To assess a SaaS company’s performance, a popular metric called the SaaS Rule of 40 has emerged. This rule helps gauge the balance between a company’s revenue growth and profitability. The idea behind the rule is that a SaaS company should have a combined growth rate and profitability of at least 40%. It acknowledges that while rapid growth is desirable, it should not come at the expense of profitability.
The Rule of 40 is a mental model to help evaluate the balance between revenue growth and profitability in software businesses. It provides a simple yet powerful guideline to assess the financial health of SaaS companies and determine if they are on a sustainable path.
Statistics show that companies that adhere to the Rule of 40 tend to outperform their peers. By understanding and applying this rule, stakeholders can make more informed decisions and support the growth of sustainable and successful SaaS businesses. If you want to learn everything about the Rule of 40, including its formula, examples, and strategies to meet or even exceed it, then keep reading.
What Is the SaaS Rule of 40?
The SaaS Rule of 40 is like a financial compass that guides SaaS companies and investors on their path to success. It revolves around the idea that a healthy balance between revenue growth and profitability is vital for long-term sustainability.
The rule suggests that if a SaaS company’s revenue growth rate and profitability, expressed as the EBITDA margin, sum up to 40% or more, it indicates a favorable performance. Essentially, it means that the company is growing rapidly while also maintaining a healthy level of profitability.
Let’s illustrate the Rule of 40 with an example. SaaSPro, a fictional SaaS company, achieved a revenue growth rate of 30% in the past year while maintaining an EBITDA margin of 15%.
Applying the Rule of 40, we sum up the revenue growth rate (30%) and the EBITDA margin (15%). The result is 45%, surpassing the minimum threshold of 40%. This indicates that SaaSPro performs well, achieving a good balance between growth and profitability.
In summary, the Rule of 40 is a simple and effective tool to evaluate SaaS company performance.
How to Calculate the SaaS Rule of 40?
To calculate the Rule of 40, we should consider two key components: the revenue growth rate and the profitability margin. Here’s a step-by-step guide on how to do it:
- First, we need to calculate the revenue growth rate. Start by determining and calculating the revenue figures for the current year and the previous year. Then, divide the difference by the previous year’s revenue. Multiply the result by 100 to convert it to a percentage. This gives you the revenue growth rate, which measures the percentage increase in revenue over a specific period.
- Second, We need to calculate the profitability margin. Let’s say that this company uses EBITDA as its profitability measure. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) represents a measure of a company’s operating profitability. Then, divide the EBITDA by the total revenue and multiply the result by 100. This provides you with the EBITDA margin, which indicates the company’s profitability.
- Once you have the revenue growth rate and the EBITDA margin, you can calculate the Rule of 40. Simply add the revenue growth rate and the EBITDA margin together. The result represents the combined growth and profitability of the SaaS company according to the Rule of 40.
Examples of Rule of 40 calculation
Without a financial background, it’s normal to find this confusing that’s why a few examples might help. In this section, we’re going to give you two examples of how to calculate the Rule of 40 on an annual and monthly basis.
Example number 1
First, let’s calculate the Rule of 40 based on Annual Recurring Revenue. This company has a revenue growth rate of 50% and an EBITDA margin of 10%:
- Revenue Growth Rate = ((Current Year’s Revenue – Previous Year’s Revenue) / Previous Year’s Revenue) * 100
Revenue Growth Rate = ((50 – 40) / 40) * 100 = 25%
- EBITDA Margin = (EBITDA / Total Revenue) * 100
EBITDA Margin = (10 / 100) * 100 = 10%
- Rule of 40 = Revenue Growth Rate + EBITDA Margin
Rule of 40 = 25% + 10% = 35%
This result falls short of the minimum threshold of 40%, indicating that they should look for potential improvements to balance growth and profitability.
Example number 2
Now we’re going to calculate the Rule of 40 for a company based on Monthly Recurring Revenue. This SaaS company has an MRR growth rate of 20% and an EBITDA margin of 30%.
- MRR Growth Rate = ((Current Month’s MRR – Previous Month’s MRR) / Previous Month’s MRR) * 100
For example, if the current month’s MRR is $50,000 and the previous month’s MRR is $40,000:
MRR Growth Rate = (($50,000 – $40,000) / $40,000) * 100 = 25%
- EBITDA Margin = (EBITDA / Total Revenue) * 100
Let’s say the company’s EBITDA is $15,000 and the total revenue is $50,000:
EBITDA Margin = ($15,000 / $50,000) * 100 = 30%
- Rule of 40 = MRR Growth Rate + EBITDA Margin
Rule of 40 = 25% + 30% = 55%
In this example, the SaaS company exceeds the Rule of 40 thresholds of 40%, indicating favorable performance. The combined MRR growth rate and EBITDA margin of 55% suggest a strong balance between revenue growth and profitability.
What Are the Benefits of SaaS Rule of 40?
There are several benefits to calculating the Rule of 40. If you’re still wondering whether you need to measure it or not, keep reading.
- Providing a Benchmark
The Rule of 40 offers a standard benchmark to evaluate the financial performance of SaaS companies. It provides a measurable threshold that allows stakeholders to assess whether a company’s growth and profitability align with industry norms and expectations. This benchmark enables comparisons across different businesses and helps identify outliers or companies that may require further analysis.
- Guiding Decision-Making
The SaaS Rule of 40 plays a crucial role in guiding decision-making processes for investors, executives, and stakeholders. By considering both growth and profitability, the rule helps inform strategic decisions, such as resource allocation, investment choices, and expansion strategies. It ensures that decisions prioritize a sustainable balance between scaling operations and maintaining profitability.
- Highlighting Balance
The SaaS Rule of 40 emphasizes the importance of balancing growth and profitability. It discourages unsustainable growth strategies that may prioritize rapid expansion at the expense of profitability. By promoting a balanced approach, the rule encourages companies to focus on achieving sustainable growth that aligns with their long-term goals and ensures financial stability.
- Identifying Potential Issues
The SaaS Rule of 40 can act as an early warning system, highlighting potential issues in a company’s financial performance. If a company’s combined growth and profitability fall below the 40% threshold, it indicates that adjustments may be needed to enhance either growth or profitability. This insight can prompt further analysis and strategic adjustments to address underlying issues and improve overall financial health.
When Should You Apply the Rule of 40 to Your SaaS Business?
The Rule of 40 was originally meant for SaaS businesses that surpassed $50 million in annual revenue. But guess what? You don’t have to wait until you reach that milestone. Industry experts, including the renowned Brad Feld, recommend applying it even if you’ve hit $1 million in annual recurring revenue (ARR).
According to a SaaS Capital survey, many SaaS companies achieve $1 million in ARR within approximately five years. However, if you want a clearer picture of your growth trajectory as a younger company, assessing a 12-18 months period can provide more accurate insights into your SaaS growth curve.
As an alternative, you also have the option to wait until you have established key departments, achieved a solid product-market fit, and resolved any cash flow challenges. By doing so, you can assess your performance in relation to the Rule of 40 on a stronger and more stable foundation.
But here’s the catch: while the Rule of 40 is valuable, it’s not the be-all and end-all. Treat it as part of a comprehensive assessment of your business’s overall health. Just like any other SaaS value metric, it should be used in conjunction with other performance indicators to paint a complete picture of your company’s financial well-being.
So, don’t be afraid to apply the Rule of 40 earlier, use it wisely alongside other metrics, and gain valuable insights into your SaaS business’s growth and profitability. It’s a tool that can guide your decision-making and contribute to your long-term success in the ever-evolving world of SaaS.
What Do Top-Performing Companies Do to Leverage the Rule of 40?
At this stage, you may be wondering what you should do to gain a higher Rule of 40. The best thing to do is to know what top-performing companies are doing. That’s why we’re going explore the distinguishing factors and strategies that contribute to the success of leading SaaS companies in meeting or exceeding the Rule of 40.
Sustainable Growth Strategies
Top-performing SaaS companies prioritize sustainable growth strategies. They focus on achieving a healthy revenue growth rate while maintaining profitability. These companies implement targeted marketing and sales efforts to acquire new customers, optimize pricing models, and explore expansion into new markets. By strategically scaling their operations and managing costs effectively, they achieve sustainable growth that aligns with the Rule of 40.
Efficient Cost Management
Leading SaaS companies excel at cost management to maintain profitability. They carefully analyze and optimize their cost structures, identifying areas for efficiency gains. These companies leverage automation, cloud infrastructure, and scalable solutions to control expenses while meeting increasing customer demands. By striking a balance between cost control and investment in growth initiatives, they achieve a favorable EBITDA margin that contributes to meeting the Rule of 40.
Customer Success and Retention
Successful SaaS companies prioritize customer success and retention as key drivers of profitability and growth. They invest in robust customer onboarding processes, provide proactive customer support, and continuously improve their products based on customer feedback. By maximizing customer satisfaction and minimizing churn rates, these companies generate recurring revenue from loyal customers, contributing to the Rule of 40 through increased customer lifetime value.
Developing New Business Lines
According to McKinsey & Co Developing new business lines at a reasonable pace is crucial for SaaS companies aiming to sustain growth. When reaching the peak of their initial growth curve, these companies often face a dip due to the lack of market-ready offerings. However, by adhering to the Rule of 40, they maintain their momentum by swiftly establishing new business ventures. For instance, a $500 million SaaS company successfully developed a $60 million annual recurring revenue (ARR) business within 15 months. Leading companies strategically incubate new ventures by carefully selecting niche markets based on customer profiles. They dedicate resources and meticulously address operational and go-to-market aspects, just as they would with product development. Given the challenge of sustaining growth, the ability to rapidly build new business lines becomes vital for long-term success and value generation.
Strategic Decision-Making Based on Data
Leading SaaS companies base their strategic decision-making on data analysis and insights. They leverage analytics tools to monitor key performance indicators, customer behavior, and market trends. By utilizing data-driven insights, these companies can make informed decisions about resource allocation, product roadmap prioritization, and expansion strategies. This data-driven approach helps them optimize their operations and achieve the right balance between growth and profitability required by the Rule of 40.
Conclusion
The SaaS Rule of 40 offers valuable insights into the financial health and sustainability of SaaS companies. By considering the balance between revenue growth and profitability, this rule serves as a guiding principle for decision-making and performance evaluation.
Throughout this article, we explored the components and significance of the Rule of 40. We learned that it provides a benchmark for assessing company performance, attracting investors, and allocating resources effectively. It is applicable at various stages of a company’s lifecycle, including start-ups, where it can validate growth strategies and aid in securing funding. Wish you an exceeding Rule of 40, good luck!
