April 28, 2020

Understanding the Rule of 40% and What is Needed to Master It

The Rule of 40%: What Does It Mean?

The rule of 40% applies to Software-as-a-Service (SaaS) companies and is used to analyze the health and/or attractiveness of the company. The 40% rule determines this by considering the two most important metrics for a SaaS company: growth and profitability.

The rule requires the combined profit margin and growth rate of a company to be at least 40%. Today, it is an increasingly popular way to gauge the performance of a software company or SaaS businesses. More and more executives in the software industry today are embracing the 40% rule, because the rule makes it easy for them to measure the trade-off between growth and profitability.

Before we proceed further with the 40% rule and how you can master it, it is important to revisit the past. This is required to show how and when the rule started to gain traction. Most investors in the not too long ago had a mindset of growth-at-all-costs. However, this started to change in 2016, and investors began valuing SaaS companies that had the ‘right’ balance of growth and profitability. This was when the rule of 40% started to gain traction.

The simplest way to explain this rule is that growth rate + profit should be equal to or more than 40%. Anything under that and the rule will not be satisfied. Is the rule clear yet? If it isn’t, then you would do well to pay careful attention to the section that follows next.

A Break Down of the 40% Rule

The formula of the 40% rule is as follows:

GP Ratio=Growth Rate + Profit

As seen above, the rule of 40% formula adds the growth rate to the profit percentage. For example, say your growth rate is 17% and your profit percentage is 13%. Adding the two numbers gives you 30%. This is well below the 40% target required by the rule.

If you want to satisfy the 40% rule, then you need to ensure that adding your profit and growth rate will give you a number that is equal to or more than 40%. This means a growth rate of zero and profit of 40% would do the trick. This can work the other way around as well.

In fact, you can satisfy the 40% rule when either of your growth rate or profit percentage is above the 40% mark and the other side of the coin shows a negative sign. If you hit the 40% mark, then you are doing well as a SaaS business. If its anything above that, then you should be proud of your business.

Calculating Growth Rate and Profit Percentage

The next step after understanding the 40% rule formula is to find out how to calculate growth rate and profit. Let’s start with growth. Growth can be measured in several different ways. However, the easier way to measure it is with Year-over-Year (YoY) on Monthly Recurring Revenue (MRR) growth. You can find the growth rate by comparing the total revenue. However, considering monthly revenue for this purpose is recommended, which is especially important when one-time services are in the mix.

The profit percentage of a SaaS business can be measured in several different ways just like the growth rate. GAAP accounting has quite a few options for this including Cashflow, Free Cashflow, Net Income, Operation Income, and more. However, the most popular and most used measure is Earnings before interest, taxes, depreciation and amortization (EBITDA). This measures profit without accounting for tax tables, depreciation and amortization, and interest.

However, EDITDA might not be the best option for SaaS companies that host their product/solution on their own platform. This is because of the equipment purchases and the debt to finance them that apply to these companies.

Growth Vs. Profit

If you listen to the rule, then you can lose money even if you are grow or make a profit. A SaaS company has two options to satisfy the rule. The first is to sacrifice one for the other. This means give up on company growth to focus on profitability or vice versa. The other way to satisfy the rule is by achieving a balance between the two measures.

The goal is to achieve a profit+ growth rate that is equal to or more than 40%. That is all that is required for your company to be perceived as healthy or attractive. The approach you take to satisfy the 40% does not matter. So, there is no winner between growth and profit in the context of the 40% rule.

The Right Time to Measure the Rule of 40%

Profitability can be achieved early on for most parts of a SaaS business by lowering the growth rate.  However, this is not recommended.  Before pursuing profit, there is a rule of thumb that indicates the amount of money to invest. This rule of thumb is referred to as the T2D3 approach.

The rule recommends increasing revenue by as much as three times for two years in a row. In the three years thereafter, the revenue should be doubled. The 40% rule can be pursued once this is accomplished. Put simply, the 40% rule comes into play when you’re a mature SaaS company. If you are a startup, then you shouldn’t be measuring this.

Brad Feld—the man who popularized the rule, recommends using the 40% only after you’ve reached an MRR of $1 million. Typically, this would be a time when all the functional departments that make a SaaS company tick are in place.

Most of the functional departments are in place by this time. Therefore, your focus at this point will be on the revenue growth, operating leverage, gross margins, EBITDA etc. of your SaaS business. The rule of 40% will simply be an extension of this reporting package.

by Bobby J Davidson

I love our companies  and we love what we do.  For more information on the Davidson Family of Companies, visit www.bobbydavidson.com/about.  Sign up for my Newsletter at the bottom of this page.