The Rule of 40: Balancing Growth and Profitability in SaaS (2024)

Contents

  • The Rule of 40
    • The formula
  • Why is it important?
    • Ensuring sustainable growth
    • Investor benchmark
    • Encouraging long-term thinking
  • Limitations
    • Narrow focus
    • Simplicity
  • Alternatives
    • Adaptability

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      The Rule of 40 is a straightforward yet powerful benchmark. It states that a company's combined growth rate and profit margin should equal or exceed 40%. In simpler terms, if you're running a SaaS startup or in charge of the marketing engine, this rule is your litmus test for balancing rapid growth with sustainable profitability.

      Why 40%? Well, it's not just a random number. The SaaS market is huge, but it’s only going to get bigger, with forecasts indicating it will hit a staggering $232 billion by 2024. This threshold has emerged from the analysis of successful companies that have mastered the art of growing fast without burning through cash at an unsustainable rate. It's about striking that delicate balance where your revenue growth and profit margins are in harmony, ensuring long-term success and stability.

      In this article we’ll be exploring the essentials of the Rule of 40, what it means, and how to apply it in your goal setting, growth planning, and budgeting.

      The Rule of 40 and the evolution of metrics

      Traditionally, success in the startup ecosystem was predominantly measured by growth metrics. Think user acquisition rates, market share expansion, and revenue growth. These figures were the holy grail, often overshadowing other aspects of business health. The mantra was simple: grow fast, capture the market, and worry about profits later.

      However, this growth-at-all-costs approach has its pitfalls. It led to companies burning through cash with little regard for sustainability, resulting in a landscape littered with startups that grew rapidly but collapsed just as quickly. This unsustainable growth model prompted a shift in thinking, giving rise to the importance of profitability metrics.

      Want to learn more about the growth framework we use at Kalungi? Check out the T2D3 marketing playbook.

      Enter the Rule of 40….

      This metric represents a more holistic approach to measuring business success, combining growth and profitability into a single, balanced benchmark. The rule states that a company's growth rate plus its profit margin should equal at least 40%. For instance, if a company is growing at 30% annually, it should also have a profit margin of at least 10% to meet the Rule of 40 threshold.

      The formula: growth rate + profit margin ≥ 40%

      This can look very different for a young company and a mature one. If your company is making a consistent 32% profit annually, then an 8% growth rate would be healthy according to the rule of 40. If, on the other hand, you’re a young, fast-growing company, these numbers may be flipped: 32% growth and 8% profit.

      The significance of the Rule of 40

      In essence, the Rule of 40 serves as a health check. It encourages CEOs and marketing leaders to ask the right questions: Are we growing too fast at the expense of profitability? Are we profitable but stagnating in terms of growth?

      Striking the right balance is key, especially when it comes to the tech industry. But why is this rule so important for CEOs and marketing departments to understand?

      Ensuring sustainable growth

      As previously mentioned, the Rule of 40 isn't about championing growth at any cost. Instead, it advocates for balanced, profitable growth. This distinction is crucial. Rapid growth can be exhilarating, but without profitability, it's like running a race with no finish line in sight. The Rule of 40 encourages companies to grow but to do so while maintaining a healthy bottom line. This approach ensures that growth is not just impressive in the short term but sustainable in the long run.

      A benchmark for investors

      For investors, the Rule of 40 serves as a critical benchmark when evaluating the health and potential of SaaS and tech companies. Basically, companies meeting or exceeding this rule are often seen as well-balanced, with a strong grasp on both market expansion and financial health. This makes them more attractive investment opportunities, as they demonstrate a capacity for managing growth and profitability simultaneously.

      Encouraging long-term thinking

      One of the most significant impacts of the Rule of 40 is its ability to shift the focus from short-term gains to long-term strategy. After all, it's easy to get caught up in immediate growth metrics. However, the Rule of 40 nudges companies to think beyond the next quarter or fiscal year. It's about building a business that not only grows but does so in a way that's financially sound for years to come.

      Limitations of the Rule of 40

      Though its a helpful rule-of-thumb, the 40% threshold in the Rule of 40 is not a magic number. The historical context of this rule comes from analyzing successful companies and finding a common pattern in their growth and profitability metrics. However, it's crucial to remember that this is more of a guideline than a strict rule. The 40% figure is a benchmark that indicates good health and balance, but it's not a one-size-fits-all target. Different companies, depending on their size, market, and maturity, might have different ideal benchmarks.

      The downside of a narrow focus

      Focusing too narrowly on the Rule of 40 can also lead companies astray. Obsessing over hitting that 40% mark might result in short-term decisions that aren't in the best interest of the company's long-term health. For instance, a company might cut essential research and development costs to boost short-term profits, harming its future growth potential. Or, it might push for unsustainable growth rates that compromise the quality of its product or service.

      Factors distorting the simplicity of the rule

      The simplicity of the Rule of 40 is both its strength and its weakness. Several factors can distort its effectiveness:

      • Market conditions: In a booming market, achieving high growth rates might be easier, but this doesn't necessarily reflect a company's internal strengths or weaknesses.
      • Business model variations: Different SaaS business models might have varying capital requirements and profit margins, making the Rule of 40 less applicable across the board.
      • Stage of growth: Early-stage companies might prioritize growth over profitability, while more mature companies might do the opposite. The Rule of 40 might not equally apply to both.

      Alternatives to the Rule of 40

      While the Rule of 40 is a valuable metric, it's not the only measure of success. As industries and businesses evolve, you should consider a range of metrics that can provide a more comprehensive view of your company's health and potential. Here are some of these alternatives that you might want to consider alongside, or instead of, the Rule of 40.

      • Customer lifetime value (CLV): This metric measures the total revenue a business can expect from a single customer account throughout their relationship with the company. It's crucial for understanding the long-term value of customer acquisition and retention strategies.
      • Customer acquisition cost (CAC): CAC is the cost associated with convincing a customer to buy a product or service. Balancing CAC with CLV is essential; acquiring customers shouldn't cost more than they're expected to bring in over time.
      • Net promoter score (NPS): NPS gauges customer satisfaction and loyalty. It's a simple yet powerful way to measure customer experience and predict business growth through referrals and repeat business.
      • Monthly recurring revenue (MRR) and annual recurring revenue (ARR): Especially relevant for SaaS businesses, these metrics provide insight into the predictable revenue generated from subscriptions, crucial for long-term planning and valuation.
      • Burn rate: This is the rate at which a company is spending its capital to finance overhead before generating positive cash flow from operations. It's a vital metric for understanding how long a company can keep operating in its current state.

      Check out this blog for a more detailed understanding of our top B2B SaaS metrics and KPIs

      Industry experts often stress the importance of not depending exclusively on a single metric, especially when it comes to tech and SaaS. A singular focus might offer a myopic view of a company's health and potential. For example, while your company may meet the Rule of 40, a poor NPS could indicate underlying issues with customer satisfaction that might jeopardize long-term success. This shift in perspective is crucial as we move towards a more customer-centric approach, where metrics that measure customer satisfaction, engagement, and lifetime value are increasingly vital.

      This evolving focus is reflected in findings from the KeyBanc Capital Markets (KBCM) 2021 SaaS Survey. The survey showed that out of 175 SaaS companies, each with over $5 million in annual recurring revenue, only 50 complied with the Rule of 40, translating to just 29% of these companies. This statistic highlights the challenge of balancing financial performance with customer-centric measures, underscoring the need for a more holistic approach to evaluating company success.

      Adaptability and the role of the Rule of 40

      The Rule of 40 has gained traction for good reason. It offers a clear, quantifiable target that balances growth with profitability, providing a snapshot of a company's health. However, as we mentioned previously, it's not the only determinant of success.

      The most successful businesses are those that remain agile and adaptable. This means continuously evaluating and re-evaluating strategies, staying attuned to market changes, and being willing to pivot when necessary.

      The Rule of 40 should be part of your holistic approach to business strategy. It's a valuable tool in your arsenal, but it's not the only one. By combining this rule with a flexible, responsive approach to business planning and execution, you can steer your company toward long-term success.

      Remember, the ability to adapt is just as important as any metric. The Rule of 40 can guide you, but it's your adaptability and strategic vision that will ultimately define your success.

      At Kalungi, our focus is on helping B2B SaaS startups balance profitability with long-term sustainability. Schedule a consultation to find out more about our strategies and how we can tailor them to your company’s needs. We’re ready to learn about your business and support you in achieving success.

      The Rule of 40: Balancing Growth and Profitability in SaaS (2024)

      FAQs

      The Rule of 40: Balancing Growth and Profitability in SaaS? ›

      The Rule of 40 is a principle that states a software company's combined revenue growth rate and profit margin should equal or exceed 40%. SaaS companies above 40% are generating profit at a rate that's sustainable, whereas companies below 40% may face cash flow or liquidity issues.

      What is the 40 rule for sustainable growth? ›

      It states that a company's combined growth rate and profit margin should equal or exceed 40%. In simpler terms, if you're running a SaaS startup or in charge of the marketing engine, this rule is your litmus test for balancing rapid growth with sustainable profitability.

      What is the rule of 40 in Intuit? ›

      Definition of Rule of 40

      Rule of 40 measures a company's combined growth and profit margin. Many venture capital and growth equity investors believe this ratio should exceed 40%, especially for software companies.

      What is the golden rule of SaaS? ›

      The Rule of 40 is a SaaS financial ratio which states that a healthy SaaS company has a combined growth rate and profit margin of 40% or more.

      Is a 40% EBITDA good? ›

      Simply put, you take you growth rate and subtract your EBITDA margin. If it's above 40%, you're in good shape. If it's below 40%, you should start figuring out how to cut costs.

      What is the rule of 40 in SaaS? ›

      The Rule of 40 is a principle that states a software company's combined revenue growth rate and profit margin should equal or exceed 40%. SaaS companies above 40% are generating profit at a rate that's sustainable, whereas companies below 40% may face cash flow or liquidity issues.

      What is the 40 rule? ›

      The 40 Percent Rule is a mindset that Navy SEALs use to push through physical and mental pain when they think they have reached their limit. The idea is that when your mind tells you that you are done and can't go any further, you are only at about 40 percent of your actual capacity.

      What is the rule of 40 in tech investing? ›

      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%.

      What is rule of 40 capital efficiency? ›

      In recent years, the Rule of 40 has been a standard benchmark used to define a healthy SaaS company. This rule states that the sum of a company's percent ARR (Annual Recurring Revenue) growth and its margins (free cash flow) should be greater than or equal to 40 percentage points.

      What is rule of 40 IBM? ›

      The Rule of 40 is a financial benchmark used to assess the health and performance of SaaS companies. It stipulates that the sum of a company's annual revenue growth rate and profit margin should be at least 40%​​. This metric balances revenue growth against profit, providing a quick health check for SaaS companies​​.

      What is the 80 20 rule in SaaS? ›

      The 80/20 rule has applications in computing and social behavior but has also been observed in economics and business. When applying this principle to business, the common observation is that 20% of the activities in a business lead to 80% of the results.

      What is the magic number in SaaS? ›

      The SaaS Magic Number is calculated by dividing the growth in recurring revenue by the previous period's recurring revenue. This indicates that the metric is heavily influenced by your capacity to retain existing customers and generate additional revenue over time.

      What is the rule of 50 in SaaS? ›

      Its evolved state, the Rule of 50 (ARR Growth Rate + EBITDA Margins > 50), has taken hold across growth equity investing in 2023 as SAAS companies have rationalized costs and S&M spend and boosted EBITDA margins at the expense of eye popping higher growth rates. 50% growth + a negative 10% EBITDA margin was great.

      What is a good EBITDA for SaaS? ›

      An EBITDA margin falling below the industry average suggests your business has cash flow and profitability challenges. For example, a 50% EBITDA margin in most industries is considered exceptionally good. If your EBITDA margin is 10%, your SaaS startup's operations may not be sustainable.

      How to improve the rule of 40? ›

      The Rule of 40 measures a company's growth rate against its profitability, providing a clear benchmark for assessing business performance. Strategies for improving your Rule of 40 score include focusing on revenue growth, optimizing your cost structure, and prioritizing customer success and retention.

      Who invented the rule of 40? ›

      The term “Rule of 40” was originally coined in 2015 by venture capitalists Brad Feld and Fred Wilson, referring to their view that venture-backed companies should strive to achieve 40% or greater when combining growth rate plus profitability margin.

      What is the rule of 40 in investment strategy? ›

      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%.

      What is sustainable development in 40 words? ›

      Sustainable development is an approach to growth and human development that aims to meet the needs of the present without compromising the ability of future generations to meet their own needs. The aim is to have a society where living conditions and resources meet human needs without undermining planetary integrity.

      Where did the rule of 40 come from? ›

      Venture capital investors initially came up with the Rule of 40 as a way to quickly assess the perfor- mance of small, fast-growing companies. For larger companies, beating the Rule of 40 in a single year is not exceptional.

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