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What Is the Rule of 40 and Why Should SaaS Businesses Care?

|March 26, 2021|

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In the Software as a Service community (SaaS), benchmarking is crucial for any business that wants to succeed. Without benchmarking, it can be very difficult for a business in this space—especially in the early stages—to know whether they are moving in the right or wrong direction.

Benchmarking is not only useful for making changes internally but also useful for comparing one company to another. This is particularly useful for investors and potential clients who are comparing multiple options at once.

As SaaS becomes even more competitive, introducing effective benchmarking strategies is something that becomes even more important. Currently, there are many different benchmarks that might be employed. The one that makes the most sense for a given organization will depend on the party using the benchmark, the types of businesses being compared, and other relevant factors.

One of the most common benchmarks used in the SaaS space is revenue growth and profitability margin. When all else is equal, companies will want both revenue growth and profitability margin to be as high as possible.

Keeping this in mind, how can a SaaS company know that it is growing and generating profit at an acceptable rate?

The Rule of 40 - Explained

The “Rule of 40”, simply, is that a SaaS company’s revenue growth rate (measured as a percent) and profitability margin (also measured as a percent) should equal at least 40%.

Naturally, in order to determine whether the company is above 40% or below, they will need to know two things.

  • Revenue growth
  • Profitability margin

Companies that are above 40%, for this particular metric, are either generating profit or increasing revenue at a rate that can be more easily sustained. Companies that are below 40% are not necessarily doing terribly, but this does suggest that there may be some cash flow or liquidity issues faced in the near future.

The Rule of 40 cannot be applied across every industry (it is specifically used within the SaaS), but it is still a very useful benchmark.

Again, the primary purpose of benchmarking is to make it easier to compare companies that have different operating structures, are at different phases of the business cycle, or are otherwise difficult to compare.

Calculating Growth Rate and Profitability

Calculating revenue growth should be easy for any SaaS company that has been operating for at least a year. The Generally Accepted Accounting Principles (GAAP) establish clear definitions for what constitutes revenue, and these definitions tend to remain consistent year over year.

Keeping this in mind, your business should be able to easily look at the revenue column on your most recent income statements and calculate your annualized revenue change.

On the other hand, “profitability margin” is a rather broad term that can potentially be used to describe several different items on your company’s balance sheet or income statement. A few of these possible items might include free cash flow (meaning you might need to create a statement of cash flows), total operating income, and earnings before interest, taxes, debt, and appreciation (EBITDA).

If using EBITDA, profitability margin will be calculated by measuring EBITDA as a percentage of total operating revenue (mentioned above).

Let’s look at a simplified example. If a company generated 10 million USD in revenue in 2019 and 12 million USD in revenue in 2020, then the company’s year-over-year revenue growth would equal 20%(2 million divided by 10 million).

Suppose the same company is using EBITDA as its primary “profitability” metric and that its EBITDA for 2020 was 3 million USD. In this case, the profitability margin for the company would be 30% (3 million divided by 10 million).

In this example, the company’s revenue growth plus profitability margin would equal 50% (20% plus 30%). This means that the company has “passed” the Rule of 40 and is likely well-positioned for the future.

Both revenue growth and profitability margin could be negative, especially if the company has recently accrued significant amounts of debt or major capital expenses. However, even when either of these figures is, in fact, negative, the company can still utilize the rule of 40 and hope that success in one area could offset any issues created by the other.

Balancing Competing Goals

Ultimately, running a business—whether in the SaaS industry or any other—is going to involve making some important tradeoffs. One common tradeoff is that pursuing additional revenue streams will often (at least temporarily) eat into a company’s profit margin.

Pursuing revenue-generating activities, such as reaching a wider audience, expanding a product line, or enhancing a product via additional research and development will introduce additional expenses that can eat at marginal profitability.

At the same time, finding ways to improve profit margins—such as cutting the marketing budget—can cause revenue to decline.

This all totally okay and normal.

The role of the management team is to carefully balance both competing interests at once and think about the company’s long-term financial plan. The reason why the Rule of 40 is so useful is that it allows managers to consider how each of these metrics relates to one another while still ensuring the company is at least making some type of progress.

Both pursuing revenue growth and managing profit margins will be an important component of running a SaaS business. The main point of emphasis here is that your business should be actively pursuing and enhancing at least one of these goals at a time.

Benchmarks With a Grain of Salt

Clearly, the Rule of 40 can be very useful for SaaS companies. Between 2011 and 2019, the average revenue growth plus EBITDA for public SaaS companies was 41%, which suggests that the rule is closely aligned with the industry norm. By using the Rule of 40, managers can determine if their organization is overperforming or underperforming the industry as a whole.

However, while the Rule of 40 is undoubtedly something that can benefit many SaaS enterprises, it is also something that should be taken with a grain of salt. There are plenty of companies that are above 40 that still have other financial issues and plenty that are below 40 that are actually doing quite well. Furthermore, the unusual economic year we witnessed in 2020 will inevitably cause some benchmarks to be less useful than usual.

Still, even keeping these things in mind, the Rule of 40 has become quite popular throughout the broader SaaS industry. When combined with other useful metrics, it can help managers make decisions that are truly best for their business.

Looking To Control Your Profit Margin and Achieve the Rule of 40?

For many SaaS companies, cloud infrastructure costs are one of the most significant contributing factors to operating costs. If you’re looking to get control of your costs and understand how they map to your key business metrics, like cost per product feature, customer, and more, check out CloudZero.

Here are a few of the reasons finance teams love CloudZero, even if it’s designed for engineering.  

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