What is the Rule of 40?
The Rule of 40 states that, at scale, the combined value of revenue growth rate and profit margin should exceed 40% for healthy SaaS companies.
- The Rule of 40 – popularized by Brad Feld – states that an SaaS company’s revenue growth rate plus profit margin should be equal to or exceed 40%.
- The Rule of 40 equation is the sum of the recurring revenue growth rate (%) and EBITDA margin (%).
- The Rule of 40 measures the balance between a SaaS company’s growth rate and profitability.
- The management teams of high-growth SaaS startups are often required to choose between rapid growth and expansion, or improving profitability – for which, the Rule of 40 has become a practical framework to balance the two concepts.
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How to Calculate the Rule of 40?
Under the Rule of 40, the sum of the SaaS growth rate and profit margin should be equivalent to or exceed 40%.
The Rule of 40 ties the trade-off between growth and profit margins to prevent the single-minded focus on growth in lieu of cost efficiency, which is frequent in the SaaS industry.
The 40% rule implies that early-stage SaaS startups either barely profitable (or unprofitable) could still be reasonably priced at a high valuation multiple if their growth rate can offset their burn rate.
While seemingly a “back of the envelope” generalization, the Rule of 40 – popularized by venture capitalist, Brad Feld – has increasingly gained credibility 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.
The Rule of 40 – Brad Feld
The Rule of 40% For a Healthy SaaS Company (Source: Brad Feld)
Rule of 40: SaaS Valuation KPI Metric
The Rule of 40 states that if an SaaS company’s revenue growth rate is added to its profit margin, the combined value should exceed 40%.
In recent years, the 40% rule has gained widespread adoption as a popularized measure of growth by SaaS investors.
The revenue growth rate, rather than referring to the gross or net revenue of a company, typically refers to the monthly recurring revenue (MRR) or annual recurring revenue (ARR).
To convert the MRR into ARR, we simply multiply by twelve months.
Once annualized, the growth rate in the recurring revenue metric is computed.
As for the profit margin, the most common metric used is the EBITDA margin in the corresponding period.
Why EBITDA? Most growth-stage companies are either unprofitable or barely profitable if analyzed using traditional GAAP metrics such as operating income (EBIT).
Opinions can differ on which funding stage the 40% rule becomes most applicable (or is less applicable) and how reliable it is as a metric.
For instance, according to the Rule of 40, an SaaS company growing 35% month-over-month (MoM) with a profit margin of 5% is not necessarily a concern.
The simplicity of the rule – not to mention its accuracy – is the main reason for its widespread use among practitioners in the SaaS sector.
Rule of 40 Formula
The Rule of 40 is a straightforward calculation, where the formula adds the recurring revenue growth rate to the EBITDA margin for a stated period.
Conceptually, the Rule of 40 ties two of the most important metrics for SaaS or subscription-based companies:
- Revenue Growth (%) → The growth rate in recurring revenue (MRR or ARR)
- Profitability (%) → The ratio between an operating metric, such as EBITDA, and recurring revenue, expressed as a percentage.
The Rule of 40 is a mere rule of thumb to analyze the health of an SaaS business, with regard to its growth rate in recurring revenue and profit margin.
To accurately interpret the SaaS KPI metric, 40% is the baseline figure at which the company is considered healthy and in good shape.
If the percentage exceeds 40%, the SaaS business is likely in a favorable position to attain long-term growth and profitability.
To reiterate from earlier, either MRR or ARR is normally used as the revenue component, especially since GAAP metrics often fail to capture the true performance of SaaS companies.
Why Does the Rule of 40 Matter?
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 is most reliable for mature, established SaaS companies.
In other words, SaaS companies that are high growth and unprofitable, but still past the “mid-stage” point (or beyond).
Early-stage startups around the seed stage in their life-cycle exhibit volatile Rule of 40 figures, making the metric difficult to interpret, especially considering how their business models are likely still a work-in-progress (WIP) and continuously undergoing changes.
In short, a gradual decline in an SaaS company’s MRR and ARR growth rate over time as a startup matures is an inevitable outcome.
However, a more sustainable balance must be struck between growth and profitability at some point.
Therefore, reliance on growth should gradually decline as a company reaches the later stages of its growth.
The Rule of 40 can guide an SaaS business in determining the timing of prioritizing growth or profitability at its current stage.
The critical question answered here is, “When should the SaaS startup pivot to focusing more on profitability than growth?”
Rule of 40 Calculator
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
SaaS Rule of 40 Calculation Example
Suppose we have four SaaS companies, which we’ll refer to as Company A, B, C, and D.
Use the following monthly recurring revenue (MRR) growth rates for each company.
- SaaS Company A = 20% Growth Rate
- SaaS Company B = 0% Growth Rate
- SaaS Company C = 40% Growth Rate
- SaaS Company D = 60% Growth Rate
Since the minimum threshold is 40%, we’ll subtract the MRR growth from the target of 40% for the minimum EBITDA margin.
- SaaS Company A = 40% – 20% = 20%
- SaaS Company B = 40% – 0% = 40%
- SaaS Company C = 40% – 40% = 0%
- SaaS Company 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 rate was 20% – therefore, its EBITDA margin must be 20% for the sum to equal 40%.
- SaaS Company A = 20% + 20% = 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.
