Finance:Rule of 40

Short description: Financial heuristic

The Rule of 40 is a common financial heuristic used to measure the performance and health of software as a service (SaaS) companies. It states that a healthy SaaS company's annual revenue growth rate and its profit margin should add up to 40% or more.

The rule provides a high-level view of a company's sustainability by balancing two critical, and often competing, objectives: rapid growth and profitability. It is widely used by venture capitalists, public market investors, and company executives to assess the trade-offs in capital allocation and strategy, particularly in determining whether to invest more heavily in growth or to focus on operational efficiency.

Formula

The rule is calculated with the formula:

$\text{Growth Rate}(\mathrm{\%})+\text{Profit Margin}(\mathrm{\%})\ge 40\mathrm{\%}$

Growth rate

The growth rate is typically the year-over-year (YoY) growth in revenue. For SaaS companies, this is most often calculated using Annual recurring revenue (ARR) or Monthly Recurring Revenue (MRR).

$\text{Growth Rate}=\frac{(\text{Current Year Revenue}-\text{Previous Year Revenue})}{\text{Previous Year Revenue}}\times 100$

Profitability margin

The definition of "profit margin" can vary, which is a key nuance in applying the rule. The two most common metrics used are:

• EBITDA Margin: Earnings Before Interest, Taxes, Depreciation, and Amortization as a percentage of revenue. It is often used as a proxy for operational cash flow.
• Free Cash Flow (FCF) Margin: The cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. Many investors prefer the FCF margin because it is less susceptible to accounting manipulations and represents the actual cash available to the company.

The choice of profitability metric can significantly alter the outcome and should be applied consistently for accurate comparisons.

Interpretation

The Rule of 40 allows for flexibility in a company's strategy. A company can achieve the 40% benchmark through different combinations: High Growth, Low Profitability: A company growing at 60% YoY with a -20% profit margin meets the rule (60% + (-20%) = 40%). This is common for earlier-stage companies in a high-growth phase, aggressively investing in sales, marketing, and product development to capture market share. Moderate Growth, Moderate Profitability: A company with 20% YoY growth and a 20% profit margin meets the rule. This may represent a more mature, stable company with a balanced approach. Low Growth, High Profitability: A company with 5% YoY growth and a 35% profit margin also meets the rule. This often characterizes a market leader in a mature market that is focused on maximizing cash flow rather than expansion. A company that falls below the 40% threshold may be a cause for concern, suggesting either that its growth is too slow for its level of investment or that its business model is not yet efficient enough.

Strategic implications

The Rule of 40 is not just a backward-looking metric but also a forward-looking strategic tool. Studies have shown a strong correlation between a company's Rule of 40 score and its valuation multiple. Companies that consistently outperform the 40% benchmark tend to achieve premium valuations. Management teams use the rule to guide decisions on capital allocation. For example, if a company's score is well above 40%, it may justify further aggressive investment in growth. If the score is below 40%, the focus may need to shift toward improving operational efficiency, optimizing pricing, or reducing customer churn to improve profitability.

History

The Rule of 40 gained prominence in the mid-2010s within the venture capital community. While its exact origin is debated, it was popularized by investors like Brad Feld as a simple way to evaluate the health of their SaaS portfolio companies. Its simplicity has led to its broad adoption in both private and public markets for valuing software businesses.

Criticism and limitations

While widely used, the Rule of 40 is a heuristic, not a rigid law, and it has several limitations:

• Arbitrary Benchmark: The 40% figure is arbitrary and may not be suitable for all market conditions. In bull markets, investors may prioritize growth far more, accepting a lower combined score, while in bear markets, a greater emphasis is placed on profitability and cash flow.
• Varying Definitions: As noted, the lack of a standardized definition for "profit margin" (e.g., EBITDA vs. FCF vs. net income) can lead to inconsistent application and "metric shopping."
• Company Stage: The rule is less applicable to very early-stage startups, where growth is the singular focus and profit margins are deeply negative. It is more relevant for venture-growth and later-stage companies.
• Industry Specifics: The rule may not apply equally to all software sub-sectors. Companies in highly capital-intensive or competitive niches may have different healthy baseline metrics.
• Doesn't Measure Quality: The rule is a quantitative measure and does not provide insight into the quality of the revenue, the stickiness of the product, or the size of the addressable market.

See also

• Financial ratio
• Customer acquisition cost (CAC)
• Lifetime value (LTV)
• EBITDA
• Free cash flow