Here’s a common dilemma that all SaaS business owners face — should you pursue growth at all costs, or is it more important to make sure that your margins are healthy, and that you’re not losing money with each new customer that you bring on board?
Enter the Rule of 40!
If this is the first time you’re hearing about the Rule of 40, this financial framework helps you weigh up your revenue growth against your margins. Using this framework, you can:
- Understand the trade off between growth and profitability
- Benchmark the health of your SaaS company, and
- Demonstrate to potential investors that your company is worth putting money into
In this blog post, we’ll walk you through how the Rule of 40 works, and teach you how to calculate your Rule of 40 number. Read on to find out more!
How does the Rule of 40 work?
The Rule of 40 essentially reflects the tradeoff between growth and profit.
Think of it this way: most SaaS companies have high customer acquisition costs, as you have to invest heavily in sales and marketing in order to realize high growth. Those PPC ads that you run and the sales reps that they hire don’t come cheap, and as such, this eats into your profit margin.
Companies in these situations are essentially trading profit for growth, in the hopes that you’ll eventually achieve a monopoly. Yes, you might be burning a ton of money on Customer Acquisition Costs, but if you do manage to dominate your market, then this will give you the power to realize higher margins in the future.
What if your business has a low growth rate? Since these companies aren’t growing quickly, they have to compensate with high cash flow and high EBITDA margins if they want to be seen as attractive. These companies aren’t likely to become the market leader anytime soon, but at least they can turn over a decent amount of revenue due to their higher profit margins.
Of course, if a company’s Rule of 40 number is higher than 40%, that’s even better. This signals that the company is strong on both fronts (growth and margin), meaning that it might be an excellent investment opportunity.
When should SaaS companies make use of the Rule of 40?
Generally speaking, SaaS companies who are new to the market should NOT be overly concerned with the Rule of 40 but focus on “T2D3”, which we’ll cover in a separate post.
If your SaaS business is in its early years, the goal is really to realize product-market fit, and to grow as quickly as possible. There’s no one strategy that can guarantee you success, of course — but most experts advise SaaS companies to pursue growth as their primary objective (even if this means neglecting profits) during this period of time.
Once your company hits a certain size – Feld, the first to introduce the Rule of 40, uses $1M MRR as an approximate cut off point, then it makes sense for you to pivot to focusing on achieving the Rule of 40. Now that your company is more mature, it’s important to start hitting that balance.
How to calculate your Rule of 40 number
Your Rule of 40 number is also known as your growth and profit ratio; here’s a simple formula that you can use to calculate it:
Rule of 40 = Growth rate (%) + Profit (%)**
**As to which profit and time period to use, we’ll cover this in the next section of this post!
According to the Rule of 40, this number should add up to 40%.
We’ll break it down for you: assuming your company is growing at just 5%, this means that your margin should be on the high side (35%, to be precise) in order to make up for your slow growth.
On the flip side: if your company is growing at 50%, this means that you can afford losing 10% on each sale that you close — and you’re still (arguably!) considered a “healthy” or “attractive” SaaS company to invest in.
Measuring your growth and profit rate
In calculating your Rule of 40 number, you’ll have to plug both your growth and profit rate into the formula.
Now, there are various ways of measuring your growth rate, but one of the most straightforward methods is to use your MRR growth. Some companies choose to look at total revenue, but if you offer one-time services on top of monthly subscriptions, then looking at monthly recurring revenue will give you a more accurate picture.
When it comes to profit, there are various ways you can measure this — including Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), Operating Income, Net Income, Cashflow, etc.
So which profit metric should you use? It depends, assuming you run your service from AWS or a similar cloud platform, we recommend using EBITDA — since your COGS scales with your revenue, and your gross margin is pretty consistent, this metric should be sufficient.
When it comes to the time period, you can add rigour to your estimations by looking at the Rule of 40 using both quarterly and year-to-date (YTD) measurements (benchmarking these against the previous year). Taking both these measurements gives you more data, and this minimizes month-to-month fluctuations and increases the reliability of your findings.
A final word on the Rule of 40
Regardless of whether you’re keen on getting more investors on board, or you simply want to benchmark the performance of your SaaS business, the Rule of 40 is an excellent gauge that you can use.
If you need help hitting that magical “40” number, consider consulting with a Virtual CFO from ABEL to learn how to increase your growth rate and/or profit margin. Our Virtual CFOs can help you identify opportunities to grow your business and revenue, and restructure your finances to optimize cash flow.