Why Does the Rule of 40 SaaS Matter?

Once upon a time, value investor Whitney Tilson took a short position, or, in other words, made a bet against the success of a business that had no chances to become successful.

Judge for yourself — not profitable, net insider selling, excessive stock options for employees. All traditional investor’s valuation methods proved it was the right move for Tilson back in 2011. The blue line from the figure below should have sloped down to make stellar profits for Tilson.

The unpromising company was Salesforce, and for the last 10 years, it was busy proving the value investor was wrong. In 2020, Salesforce became a non-replaceable #1 CRM in Gartner’s ranking for the 8th year in a now, having a bigger market than the next nine competitors taken altogether. And mark my words, in 2021 Salesforce will maintain its #1 position.

Salesforce’s stock performance

What is the rule of 40

The rule of 40 SaaS was created by Silicon Valley angel investors to better evaluate unpredictable SaaS businesses of low margins and exponential scaling potential. It works as a quick litmus test to indicate if a small SaaS business is healthy.

The 40% rule says that your growth rate and your profit margin should make 40% together, and it means even unprofitable businesses can be considered healthy. As long as your sales growth reaches at least 40%, profitability is believed to come in the future.

Look at Datadog, a software platform that monitors customers’ cloud activity. By the time the company IPO’d, it reported an outstanding 82% revenue growth and a negative profit margin of 9%. When we sum the two numbers, we get 73%, which is far above the required 40%.

As we see from the company’s rocking post-IPO stock performance, rule 40 wasn’t wrong in predicting a bright future for Datadog when it was an unprofitable company.

Datadog’s post-IPO stock performance

The gap between the growth and profitability is because user acquisition expenses are front-loaded, but the recurring subscription revenue stream comes over the life of the customer. The subscription model assumes small regular payments during the whole customer’s lifetime. That’s why you can have a bunch of users with only a fraction of them generating profit.

Look at Slack that had more than 600,000 customers, but only 575 paid more than $100,000 a year for the service. Once considered the fastest growing business app, Slack ended the year 2020 struggling under $91 million of losses and has to sell itself to a strategic acquirer.

How to calculate the rule of 40

First, we have to calculate the revenue growth rate — the percentage at which revenue was added this year over last year.

Say your current year’s annual revenue is $5,000,000, and for the prior year you’ve got $4,500,000. Thus, your annual growth rate would be (5,000,000 – 4,500,000) / 4,500,000 = 0,11 or 11%.

And now profit. When we speak about profit margin, we usually mean EBITDA — earnings before interest, tax, depreciation, and amortization.

To calculate the margin, take your EBITDA (let it be $1,500,000) and divide it by your overall revenue (let’s say, $5,000,000) to get 0,3 or 30% as your growth margin.

Now, all we have to do is to sum the two numbers in percentage terms to get 41%. Yay, we’re ready to pitch California investors!

How growth rate and burn rate are related

The rule of 40 teaches us that it’s impossible to try to maximize growth and profitability at exactly the same time. All companies make tradeoffs between profits and growth.

What do you need to boost growth? Increase marketing budgets and sales teams, or, simply put, burn your money. Sacrificing profit margin in the name of growth usually pays off, since it enables a company to establish a greater market share in expanding markets.

Generally, the top two or three companies ultimately gather most of the market profits, so investing early in growth can help ensure the company’s postponed profits and long-term market dominance.

When the rule of 40 SaaS matter, and when not

As a business makes its first steps, the rule of 40 is barely applicable, since the median growth metric is substantially greater at this stage, sometimes even above 100%. Even though many high-growth subscription companies are unprofitable, they outperform the rule of 40 due to their explosive growth. At this point, the rule of 40 doesn’t make much sense.

Image credit: saas-capital.com

A consistently strong performance against the Rule of 40, however, is challenging to maintain, because as the company matures, its growth typically slows down, as shown in the figure above. With a lower growth rate, it becomes uneasy to sustain a 40% rule, and that’s the point where the rule can point out the company with a healthy balance between growth and profitability.

So to apply the rule to a company, it makes sense to wait until it reaches a certain revenue level.

A venture capitalist at Foundry Group, Brad Feld, in his article about the rule of 40%, claims that the rule is already working for the companies that have reached $1M in monthly recurring revenue, which is pretty early.

Another venture capitalist, Tomasz Tunguz, argues that it makes more sense to wait for the company to reach $50M in revenue — after it has already spent five or six years on the market.

Wrapping up the rule of 40

It is nice to use the Rule of 40 when pitching California investors, but for early-stage companies, whose growth is stellar, founders should focus on more representative metrics.

That may be unit economics, which helps to figure out whether you earn with a consumer less than you spend to acquire one, or monthly recurring revenue, to know if your business is sustainable relating to the time.

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