Are you a new SaaS business trying to maintain steady revenue growth and profitability? Then the Rule of 40 will be very helpful for you to determine the health of your company and build a successful business. If you are still unaware and don’t know how to go about it, then worry not! In this blog, we will explain it in detail, along with its benefits, use cases, and best practices. So keep reading till the end!
What is the Rule of 40?
According to the Rule of 40, the combined value of the revenue growth rate and the profit margin should exceed or equal 40%. Most SaaS companies that can achieve this can generate healthy and sustainable revenue growth and profit margins, while companies that cannot may face issues with cash flow and liquidity.
The concept was first popularized in February 2015 by venture capitalist Brad Feld. In his famous blog post titled “The Rule of 40% for Healthy SaaS Companies”, he shared how he first learned about this rule from a late-stage investor. In the same meeting with them was Fred Wilson, whose blog about the Rule of 40 also became quite famous, but Brad Fled is considered the one who popularized it.
According to this theory, investors can determine the financial health of companies and decide on their suitability before investing in them. While the investor considered only companies with an annual revenue of $50 million were suitable for it, Brad Fled believes that this rule also applies to companies earning an annual revenue of $1 million.
Simply put, the Rule of 40 applies to early-stage SaaS companies that are not yet profitable or barely profitable to still get a reasonably higher valuation if their growth rate can neutralize their burn rate. Combining a company’s recurring revenue growth rate and profit margin actually helps companies get investors to boost their business and even investors can avoid downside risks.
Understanding the Rule of 40
Calculating the Rule of 40 requires this formula for all businesses:
Rule of 40= Recurring Revenue Growth (%) + EBITDA Margin (%)
While the formula might seem very straightforward, all business owners will agree that it is not so. You need a close and in-depth review of your figures and company performance to determine the metrics required.
The Rule employs two key metrics:
- Recurring Revenue Growth (%): The recurring revenue growth rate of a company (ARR or MRR)
- EBITDA Margin (%): Calculating the profitability from the ratio of EBITDA and recurring revenue in percentage.
SaaS companies that can score 40% and above after the calculation, and considering the key metrics, are regarded to be in a favorable position and achieve sustainable growth and profits.
Example of Applying the Rule of 40
Now that you know how to calculate for the Rule of 40, let us look at some examples.
Say, there are four SaaS companies in a specific industry: A, B, C, and D. Now let’s take their metrics as a case study in a particular financial year:
- Company A has earned 40% profits but 0% growth.
- Company B has 0% profit but 40% growth.
- Company C has achieved 20% growth and 20% profit.
- Company D has earned 50% growth but incurred a 10% loss.
Now, let us look at these metrics in the form of a table:
| Metrics | Company A | Company B | Company C | Company D |
|---|---|---|---|---|
| Recurring Revenue Growth (%) | 0 | 40 | 20 | 50 |
| Profitability (%) | 40 | 0 | 20 | -10 |
| Final: | 40% | 40% | 40% | 40% |
As we can see in the above table, in all the instances, all the companies have managed to maintain a minimum of 40%, and therefore they adhere to the Rule successfully.
Rule of 40: Use Cases
Did you know, the Rule of 40 becomes useful for both investors and CEOs? It becomes an important metric to evaluate the health and performance of SaaS companies. Let us look at some of its uses and importance:
Benefits of the Rule of 40
Now that we have understood the use cases for the Rule of 40, let us get to know some of its benefits as well:
Best Practices for Applying the Rule of 40
Are you wondering how the fast-growing businesses and competitors keep up with maintaining their 40% mark? As we know, it is quite challenging and not easy at all, but what is business without a little risk? Let us take a look at some best practices that high-growth businesses apply to maintain the Rule of 40.
Final Thoughts
Starting a new business and maintaining its growth can be very challenging. However, following the Rule of 40 can help you look into some of the key metrics of your business and determine its overall financial health and success. We hope this blog will be helpful for you, and that you can achieve success in all of your business aspirations!
Srijita Datta is a content writer with over 4+ years of experience in various niches. Her active interest in exploring new and emerging SaaS software and the evolving world of AI motivates her to write crisp, engaging, and informative articles to share her knowledge. She is working with How to Buy SaaS as a content writer and curating fresh and unique content every week with an added expertise in SaaS content.
