How do you signal to investors that your company is worth putting money behind? How can you tell whether your growth rate and profit margin are healthy for a company at your stage?
The answer to both is by meeting or exceeding the rule of 40.
The rule of 40 is a golden figure which will catch an investor’s eye and a performance metric rolled into one. By showing your performance against it you’re demonstrating not only how well your company is currently doing, but also (if you’re consistently achieving it) how well you’re managing your company.
In other words, it shows that you’re worth putting money behind.
So, in this post we’ll cover:
- What is the rule of 40?
- Why the rule of 40 is important
- How to calculate your performance vs the rule of 40
- How to achieve the rule of 40 as a startup
- How to maintain the rule of 40 as you scale
Let’s get started.
What is the rule of 40?
The rule of 40 is a common high-level measure of a company’s performance, stating that the combined growth rate and profit margin of the company should be equal to or above 40%.
Straight away we need to add some provisos to this.
First, it’s only a common measure for software companies, particularly those dealing in SaaS. This is due to the metrics being mostly accurate for these types of companies - brick-and-mortar businesses such as building suppliers are better suited to different growth and profit rates.
Second, the rule of 40 is mostly used to quickly convey the company’s performance to investors such as venture capitalists. It’s a great way to hook the interest of an investor by showing them the potential of the company that you want them to buy into, but doesn’t hold enough detail to sell them by that figure alone.
The rule of 40 interacts a little differently with private equity (or other buyout-style) investors. Since these investors are looking for companies that they can easily boost the value of and then sell on, they’ll be looking for evidence that your company could easily reach the rule of 40 instead of already being there. Showing evidence that your company already has a solid growth rate but is lacking in profit margins would make it very attractive to these investors, since they could simply raise prices and cut costs in order to raise performance.
Third, it’s not a golden rule which cannot be broken. There are situations where costs spike in an attempt to vastly increase future profits (such as buying new equipment or making new hires). There may also be times when your growth rate is largely out of your control, for example a predictable seasonal drop in interest or a global scare/incident such as COVID. Any of these elements and more may affect your performance versus the rule of 40, and not all of these reasons will be an overall negative to your company.
Think of it this way.
SaaS companies in particular are often pressured to focus on exponential growth or generally boosting profits. It makes sense with their scalability, ease of access, and the booming state of the SaaS market over the last 10 years.
As such, the rule of 40 is reasonably easy to meet in any given average year. The real difficulty comes with consistently hitting or exceeding it.
Maybe your top-performing salesperson leaves, or perhaps you were in the travel industry during the lockdown years of the COVID pandemic. It’s hard enough to responsibly balance growth and profits without also trying to deal with forces out of your control.
This means that it’s even more valuable if you can consistently meet the rule of 40.
Why the rule of 40 is important
The rule of 40 is vital to demonstrating to investors (current and potential) the value of your company and its potential.
Younger companies tend to grow faster whereas older, more established ones can generally cut their costs more easily and become more profitable. This isn’t a bad thing - it’s a fact of doing business (the S-curve) as you land more of your total addressable customer base. However, the rule of 40 lets you consistently demonstrate your performance to investors in a way that they can easily understand.
In one simple figure you’re demonstrating to investors whether they can have confidence in your company and your management. If you can meet or exceed the rule of 40, you’re showing that you know how to run a successful company and maintain a healthy balance of bringing in new customers while also making a reasonable profit, thus paving the way for greater profits.
It’s also a great way to take stock of your own performance.
It’s all too easy to get lost in a sea of analytics when it comes to figuring out what you’re doing right and what needs improvement. The rule of 40 cuts through that clutter by giving a core metric which you can use to gauge at a glance whether you need to be taking action or adjusting course.
For example, let’s say that you’re running a medium-sized SaaS company which has managed to meet or exceed the rule of 40 in the last few years. Then, all of a sudden, for two quarters in a row you drop significantly below it.
Your focus on the rule of 40 has prepared you for this, because you’ve been keeping track of your growth and profits for years. This means that you’re more than aware of where you are in your S-curve based on elements like your market penetration, sales effectiveness, and the competitive landscape, and so can prepare for your progress along it in advance.
The mid-market growing SaaS company you run is slowing down in growth, causing you to dip below the rule of 40 threshold. However, you’re already cutting costs and increasing your profit margin to account for that. Once the effects of these changes hit, you’ll be back into the rule of 40 sweet spot and thus be able to hit that goal for another year running.
Speaking of which, let’s cover how to calculate your own performance versus the rule of 40.
How to calculate your performance vs the rule of 40
The rule of 40 is all about measuring your company’s performance versus a target of 40%. “Performance” in this instance refers to a combination of your profit margin being added to your growth rate.
The basic formula is “operating profit margin % + annual growth rate %” vs 40%, but it’s very important to know exactly which values should be used to determine these variables in order to get it right.
Let’s tackle your growth rate figure first. In SaaS companies this is commonly measured (at a high level at least) as Monthly Recurring Revenue (MRR) or Annual Recurring Revenue (ARR). These are the monthly and annual figures for how much revenue you earn on a consistent, reliable, recurring basis, respectively. For your ARR you need to be using your run rate, which means that instead of adding together your MRR for 12 months, you take your current MRR and multiply it by 12 to project what your ARR will currently be.
One easy mistake here would be to use your total Annual Contract Value (ACV) instead of your ARR. This is because ACV includes your ARR plus any one-time fees and contracts that will not automatically renew, so it doesn’t accurately reflect your consistent growth.
Also, while you can calculate annual revenue growth based on both ARR and MRR figures, we find it easiest to use MRR. To generate your annual revenue growth rate, take your most recent month’s recurring revenue (MRR) and divide it by the monthly recurring revenue recorded 12 months prior. This percentage is your annual revenue growth rate.
Moving on to your profit margin, many companies and VCs alike use operating profit margin (which uses EBITDA as the numerator) as their preferred figure. This stands for Earnings Before Interest, Taxes, Depreciation, and Amortization, and is calculated by adding your net income to your taxes, depreciation and amortization.
Depreciation is a measure of how much your tangible assets have lowered in value over time due to things like wear and tear, and amortization is the same but for intangible assets, such as loss of value due to having a set expiry date which has gotten closer since the last measurement.
Typically, quarterly figures are used to calculate your operating profit margin for a rule of 40 calculation, but monthly will work just as well. Simply take your EBITDA value for the selected time period and divide it by your total revenue (not just ARR) for the same time period. This percentage is your operating profit margin.
Once you have your profit margin and growth rate, combine both of your percentages by just adding them together (or subtracting if one is negative), then see whether your result is above, the same as, or below 40%.
If your final figure is below 40%, that means that your company is underperforming and you need to work on your growth rate (revenue increase), profit margin (cutting expenses), or both in order to meet common investor expectations. If you’re performing above 40% you’re generally considered to be performing well and maintaining a healthy company track.
The only exception to this is when you’re sacrificing one of your key figures (ARR or EBITDA) to bolster the other without accounting for the long-term consequences of this.
Your profits can be increased by reducing your costs, making layoffs, and raising your prices, but doing so can stifle your growth and lead to a smaller addressable audience in the future. Likewise, high growth rates are generally very good, but overspending to push growth above all else can turn into a dangerous bubble if you’re not planning for the sustainability of your spending, and how you’re going to later turn a much bigger profit as a result of your growth.
The key to knowing when these are a problem is by knowing where your company is (and where you should be) on your growth (S) curve.
For example, if you’re a small company and you’re above the rule of 40 through the strength of your year-on-year profits, you’re stifling your growth at a time when you should be expanding fast and scaling aggressively. If you’re an enterprise-level company that is beating the rule of 40 through profit then you’re running a massively successful business, as you’ve already grown and hit your plateau, so your profits are the only thing that you can realistically boost.
How to achieve the rule of 40 as a startup
The most important thing to remember when trying to meet the rule of 40 as a startup (or any small company) is that your best friend is growth.
Landing even one or two extra clients can cause a huge spike in your growth rate in your early stages, which will more than make up for the inevitable negative that is your profit margin. That’s how it’s designed to go when you’re a startup - you’re spending investors’ money in order to build a platform that will later be massively profitable.
The main thing that you have to worry about is your product-market fit, and whether you’ve achieved it before you start investing your VC funds.
If you aren’t offering a product or service which meets your market’s demands, you aren’t going to grow quickly no matter how much money you put in. This is when spending far more than you’re earning will become too great for your growth rate to balance out, making it impossible to hit that golden 40%.
Once you have a product that fits your market, then it’s time to start investing your cash reserves aggressively into growth. In pursuit of this, you’ll likely have to focus on sales and marketing while keeping an eye on customer services (especially in regards to churn) and ways to expand on your product’s base state.
However, this is only the start of your efforts. It’s far more difficult to maintain the rule of 40 than it is to achieve it a single time, or during your early years when growth rates are naturally going to be skyrocketing.
How to maintain the rule of 40 as you scale
The first thing you need to do is to keep re-examining and monitoring your performance versus the rule of 40. When combined with keeping an eye on where you are in your company’s S-curve, this will give you a good idea of how you’re performing versus where you need to be to meet your predictions.
Knowing what your growth rate should be will let you carefully control your spending in order to keep your profit margin (or lack thereof) under control and still reach the rule of 40 overall.
The second is knowing when to “hack” the S-curve and when to settle in for a more profitability-focused future.
The idea behind “hacking” the S-curve is to create a new curve which will start at the point where your last one ends. Once your original angle, target market, product or service meets its natural maturity, it’s time to either create a new product for the same market or target a new market with the same product. It’s a way of creating new growth opportunities for your company as soon as your others start to reach their natural peak, leading to a far larger potential profit margin once your new ventures also reach fruition.
No matter how many new products you create or markets you address, there will eventually come a time when your in-house efforts have reached their practical limit. This is when your Customer Acquisition Cost causes any further attempts to grow to be prohibitive and not worth the potential returns.
So let’s say that you’ve run out of all but a handful of potential customers with no current solution to the problems you solve (or who use an inferior solution to yours). Your product has reached its zenith and, aside from keeping ahead of the competition, your install base dominates the market.
How do you still meet the rule of 40?
The answer lies in either researching and developing a new product/service in-house or looking into acquiring other products to sell to your market. These are both hugely expensive options, but by the time you’re considering them your company should be large enough to shoulder the cost and not take too much of a hit.
However, to still meet a 40% improvement you’ll need to compensate by reducing costs somewhere else. Remember, you don’t have a way to make up for the difference with your growth rate as it is, so the money you spend will need to be subtracted from somewhere else in a way that won’t affect your profits.
It’s all a massive balancing act, no matter what stage your company is at. If you’re aiming to meet or beat the rule of 40, you always need to be weighing your growth rate against your profit margin, with an eye on your growth curve and potential investments that you can leverage once your growth starts to stagnate.
It’s far from easy to consistently perform at or above the rule of 40, but with these tips and some careful planning and monitoring, you’ll already be better equipped than any other companies that are flying without a plan.
