Rule of 40 & SaaS: Calculation, how it works & more

The rule of 40 is a financial metric that combines revenue growth and profit margins to determine the health of a SaaS enterprise. It is a practical tool for investors and buyers to estimate a company's growth and profitability balance. 

For instance, if a firm makes 20% profit quarterly, its growth rate should also be 20% for a healthy balance.

According to McKinsey research, investors reward enterprises that maintain this functional performance marker, yet a surprisingly small number have been able to do so.

‍About one-third of software organizations meet the rule of 40, and even fewer succeed in maintaining it.

Between 2011 and 2021, an analysis of more than 200 software companies of distinct sizes demonstrated that organizations only exceeded the rule of 40 performance 16 % of the time.

That’s a staggeringly small number and a major missed opportunity.

So, what is the rule of 40, and how do we calculate it?

Let's discover.    

What is the Rule of 40?

The rule of 40 is a critical financial metric that measures the combined growth rate of its revenue and profit margin.

‍Ideally, this combined percentage should reach or exceed 40%. Companies that consistently achieve this benchmark are generally considered to be on a sustainable growth trajectory.

Falling below 40% may indicate potential liquidity issues in the future.

The rule of 40, coined by famous venture capitalist guru, Brad Feld, became known in 2015 in his article "The rule of 40 for healthy SaaS companies". He stated that he used the metric to measure his company's suitability to stakeholders after he started making over $50 million in profits annually.

So how exactly does the rule of 40 in SaaS work?

How does the rule of 40 work?

The rule 40 highlights a company's progress in balancing profits and growth.

As a business, you must consider the following:

• You can record losses of up to 10% if your growth rate is 50%.
• If your company is growing at 20%, it should have a 20% growth rate.
• You can grow at 40% and still have 0% gains.
• Your firm must have profits up to 40% even without foreseeable progress.

If you want to establish whether your company follows the rule of 40, consider:

• Profitability margin
• Revenue growth

💡NOTE: The rule of 40 does not apply to all industries, only SaaS companies. However, most enterprises globally use it as a benchmark.

Why?

SaaS industries enjoy profitable margins of between 70-90% compared to those that rely on subscriptions or traditional business models.

Also, companies bank on benchmarking to streamline the process of comparing business's operating standards, especially those at different trade cycles.

How to calculate the rule of 40?

To compute the rule of 40 for SaaS companies, add its revenue and profit margins.

Below is a detailed expansion on how to do it:

1. Calculating the revenue growth rate

Revenue growth rate is the % increase of a company over a certain period, often annually.

Formula:

Revenue growth rate = (Revenue in current year – revenue in previous year) / Revenue in previous year) x 100

‍

For instance:

Company A:

The previous year’s revenue was $ 15 million

The present year's revenue was $19 million

Revenue Growth Rate = ((19,000,000 - 15,000,000) / 15,000,000) * 100

2. Calculating the profit margin/ EBITDA margin

‍

Formula:

EBITDA Margin = (EBITDA / Revenue) x 100%

For instance:

EBITDA: $ 3 million

Total revenue: $ 14 million

EBITDA Margin = (3,000,000 / 14,000,000) x 100%

3. Adding the revenue growth and profit margin

‍

Formula:

Rule of 40 score = revenue growth rate + profit margin

For instance:

• Revenue growth margin: 40%
• EBITDA margin: 16.90%
• Rule of 40 score margin: 40 + 16.90 = 56.90%

What is the importance of the rule of 40 in SaaS?

The rule of 40 is an essential tool for investors and stakeholders to assess the health and stability of a software company. So, why is it important?

1. Balancing growth and profitability

The rule of 40 in SaaS helps companies to steady profitability and growth, which is an integral factor in the business domain. The state of the market forces most companies to rank short-term revenue collection strategies over long-term profitability avenues.

This process often involves constant investments in sales, product development, and marketing strategies.

Contrariwise, focusing on company profits leads to conventional growth ideas that stress operational efficacy and cost management, which impedes development.

However, with the rule of 40, companies approach expansion with a holistic view as it combines EBITDA (Earnings before interest, taxes, depreciation, and amortization) margins and growth.

For example, if a company enjoys EBITDA margins and growth rates of 40% or above, it highlights its foreseen stability and ultimately steady success even in unprecedented market conditions. Such a balance is imperative for companies looking to attract investors and cement their stability.

2. Understanding investor’s perspective

Investors use the rule of 40 to determine the potential and performance of SaaS companies, especially when identifying those with an impressive balance of profitability and growth.

Companies that follow the rule of 40 are sound investment options because it highlights their proficiency in balancing fiscal and operational wellness.

Such a balance is crucial for SaaS companies where speedy growth often conceals ongoing financial constraints and weaknesses.

Reaching the metric shows investors that your company has taken the necessary steps towards curbing overspending and over-expansion.

3. Making strategic decision making

SaaS companies rely on the rule of 40 to evaluate performance, make strategic decisions, or refine resource allocation to stabilize profits and balance growth.

‍For example, a company with a high growth rate that does not meet the rule of 40 may highlight the need to strategize effective operational and spending ideas.

If a company experiences a slow growth rate, it might invest heavily in uncovering appropriate products, marketing strategies, and sales.

Ultimately, calculated decisions help companies draft superior tactics that propel their progress.

4. Evaluating market comparison

The rule of 40 metrics is powerful for healthy market comparison because it allows companies to scale their progress against competitors.

This step is crucial, especially with the current market standing, since companies experience varying profits and growth rate margins.

Such insight is pivotal for investors and company management teams to assess their standing in crowded markets.

Also, the metric ensures companies know what they need to improve and why, for superior market standing. 

In essence, the rule of 40 sets the stage for actionable insights for businesses looking to take effective decisions.

5. Maintaining financial health

Financial health increases the profit margins of a company.

An enterprise that exceeds or meets the 40% threshold highlights its dedication to sustainable growth and revenue. Such a balance is necessary for long-term success and market viability. 

Hence, a stable rule of 40 beacon investors to invest despite unstable market conditions.

Practical applications of the rule of 40

1. Resource allocation

The rule of 40 helps company management teams to balance operations, resource allocation, and performance. It directs the management team on the right growth initiatives to increase profits.

For instance, a company with high growth rates but a low EBITDA margin may revamp cost efficiency, but a slow rate may enhance stakeholders, sales, and marketing tactics.

In essence, frequently calculating the rule of 40 helps companies to create exceptional strategies.

2. Advanced considerations

When integrating the rule of 40, it is crucial to consider economic downtimes, market competitiveness, and profits since they play an integral role in its evaluation.

‍Also, the relevance of the metric lies in its development since most Startups overlook profits over growth.

For instance, according to a report in Harvard Business Review, in 2017, WeWork, a prominent coworking venture, had raised $10 billion in equity and debt. Its top-line earnings had doubled for five consecutive years, and its membership had expanded 10-fold. 

But over the same period, operating costs rose from $400 million to almost $2 billion, leading to significant and deepening losses. Other similar examples are cited in the report.

3. Tools and resources

SaaS companies can use various tools and resources like financial management software, CRM systems, business intelligence and analytics platforms, and industry benchmarking reports to check their rule of 40 scores.

‍Most software calculates key metrics, which play a decisive role in tracking financial systems.

Also, this software has analytics features integrated with dashboards to certify a smooth benchmarking process of the company's performance.

4. Market conditions

The business market is prone to turbulence, which causes unstable market conditions.

Economic downtimes impact a company's revenue collection and profitability process.

For instance, when a company is facing an economic recession, it could slow down revenue growth while also maximizing profits.

A company's progress depends on how it interprets the rule of 40 scores.

Therefore, understanding how these intricacies work enables institutions to make strategic decisions that promote success.

Rule of 40 successful implementation case studies

1. Salesforce

Salesforce has consistently surpassed the SaaS rule of 40 benchmark as a leading provider of CRM software for years. 

According to a case study from Binadox, a private tech company based in Washington, Salesforce achieved a rule of 40 score of around 55%, driven by a revenue growth rate of 25% and an operating margin of 30% during the year 2022.  

Salesforce's achievements are a result of creating products and making strategic acquisitions, such as Slack and Tableau while prioritizing customer satisfaction and venturing into fresh markets and industries. The business has enjoyed steady growth with the following key strategies:

• Marketing efforts and sales: the company has invested heavily in its marketing and sales teams – since they are the pivot of revenue growth. Their strategic approach to sales and marketing ensures stable market expansion.
• Strategic acquisitions: Salesforce has a steady history of making tactical purchases, a move that has ameliorated its product and service delivery, ultimately contributing to immense profits and revenue growth.
• Continuous product innovation: by introducing better and more innovative products, Salesforce has wooed satisfactory clients, which is a stable ground for immense growth.

2. Atlassian

Atlassian is prevalent for its incomparable products, including Confluence and Jira. According to the official website, its data center and cloud technologies accrue a 60% operating cash flow and 59% free cash flow in the previous year. Below are some steps the company took to uplift their standing in the market:

• Product growth: over the years, Atlassian has focused on appropriate product strategies to amend customer retention.
• Efficient operational model: maintaining a steady business model despite the weathering market conditions streamlines operations.

Rule of 40 challenging implementation case studies

1. WeWork

WeWork is an example of a groundbreaking SaaS company that prioritizes excessive growth at zero profitability. 

According to a report from WSJ, in 2019 WeWork filed for an IPO, revealing significant losses - $1.9 billion on $1.8 billion in revenue for 2018 and $690 million on $1.5 billion earlier the same year.

WeWork went public at a $9 billion valuation via a SPAC merger but continued to incur losses.

Despite reaching pre-pandemic occupancy levels in 2022, financial difficulties persisted. Its assets totaled $15 billion at the height of its bankruptcy, but it owed $18.6 billion in debt, plus more than $100 million in unpaid arrears and lease termination penalties.

Here are some instances of how the business failed:

• Aggressive expansion: the company focused more on expanding to new markets, but due to its unnecessary spending, it experienced losses.
• Unsustainable business model: the company invested in short-term and long-term customer contracts and leases, which affected costs and revenue.
• Management issues: poor leadership hampered WeWork since stakeholders and investors ignored the progress of the company.

2. Blue Apron

Blue Apron entered the market with growth figures, going from $341 million in revenue in 2015 to $800 million in 2016.

However, it faced challenges around its IPO as the initial offering price was adjusted due to lackluster investor enthusiasm, leading to only moderate gains on the first day of trading. 

As revenue from its customer base grew steadily over time, Blue Apron grappled with expensive efforts to attract new customers and struggled with retaining them. Blue Apron's financials showed signs of distress early on.  

According to the TechCrunch report, in 2017, after going public for the first time, the company experienced financial losses and was nowhere near making a profit. The amount of money lost increased from $52 million in 2017 to $61.9 million in 2019. 

Blue Apron received $73 million in funding towards expanding its customer base in 2021;.

However, its revenue net losses increased to $109 million in 2022. 

The company’s adjusted EBITDA also suffered a decline while operational efficiency issues arose. 

In an attempt to save costs and decrease debt in 2023, Blue Apron outsourced food preparation to FreshRealm, but the cash infusion couldn’t fix its unprofitable, low-margin model.

Here is why the company’s operations flopped:

• Operational inefficiencies: the company experienced functional hurdles by purchasing more than needed.
• Competitive pressure: intense competition from other companies in the industry caused an imbalance between profits and growth.

Looking for growth without compromising equity?

The rule of 40 in SaaS is crucial for measuring the economic success of an enterprise.

Regardless, if you want to improve your profits and growth rate, it should not be at the expense of the company’s financial stability and equity. 

Steady cashflow upholds commercial stability, enabling ventures to grow and meet set objectives. 

Did you know that Stenn provides a solution for SaaS without sacrificing equity?

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