What is the Rule of 40 for SaaS Companies? How it Works, Calculation, and Why it is Important

How is the Rule of 40 calculated?

To calculate a company’s stance concerning the Rule of 40, you must add its revenue growth percentage to its profit margin. 

Below, we provide a step-by-step example to show you how to figure out whether your company is meeting the Rule of 40.

Step one - Choose your revenue growth metric 

The first step is to choose a revenue growth metric. You can choose one of two:

• Annual recurring revenue (ARR) 
• Total revenue

While you may have different types of revenue in your business, the key is to choose the type that represents the greatest share of your overall growth. If you rely on subscriptions for the majority of your total annual revenue, ARR is the most accurate metric to use. However, if most of your revenue comes from products that aren’t subscription-based, total revenue is a better value to use.

Step two - Choose your profit metric

When deciding on a profit metric, earnings before interest, taxes, depreciation, and amortization (EBITDA) margins work best. EBITDA levels the playing field by carrying a standardized definition that companies of any size can use.

EBITDA is also a relatively easy way to quantify cash flow without conducting deep analysis as compared to calculating free cash flow. Your aim when calculating the Rule of 40 is to quickly figure out whether you're on the right track.

Thus, picking an input like EBITDA that you can quickly use makes sense.

Calculating the Rule of 40 - An example

Below is a simple example of calculating a company’s Rule of 40.

First, we calculate the percent revenue growth over the selected time period. In this example, we’ll use the average year-to date (YTD) growth (calculated from ARR) for 2022 as our revenue growth metric: 

Then we calculate the EBITDA margin growth (our profit metric) for the same time period:

Now, we have the values we need to calculate the Rule of 40 valuation:

Per the Rule of 40, this company is above the threshold for a financially healthy SaaS.

The weighted Rule of 40

For early-stage SaaS startups, investors often place more weight on the company’s revenue growth rates instead of EBITDA (their profit margin). In such cases, the weighted Rule of 40 might make more sense to measure.

The formula for the weighted Rule of 40, which places more weight on revenue growth than on profit margin in the calculation, is:

Investors that prioritize growth will gain more insight into a SaaS company's health by using this formula instead of the traditional Rule of 40.

How does the Rule of 40 work?

The Rule of 40 was created by venture capitalists (VCs) looking for a way to assess the financial health and viability of growth-oriented SaaS companies. A company’s Rule of 40 calculation gives VC firms a single metric that defines the company’s dedication to increasing growth and profitability.

The Rule of 40 also helps SaaS founders figure out whether the balance they're striking between profitability and growth is optimal. For instance, a company might prioritize growth at the expense of profitability and still present a viable investment.

Here's a cheat sheet for how VCs view a SaaS company's Rule of 40 number:

• <40 – This is considered a poor value if your company has completed Series A or later stage funding rounds. 
• 40+ – At 40% or more, a SaaS business is attractive to a VC. However, higher is better and if your company is closer to 40 you need to focus on increasing this number.

Note that you can arrive at a number greater than 40 in several ways. A VC's investment choice depends on their preference for growth or profitability, and a number over 40 does not guarantee a high valuation multiple.

Why is the Rule of 40 important for SaaS companies?

The Rule of 40 is an important tool for SaaS growth analysis. Here are a few reasons why the Rule of 40 is crucial to growing SaaS companies:

1. It gives investors a quick metric to measure viability – The Rule of 40 is a simple way for investors to gauge how attractive your SaaS company is. At a recent event held by RevOps Squared, Ray Rike noted that the correlation between the Rule of 40 and SaaS company valuation has tripled in the last nine months from an R² of 0.14 to 0.49 meaning that the Rule of 40 – the balance between growth and profitability – has quickly become much more important to a SaaS company’s valuation.

2. It balances SaaS growth rates and profit – Many young SaaS companies tend to sacrifice one for the other. Regularly calculating your Rule of 40 position helps you identify what you ought to prioritize.

3. It aligns your FP&A around a single metric – The Rule of 40 gives your company a quick way to measure performance and align growth plans.

4. It highlights what needs to improve – Where your company stands on the Rule of 40 spectrum influences SaaS decision-making processes.

Should early-stage SaaS companies focus on the Rule of 40?

We previously noted that early-stage companies can sometimes get away with violating the Rule of 40. But does that mean they can completely ignore it? 

The answer is a bit complex. Early-stage SaaS companies should use the Rule of 40 to gauge their balance between growth and profitability. However, it should not be their only focus when assessing company performance as targeting Rule of 40 compliance would come at the cost of sacrificing growth.

Most early-stage SaaS companies place a lot more importance on growth in their business plan compared to profitability. As a result, using the Rule of 40 early on could lead to a biased view of the financial health and attractiveness of the company, causing more concern than necessary. 

Young SaaS companies may be better off using the weighted Rule of 40 or other metrics to assess their progress and save the standard Rule of 40 as they reach a more mature stage.

3 tips when tracking the Rule of 40

1. Shift to a more balanced approach between growth and profitability as your company matures

Most early-stage SaaS companies prioritize new business ARR in their plans. As your SaaS company matures, however, you’ll need to begin focusing more on profitability to meet market expectations for the more balanced approach between growth and profitability. In simpler terms, there’s more emphasis on the Rule of 40 compliance.

There are a number of ways you can improve your profitability, including reducing your customer acquisition costs (CAC), improving retention, and increasing your share of wallet with existing customers. Reducing your cost of goods sold (COGS), taking advantage of pricing leverage, and testing new, more profitable products are yet other ways to boost your profit margins. 

As the focus towards profitability increases over time from an initial growth-only mindset, the Rule of 40 compliance essentially dictates how much your company can burn in chasing growth. The key idea is that no matter how fast you grow, to be sustainable in the long term, your business needs to be profitable. Adhering to the Rule of 40 will help you achieve that at every stage of your business.

2. Invest in customer success 

Customer success plays an important role in maintaining the Rule of 40 in your business. For example, every SaaS company experiences churn. The impact of churn on your business is like a leaky bucket. While your sales team is working to pour more water (New ARR) into the bucket, your customer success teams can help to plug the leaks by increasing customer retention (renewal ARR). They’ll also work to put more water in at the top end by upselling and cross-selling to your existing customers (expansion ARR). 

As your SaaS company grows, you can also expect your customer acquisition costs (CAC) to increase, negatively affecting your EBITDA. To offset your higher CAC, you’ll need to extract more value from your existing customer base, which can only be achieved through retention and expansion. This is where investing in customer success can really pay off. 

Acquiring new customers almost always costs more than selling more to current customers. On average, current customers spend 67% more than new customers, too. According to Bain & Company research a 5% increase in customer retention boosts a company’s profitability by 95%.

The bottom line: Investing in customer success can help you boost retention, helping you meet the Rule of 40 and remain an attractive proposition to investors.

3. Leverage automation as the complexity of your business grows

With fast growth comes increasing workflow complexity. The addition of new, international customers, new products, and new business models can introduce significant complexities into your FP&A processes, which can affect productivity and negatively affect your ability to grow.  

For instance:

1. Expanding into international regions brings complexity such as multiple currencies, subsidiaries, and accounting systems. Preparing a P&L statement will involve manually consolidating data across these systems – Something that is time consuming and error-prone. Automating such processes will help you quickly calculate and track key business metrics including your growth rate and EBITDA margin.
2. Introducing new or custom pricing plans affects ARR growth significantly and to map those changes, you’ll have to update your models. This process is tedious to execute manually. For instance, if you introduce a freemium version, you’ll have to update your financial model and update your revenue reports. Automating this task will save you time and eliminate any errors a manual process introduces.

How Drivetrain makes it easy for you to track business health

The Rule of 40 is an incredibly useful tool for gauging your company’s financial health. However, early-stage companies might hobble themselves by tracking this metric closely. Using the weighted Rule of 40 at first and transitioning to the standard Rule of 40 is often the best approach.

With Drivetrain, you can easily calculate and track your Rule of 40 valuation along with other key SaaS metrics that can provide insights into the health of your business. With Drivetrain, you get: 

• Accurate revenue planning and forecasting – Track revenue growth and assess profitability and growth rates on the go.
• SaaS metrics reporting – Automatically track and calculate complex financial ratios. You can switch to KPI-based SaaS financial planning to create more accurate financial models.
• Powerful automated analytics – View important metric trends like MRR and churn on dedicated dashboards with minimal effort, and run root cause analyses on anomalies within minutes.