Don’t shoot the messenger here… But more than 90% of SaaS companies fail.
For the ones that don’t, securing funding is the statistical equivalent of winning the lottery.
Determining long-term scalability and understanding your company’s financial health requires multivariate cash flow analysis.
- How much has your revenue grown YoY?
- What did it cost to get there?
- What were the exact sources of each new revenue stream?
- Can you repeat the same processes to achieve that growth again?
- How on Earth will you communicate that to investors?
Start with the Rule of 40.
What is the Rule of 40?
The Rule of 40 is a simple equation used to assess the overall health of your SaaS business.
It focuses on two parameters:
- Revenue growth rate: How much is your company growing year-over-year (YoY)?
- Profit margin: How much free cash flow do you have left to invest in future growth and innovation after all operating costs are paid?
According to the Rule of 40, SaaS companies should aim to achieve a combined growth and profit margin of at least 40%.
For instance, if your company is growing at 20% YoY and has a profit margin of 20%, you meet the minimum requirements of the Rule of 40.
If your organization operates at or above the 40% margin, investors would say you have a healthy SaaS company.
How Reliable is the Rule of 40?
Investors and venture capital firms love the Rule of 40 because it prevents the nearsighted focus solely on revenue growth (which often comes at the expense of cost efficiency).
It underscores the fact that an early-stage startup with a low or negative profitability margin can still receive a high valuation multiple if its revenue growth offsets its burn rate.
With hundreds of millions of users, growing revenue streams, and long-term potential, these companies are more valuable to investors than their current profitability.
Although it seems like a generalized “back of the envelope” calculation, investors and venture capitalists give the Rule of 40 credibility because it helps them identify healthy companies primed for long-term success.
Especially in the startup world — where massive R&D costs usually precede high profit margins — the Rule of 40 is a quick and simple benchmark that helps investors distinguish between a Red Flag and a budding SaaS company poised for success.
How to Calculate the Rule of 40
It’s easy to calculate the Rule of 40, but it’s essential to understand the formula and its nuances to apply it effectively.
The formula for the Rule of 40 is as follows:
Rule of 40% = Revenue Growth Rate (%) + Profit Margin (%)
To calculate the Rule of 40:
- Determine your company’s revenue growth rate. The revenue growth rate is typically calculated as the percentage increase in revenue from one period (e.g., a quarter or a year) to the next. For example, if your revenue increased from $1 million to $1.5 million over a year, your revenue growth rate would be 50%.
- Determine your company’s profit margin. Calculate your profitability margin by dividing net income (i.e., profit) by total revenue and multiplying the result by 100 to express it as a percentage. If your net income is $200,000 and your total revenue is $1 million, for instance, your profit margin would be 20%.
- Add the revenue growth rate and profit margin together. Using the example figures above, the Rule of 40 calculation would be 50% (revenue growth rate) + 20% (profit margin) = 70%.
In this example, the company’s combined score is 70%, which exceeds the Rule of 40 threshold, indicating a healthy balance between growth and profitability.
Limitations of the Rule of 40 for SaaS Companies
It’s important to note that the Rule of 40 is not a one-size-fits-all solution. The weight of growth and profitability may vary depending on the company’s stage and market conditions.
SaaS businesses in early stages need to prioritize rapid growth over profitability, while more mature companies might focus on sustained value creation and a favorable EBITDA margin as growth slows.
Limitations of the Rule of 40 include:
- The Rule of 40 relies on YoY revenue growth, which may not be a reliable metric for companies with erratic or seasonal sales cycles.
- Growth at scale is more remarkable than early-stage expansion with a smaller customer base, so percentage metrics like the Rule of 40 are more useful for mature SaaS businesses.
- It doesn’t account for long-term strategies like cost reduction, R&D, or market penetration, which are standard for most SaaS companies.
- The SaaS industry is well-known for high growth at the expense of founder equity — consistently achieving the Rule of 40 may require dilution beyond the benefits of higher revenue multiples.
- Significant capital expenses skew the profit margin calculation, so businesses with a lot of annual recurring revenue may be more profitable than the model suggests.
- It doesn’t account for key SaaS metrics like customer retention, churn rate, and subscription renewal rate.
- The Rule of 40 works well for SaaS businesses with subscription revenue, but not those selling on an ad hoc basis.
Why Use the Rule of 40?
Because of the above limitations, the Rule of 40 is more of what you’d call a “guideline” than an actual rule.
Although it isn’t a strict metric by any means, it does help SaaS founders in the following areas:
- Balancing growth and profitability. The Rule of 40 helps companies find a balance between rapid growth and maintaining profitability, preventing them from solely focusing on one aspect at the expense of the other.
- Performance benchmarking. Using the Rule of 40, businesses can benchmark performance against industry peers, understand their market, and improve marketing and sales tactics.
- Investor attraction. Private equity investors rely on data and proven frameworks to make educated investment decisions. The Rule of 40 provides some of the visibility and credibility needed to attract capital from top venture firms.
- Sustainable growth. The 40% rule keeps companies from overextending themselves during periods of rapid expansion by encouraging sales growth without overspending.
- Decision-making tool. The Rule of 40 is helpful for resource allocation, prioritizing investments, and setting realistic growth targets.
- Valuation guide. Companies that consistently meet or exceed the Rule of 40 threshold are generally considered more valuable, providing a useful guideline for valuations during fundraising and M&A transactions.
- Risk mitigation. By considering both growth and profitability, the Rule of 40 can help companies identify and mitigate potential risks that could arise from focusing too heavily on either factor.
In short, a healthy SaaS business often has a combined growth rate and profitability margin of over 40%, but it’s up to founders to connect the dots when it comes to balancing growth and EBITDA margins with other key facets of their business.
Does Rule of 40 Only Apply to SaaS?
The Rule of 40 is only a SaaS rule. And it really only works well for late-stage startups and public SaaS companies.
The SaaS industry is characterized by rapid growth and comparatively high margins, often between 70% and 90%.
Software is considerably more scalable than almost any other business model — many other businesses are lucky to see gross margins of 10%.
Take ecommerce brands as an example. They rely mostly on paid advertising and pricing strategies to generate sales, meaning margins are typically much lower than those of SaaS companies.
Agencies (even those working exclusively on retainers) are another good example. Since they need to invest in talent and continuously spend money to produce services for clients, their margins and growth rates are often lower than a combined 40%.
What is a Good SaaS Growth Rate?
The optimal growth rate for a SaaS company varies wildly depending on its stage of development, with typical annual revenue growth ranging from 15% to 45%.
A 2020 study published by SaaS Capital examined SaaS growth metrics, presenting the average and median ARR growth for private SaaS businesses across various revenue brackets.
This information emphasizes the need to compare your company’s growth rate to that of similar-sized organizations to gauge performance accurately.
A $3 million startup with an 80% growth rate falls short of the average, as the $1 – $3 million category has an average growth rate of 93%.
Conversely, an 80% growth rate for a $20 million enterprise is considered exceptional, given that the average growth rate for the $10 – $20 million segment is 43%.
Since the Rule of 40 only focuses on a company’s growth rate and profitability margins, it doesn’t provide more than a snapshot of its financial health.
For early-stage startups, using only the Rule of 40 could result in a complete misevaluation of a company’s potential for future success.
For later-stage and scaled SaaS companies, positive cash flow and high growth don’t guarantee customers will stick around.
In addition to the Rule of 40, SaaS companies should use the following key metrics:
Customer churn — the number of customers canceling their subscriptions — tells you whether or not your product is good enough to keep customers long-term.
With the right sales strategies, you can convert enough new customers at a low enough cost to meet the 40% rule.
But revenues will tank if they leave your product just outside the rule’s measurement boundary, a problem only your churn rate can help you understand.
Customer Acquisition Cost (CAC)
CAC measures the cost of acquiring a single customer, accounting for all expenses associated with sales and marketing campaigns.
Your CAC helps you calculate profit margin, so you’ll already use it for the Rule of 40. But using it for that SaaS rule alone won’t tell you whether customer acquisition is sustainable in the long run.
Lifetime Value (LTV)
LTV measures how much a buyer spends throughout the customer life cycle.
It’s calculated by multiplying your average revenue per user (ARPU) by customer lifespan, then dividing it by your churn rate.
A low LTV isn’t necessarily bad. You can offset it with a low CAC and high growth rate.
To fully understand your revenue growth rate in the context of your customers, you have to measure LTV along with it.
This ratio shows you the ROI of your customer acquisition efforts and helps you assess their sustainability.
The ideal ratio is 3:1 or higher — that is, your average customer spends at least three times as much as it costs to acquire them.
Since it looks at revenue over the actual customer life cycle rather than just a snapshot of annual revenue, the LTV:CAC ratio is generally a better indicator of a healthy business than the Rule of 40 (though it helps to measure both).
Growth vs. Profit
Neither growth nor profit is more important per se — the Rule of 40 helps you understand the balance between them.
There are a lot of variables to consider.
- An early-stage SaaS company needs to prioritize growth over profitability to expand quickly and get its product to market.
- Late-stage startups already have established financial systems and customers, so they focus more on profitability until their growth rate levels off.
- In both cases, retention determines whether or not the company turns a profit on a customer-by-customer basis.
Of course, revenue growth is less common at scale — it’s much easier to grow 100% when you’re doing $100,000 MRR compared to $1 million.
That’s why the true sign of a maturing company is its ability to create scalable systems and processes that generate predictable revenue.
Speaking of scalable processes and predictable revenue…
If you only used the Rule of 40 to benchmark company health, you’d see SaaS SEO as another expense.
Admittedly, SEO is the definition of The Long Game.
But every SaaS marketing plan needs it for scalable revenue, lower customer acquisition costs, and a more efficient sales process — all things that contribute to pushing you well over that 40% margin.