What is the “Rule of 40”?
The Rule of 40 – popularized by Brad Feld – states that for healthy SaaS companies, if the growth rate were to be added to their profit margin, the combined value should typically exceed 40%.
- In the SaaS industry, what does the Rule of 40 represent?
- What is the formula involved in testing for the Rule of 40?
- If a company meets the Rule of 40 test, what does that signify?
- Which factors determine if a company meets the Rule of 40?
Table of Contents
Rule of 40 SaaS Metric
The “Rule of 40” ties the trade-off between growth and profit margins, which prevents the single-minded focus on growth in lieu of cost efficiency.
The 40% rule implies that early-stage companies with either low or negative profitability could still be reasonably priced at a high valuation multiple if their growth rate can offset their burn rate.
The Rule of 40% For a Healthy SaaS Company (Source: Brad Feld)
While seemingly a “back of the envelope” generalization, the Rule of 40 has increasingly gained creditability for analyzing a company’s operating performance.
The benchmark combines a startup’s profit margin and growth rate into a singular number to help investors protect their downside risk and steer the company toward success over time.
Rule of 40 in the SaaS Industry Valuation
In recent years, the 40% rule has gained widespread usage as a popularized measure of growth by SaaS investors.
The Rule of 40 states that if a company’s revenue growth rate were to be added to its profit margin, the total should exceed 40%.
- Monthly Recurring Revenue (MRR) = Number of Active Accounts * Average Revenue Per Account (ARPA)
- Annual Recurring Revenue (ARR) = MRR × 12 Months
- Growth Rate = (Current Year Value – Prior Year Value) ÷ Prior Year Value
As for the profit margin, the most common metric used is the EBITDA margin in the corresponding period.
- EBITDA Margin = EBITDA ÷ Revenue
Opinions can differ on which funding stage the rule becomes most applicable (or is less applicable) and how reliable it is as a metric, however, its simplicity – not to mention its accuracy – is one reason that many rely upon it.
For instance, according to the Rule of 40, a SaaS company growing 35% month-over-month with a profit margin of 5% is not necessarily a concern.
Rule of 40 for Early-Stage Companies
At the end of the day, the 40% rule for startups is a useful tool for late-stage growth investors.
Generally, the Rule of 40 tends to be most reliable for mature, established companies, i.e. companies that are high growth and unprofitable, but still closer to “mid-stage” and beyond.
Startups in the very early stages of their life cycle often exhibit volatile Rule of 40 figures, making them difficult to evaluate, especially considering how their business models are likely still works-in-progress.
In short, as a company’s MRR/ARR growth declines as a company matures, a more sustainable balance must be struck between growth and profitability.
Therefore, the reliance on growth should gradually decline as a company reaches the later stages of its growth.
The rule attempts to tie two of the most important metrics for a SaaS or subscription-based company:
- Revenue Growth
Rule of 40 Formula
The Rule of 40 formula is a straightforward calculation adding the MRR/ARR growth rate percentage to the EBITDA margin for a given time period.
The Rule of 40 Formula
- Rule of 40 = Revenue Growth Rate + EBITDA Margin
The rule of 40% is nothing more than a rule of thumb to analyze the health of a software/SaaS business. It takes into consideration growth and profit.
In terms of interpreting the rule, 40% is the baseline figure where the company is deemed healthy and in good shape.
If the percentage exceeds 40%, then the company is likely in a very favorable position for long-term growth and profitability.
To reiterate from earlier, typically either MRR or ARR is used as the revenue metric, especially since GAAP metrics often fail to capture the true performance of SaaS companies.
Rule of 40 Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
The Rule of 40 Example Calculation
Suppose we have four companies, which we’ll refer to as Company A, B, C, and D.
Use the following MRR growth rates for each company.
- A = 20% Growth
- B = 0% Growth
- C = 40% Growth
- D = 60% Growth
Since the minimum threshold is 40%, we’ll subtract the MRR growth from the target of 40% for the minimum EBITDA margin.
- A = 40% – 20% = 20%
- B = 40% – 0% = 40%
- C = 40% – 40% = 0%
- D = 40% – 60% = – 20%
The EBITDA margins we calculated just now represent the minimum profit margins for the Rule of 40 to be sufficiently met.
For instance, Company A’s MRR growth was 20%, meaning that its EBITDA margin must be 20% for the sum to equal 40%.
For Company D, the minimum EBITDA margin is negative 20%; i.e. the company can afford to have a negative 20% EBITDA margin and still raise capital at a high valuation because of its growth profile.