The rule of 40 is a metric used in order to calculate the level of sustainability for your company’s growth.
Popularised by Brad Feld, this rule of thumb has gained momentum over recent years as SaaS leaders all over the world test their businesses against the standard. In fact, it’s now one of the primary data points for investors to consider before they commit to funding. Thus, it’s incredibly important to know your revenue growth rate and profitability prior to applying for finance. Plus, those who work towards improving their rates are likely to experience sustainable, profitable business for years to come.
Rule of 40
The rule of 40 states that the growth rate and profit of a SaaS business should not total to less than 40%. This metric allows SaaS companies to find a balance between growth and profitability and highlights any key areas of improvement.
The rule of 40 is important as it sets a standard across the SaaS industry. It means that investors and analysts alike can standardize what it means to be a “sustainable” business. Economically, this refers to a strong level of growth that can be continuous over time. The rule of 40 indicates to investors that they are likely to see good returns on their contributions.
Typically at the early stage, startups struggle to find a balance between growth and profitability. It can be messy and scrappy as self-funded startups try to find direction in the marketplace. The rule of thumb states that when experiencing rapid growth, your cash flow and profit suffer. Meanwhile, those with high profit struggle to invest in sales and marketing and miss out on high growth.
When calculating the rule of 40 for your SaaS business, there are three possible outcomes:
a) Your growth rate and profit margin add up to below 40%: This means that your growth rate or profitability is unhealthy and should be higher.
b) Your growth and profit add to exactly 40%: Investors should be happy to invest as this is a healthy balance between growth and profit and you should have a good cash flow.
c) Your growth and profit add to greater than 40%: While this is incredibly impressive, most investors would view this as unsustainable and hesitate to invest.
How to Calculate the Rule of 40
The rule of 40 formula is as follows:
Revenue growth rate (%) + Profitability margin (%)
Let’s take a look at an example. Imagine your revenue growth rate is 30% and your profitability margin is 10%:
30 + 10 = 40%
But what exactly makes up your growth rate and profit margins? Unfortunately, this isn’t as standard as you’ve been led to believe.
Revenue Growth Rate
The revenue growth rate is defined as the increase in revenue over a given time period (usually monthly or annually). It is one of the most common SaaS metrics and will be used as the data for different reports and measures. The revenue growth rate is based on GAAP: the standard for accounting. Therefore, it’s hard for companies to manipulate and can offer a true comparison between competitors.
Where many software companies offer a subscription model, this metric accounts for recurring revenue in the total revenue value.
The formula for revenue growth rate is as follows:
((Revenue month 2 – Revenue month 1) / Revenue month 1) x 100
Let’s use an example with Company X who has a year-to-date revenue of $675:
Revenue in January: $300
Revenue in February: $375
((375 – 300) / 300) x 100 = 25% revenue growth.
Profit Margins
Profit margin is not a standard of calculation. In fact, each company might use a different measure in order to manipulate the data and disguise their performance. It makes sense – reaching a high level of profitability is incredibly difficult for new startups. But while it’s tempting, in order to get a realistic idea of where your company is at, you’ll need an honest number.
On this occasion, we’ll use the EBIDTA margin in order to calculate profitability. This refers to earnings before interest, taxes, depreciation, and amortization. This is a good measure since it offers an insight into the cash flow generated by your business.
However, other businesses might prefer to use different KPIs such as operating income – this is not uncommon.
In order to calculate your profit margin, use EBITDA as a percentage of GAAP revenue. For example:
$12,000 / $100,000 = 12% profit margin.
Improving Growth and Profitability
As discussed, businesses looking to secure funding in the SaaS market should aim to have their rule of 40 calculation as close to 40% as possible. Thus, there are several approaches you can take which depend on whether you are looking to scale or become more profitable.
Businesses looking to experience higher growth rates should focus on product investment. Whether you target R&D or user experience, it means you’ll lower the rate of cart abandonment and build a rapport with more of your ideal customers. Investment into the right sales and marketing management (and opting out of what’s not working) would also be beneficial in order to stimulate growth.
Alternatively, to increase profitability, focus on the company’s customer base and sales. In this case, it would be a good idea to invest in upsells and cross-sells to build the recurring revenue generated by subscription customers. In the same channel, it could be worthwhile to explore your pricing model by determining which services bring the most value to customers (and increasing the price).
The rule of 40 is one of the most common metrics used to assess a company before investors commit any funding. While it’s a clear and standard calculation across the competitive industry, most investors will frame the rule of 40 around several other key reporting metrics.
If you’re looking to secure funding as an early-stage startup, Fundsquire can help you free up the cash flow you need. No two business paths are the same, so check out the frequently asked questions to see if this is the right route for you.
