value of a company. Each of the numbers tells a different story, and as we dig into each we learn different things about companies we work with. Having said this, many a SaaS company doesn’t have the same amount of tangible assets they used to and so it’s great when the numbers tell a story of their own.
In addition to The Rule of 40, there are a number of Vital Signs at SaaS companies that help tell a complete picture. These include the burn rate against cash on hand, how well a company retains customers, growth of existing customers, how efficient sales and marketing is run, and revenue growth. Sometimes we see huge successes in one of these categories and still think a company is doing well - so The Rule of 40 isn’t the only indicator, but it’s a pretty solid look at company performance.
Finally, the valuation of a company can be a great motivating factor for employees. Because operating at a loss per customer is common for a period of time given the high cost to acquire a customer, we want to keep employees engaged when they see a lot of red on the balance sheet. It’s easy to over-index on a given attribute of performance. But given the historical analysis of SaaS companies, The Rule of 40 is a great way to track performance against other SaaS companies and how they’re able to balance growth and profit. Because without profit we won’t be in business for too long!