For SaaS businesses and particularly software startup companies, the balance of growth and profit is vitally important. A new business interested in “disrupting the industry” must at times be willing to forego profits to quickly grow and expand their customer base. On the other hand, if growth slows, the business is still sustainable, so long as profits are high enough. To successfully maintain either of these scenarios requires business growth analysis and strategic planning.
The Rule of 40 SaaS formula, designed specifically for software as a service companies, outlines a strategy to keep a business nimble and healthy in an unpredictable marketplace. The Rule of 40 is a non-GAAP metric designed to balance the tradeoff between growth and profitability. But this metric comes with big drawbacks and potential pitfalls. Is your SaaS business using the rule of 40?
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What Does the Rule of 40 Mean?
The Rule of 40 was created by Silicon Valley angel investors as a rough heuristic for SaaS companies. SaaS companies have non-traditional financial statements, so traditional metrics like current ratios and EBITDA margins don’t apply. The Rule of 40 seeks to fill that gap.
The metric centers on the balance of revenue growth and profitability margin and provides a roadmap for business success. In this model, your growth rate and profitability should add up to or exceed 40%. If a company is growing at a fast enough rate, it can withstand a certain amount of profitability or loss and still be viable. A slowdown in revenue growth can also be acceptable, so long as profitability remains high.
How can the Rule of 40 mislead me?
Like any metric or KPI, the Rule of 40 is but a single dimension of your complex business. Managing to this metric while ignoring other KPIs (like CAC, LTV, churn, and cash) can cause you to pursue unsustainable growth. In fact, at CFOshare, we do not recommend using the Rule of 40 to our clients. Instead, we take a deeper dive into growth rates and profitability to define more appropriate budgeting metrics for our clients.
It is better to use the Rule of 40 when pitching California investors, but manage the business to more insightful metrics.
What’s the Formula for the Rule of 40?
The Rule of 40 follows the basic formula: Growth Rate + Profit = GP Ratio, and your GP Ratio should always be at least 40%. In other words, if your business has been growing at a rate of 30%, it should be seeing a 10% profit. If there is 40% growth, the profit can be 0. Companies that are growing by 50% can afford a 10% loss. A GP ratio of 40% indicates a healthy business, and if it’s greater than that, even better.
While the 40% rule is typically easy for younger companies with explosive growth to reach, larger software businesses must boost their performance to make up for the slower growth of a more mature enterprise. To be able to balance growth and profit over many years can be a great challenge.
How is the Growth Rate Measured?
For a SaaS business, the simplest way to measure the growth rate is to do a year-over-year (YoY) calculation on your company’s Monthly Recurring Revenue (MRR) growth. The first step is to calculate the MRR.
MRR is a critical measurement of success for a subscription-based software company, as it shows continuing, predictable income. This is one advantage that the subscription model has over traditional companies, which must rely on less certain one-time sales. MRR calculations usually exclude such one-time payments and fees.
To obtain MRR, add the monthly revenue from all those in your company’s customer base. For the greatest accuracy when analyzing MRR growth, you need to consider the three types of MRR—New MRR, Expansion MRR and Churn MRR.
- Existing MRR – Revenue from existing customers that continue through their contract or renew their contract.
- New MRR – Revenue from newly acquired customers in that month.
- Expansion MRR – Customers that have upgraded their plans or have purchased additional services or products during that time.
- Churn MRR – Revenue that was lost because a customer cancelled or downgraded their subscription. The Churn MRR would be the total of revenue lost.
In calculating MRR growth, add together Existing MRR, New MRR and Expansion MRR, and then subtract Churn MRR for your company’s total MRR.
For your Rule of 40 SaaS calculation, you can also use the Annual Recurring Revenue (ARR) for MRR.
What if My Company Bills Customers Annually?
If your business is on full accrual financials (and you should be) then annual subscriptions are already properly amortized over the future and you can use the monthly revenue right off your profit and loss statement. This is usually the most financial complex calculation in SaaS accounting, so many startup SaaS companies do not recognize revenue properly. If you are one of these cash-based companies, you will need to spread annual payments out across twelve months to come up with a monthly amount. If billed quarterly, divide the total amount by three.
How Do You Measure Company Profits?
The most commonly used calculation to determine a company’s profits, especially for SaaS businesses, is EBITDA, which is earnings before interest, taxes, depreciation and amortization. EBITDA is the standard metric of profitability for mergers and acquisitions, thus it is commonly used in venture capital and angel investing.
Other methods that can be used to measure profit include EBIT, free cash flow, net income and operating income. The right measure will depend on your business goals.
Can You Use the Rule of 40 to Evaluate Startups?
Investors evaluating software startups typically will not use the Rule of 40 SaaS formula until the company reaches a certain revenue level, since new companies will naturally place greater emphasis on growth. Opinions differ as to when the Rule of 40 becomes an accurate measure of a company’s health. Investor and Techstars founder Brad Feld, in his article “The Rule of 40% for a Healthy SaaS Company,” states that the model works for companies that have reached $1M in MRR. Tomasz Tunguz of Redpoint Ventures argues that it makes more sense to wait for the company to reach $50M in revenue.
At CFOshare, we do not use the Rule of 40 for any of our clients. We feel there are better ways to measure the health of a company’s growth, such as a Cost of Growth Analysis.
Does the Rule of 40 Work for Any Other Industries?
The Rule of 40 valuation applies only to software companies for this reason: their profit margins are far greater than other businesses. A SaaS firm may enjoy an 80-90% profit margin, as there is no cost to service new customers with existing software. It is this unusually high profit margin that enables the rule to be an accurate measure of company health.
Professional Business Growth Analysis
CFOShare provides expert financial services that are customized to fit the needs of your business. Our seasoned financial professionals can help you analyze the cost of your company’s growth, using the Rule of 40 and other metrics like Customer Acquisition Cost Analysis (CAC) and Customer Lifetime Value (CLV) Analysis. Greater insight leads to more strategic decisions for greater profitability and long-term success.
Contact CFOShare today to discuss your business goals.