Why you need to be using the Rule of 40 to support your business growth
Let us introduce you to the Rule of 40.
Trust us, if you’re in fast-growth tech, SaaS or e-commerce, you really need to know about – and be using – it.
It’s the formula that uncovers the sustainability of your company, balancing the link between the cost of growth and your actual growth.
Why does it matter? Because it’s not just accepted – it’s encouraged – that fast-growth SaaS businesses are loss-making for a while - sometimes several years - depending on their strategy.
There are lots of reasons for this - product development and customer acquisition costs are front-loaded for most SaaS businesses, with recurring revenues paid over the customer lifetime.
So, when profit isn’t the focus in the early stage of a business, it can be difficult to judge what the right level of spend is when planning growth.
Benchmarking is a great way to know whether you’re moving in the right (or wrong) direction. But with fast-growth companies using different strategies, investments and revenue growth, it's not always easy to benchmark.
Enter, the Rule of 40. This is the formula used by investors to measure performance of a fast-growth SaaS business.
And, like all good investor focused metrics, it also helps you better manage your business, particularly during a high-growth phase. Why? Because it helps create that vital link between the investment decisions today, and the value and growth you’re driving for the future.
It combines two important metrics: growth rate and EBITDA margin. In other words, it balances greater growth investment (and thus higher EBITDA losses) with higher revenue growth, and vice versa.
How do you calculate the Rule of 40 for SaaS businesses?
Revenue growth and EBITDA margin are used to calculate your Rule of 40.
Rule of 40 number = Growth rate % + EBITDA %
According to the Rule of 40, if your revenue growth rate, plus EBITDA margin, is 40% or more, your growth and the investment needed to acquire that growth is aligned.
You might have a relatively poor EBITDA margin, but your revenue growth may over-compensate for this. Conversely, if these two are less than 40%, you could be less attractive to investors.
The examples below show a simple way to calculate the Rule of 40. You can see there are different ways for businesses to achieve the same Rule of 40 number.
Example 1 shows a much greater focus on revenue growth, whereas example 2 shows half the growth, but with a much smaller EBITDA loss. Both return the same Rule of 40 number.
Who benefits from the Rule of 40?
There’s a lot of discussion about what size of business this rule is most valuable for.
And, while there’s no one rule on what size you need to be, it's of limited value for a very new business that's still defining its product-market fit and go to market strategy – except, perhaps, in helping to plan for the future.
The Rule of 40 becomes most effective and valuable when your business is more established, commercially viable and selling to a wide customer base.
Using the Rule of 40 to determine how your SaaS business is doing
Investors will certainly be using this type of metric when assessing the financial health of any SaaS business so it needs to be something you understand and use as well.
While there will be any number of reasons companies return a result above or below 40%, reviewing this metric regularly will make sure you are focusing on two important areas of business performance - growth and EBITDA - and will show investors that your business is well-controlled and managed.
A fine balance
Revenue-generating activities, like reaching a wider audience, expanding your product offering or additional product development will impact your profitability.
There is always a balance for management teams between pursuing growth and managing EBITDA profits/losses.
The Rule of 40 highlights revenue growth in conjunction with operating results to make sure that top line growth isn't at the expense of bottom line returns.
And there will always be lots of reasons why the outcome is not 40%. For example, a large marketing campaign expected to pay back over a few years will have an impact on EBITDA, with revenue growth following in the future.
We work with businesses where their Rule of 40 is greater than 100, and we work with businesses where it's negative. Negative results don’t mean that businesses won’t be successful. The most important thing is that they’re monitoring the Rule of 40, the link between growth and profit, and understand the consequences in the decisions they make.
It’s not all about the Rule of 40
There are many businesses that return a result of more than 40% but that have other financial issues.
For example, your revenue might be growing fast this year and returning a strong Rule of 40, but if churn is running high and customers aren’t renewing, next year’s number will be a different story.
Always use the Rule of 40 in conjunction with other metrics across the business for the whole picture.