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Estd 4.22.2023
In today's hyper-competitive SaaS landscape, leadership teams face constant pressure to deliver both rapid growth and sustainable profitability. Investors, board members, and stakeholders demand clear indicators that a company is on the right track, particularly in uncertain economic environments. Enter the Rule of 40—a powerful metric that has become the gold standard for evaluating SaaS business health and performance.
What is the Rule of 40?
The Rule of 40 is a performance metric that combines a SaaS company's growth rate and profitability into a single figure. The formula is elegantly simple:
Growth Rate (%) + Profit Margin (%) ≥ 40%
The underlying principle suggests that healthy SaaS businesses should have these two fundamental metrics sum to at least 40%. For instance, a company growing at 30% with a 10% profit margin would achieve a score of 40, meeting the benchmark.
Brad Feld, Managing Director at Foundry Group, is credited with popularizing this metric around 2015, though its origins extend back further within venture capital circles. Since then, it has been embraced by investors, executives, and analysts as a quick way to gauge SaaS business health.
Why the Rule of 40 Matters to SaaS Executives
1. Balanced Growth and Profitability Assessment
The Rule of 40 elegantly addresses the growth versus profitability tension that plagues many SaaS executives. Rather than viewing these as competing priorities, it acknowledges that different combinations can represent healthy business models.
According to research by McKinsey, SaaS companies that consistently achieve the Rule of 40 command valuation multiples twice as high as those that fall short. This makes the metric particularly important for companies preparing for fundraising, M&A activities, or public offerings.
2. Versatility Across Company Stages
What makes the Rule of 40 powerful is how it adapts to different company stages:
- Early-stage startups might achieve a score of 40+ through 70% growth and -30% margins
- Mid-stage companies might balance with 50% growth and -10% margins
- Mature SaaS businesses might attain 20% growth with 20% profit margins
"The Rule of 40 gives founders and executives a flexible framework to make strategic decisions appropriate to their company's maturity," notes David Skok of Matrix Partners.
3. Investor Appeal and Valuation Impact
In Bessemer Venture Partners' State of the Cloud 2022 report, SaaS companies achieving or exceeding the Rule of 40 received valuation multiples 65-75% higher than their underperforming peers. The metric has become a shorthand for operational excellence among potential investors and acquirers.
How to Measure the Rule of 40 Correctly
While the concept seems straightforward, execution requires careful consideration of which metrics to include.
Growth Rate Considerations
The growth component typically refers to year-over-year revenue growth, but executives should consider:
- Revenue type: Most analysts prefer using Annual Recurring Revenue (ARR) growth for subscription businesses
- Time period: Year-over-year comparisons are standard, but some use quarter-over-quarter (annualized) for more recent performance insights
- Adjustments: Some companies exclude one-time revenues or focus only on subscription revenue growth
Profit Metric Options
The profitability component offers more variability in measurement:
- EBITDA Margin: Most commonly used, representing earnings before interest, taxes, depreciation, and amortization divided by revenue
- Free Cash Flow Margin: Increasingly popular, especially for capital-intensive SaaS businesses
- Operating Income Margin: Used by some public companies for consistency with other reporting
According to OpenView Partners' 2023 SaaS Benchmark Report, EBITDA margin is the most commonly used profitability metric among private SaaS companies (used by 68% of companies they surveyed), while public companies often use free cash flow margin (42%) or operating margin (38%).
Practical Implementation for SaaS Leaders
1. Set Target Combinations Based on Your Stage
Rather than fixating on the 40% threshold, develop stage-appropriate combinations:
- Hyper-growth phase: Perhaps 60% growth, -20% margins
- Scale-up phase: 40% growth, 0% margins
- Mature phase: 25% growth, 15% margins
2. Track Trends, Not Just Absolute Numbers
The direction of your Rule of 40 score over time matters as much as achieving the threshold. A company improving from 25 to 35 shows better operational momentum than one declining from 45 to 40.
3. Use It for Strategic Decision-Making
The Rule of 40 should inform key decisions:
- Investment timing: When below 40, focus on efficiency before pursuing additional growth investments
- Fundraising windows: Approach investors when your Rule of 40 score is trending positively
- Resource allocation: Balance growth initiatives with profitability improvements based on your current score
Limitations and Considerations
While powerful, the Rule of 40 isn't perfect. Executives should remain mindful that:
- It doesn't address cash runway or balance sheet strength
- Company size and maturity significantly impact achievable scores
- It may incentivize short-term decisions that hurt long-term value
- Industries outside pure SaaS may require different benchmarks
As Tomasz Tunguz of Redpoint Ventures notes, "The Rule of 40 is a great thermometer, but it shouldn't be the only instrument in your financial dashboard."
Conclusion: Beyond the Number
The Rule of 40 has earned its place as a critical SaaS metric because it captures the fundamental balance that sustainable businesses must strike: growing fast enough to capture market share while maintaining sufficient profitability to ensure longevity.
For today's SaaS executives, mastering this metric means understanding that different combinations can yield success, depending on market conditions, competitive positioning, and company maturity. The most valuable approach is treating the Rule of 40 as a guiding principle rather than an inflexible mandate.
By regularly measuring your Rule of 40 performance, tracking its trends, and making strategic adjustments accordingly, you position your SaaS company for both investor appeal and sustainable success in an increasingly competitive landscape.