Rule of 40 in SaaS: How to Apply It for Your Business

Are you a new SaaS business trying to maintain steady revenue growth and profitability? Then the Rule of 40 will be very helpful for you to determine the health of your company and build a successful business. If you are still unaware and don’t know how to go about it, then worry not! In this blog, we will explain it in detail, along with its benefits, use cases, and best practices. So keep reading till the end!

What is the Rule of 40?

According to the Rule of 40, the combined value of the revenue growth rate and the profit margin should exceed or equal 40%. Most SaaS companies that can achieve this can generate healthy and sustainable revenue growth and profit margins, while companies that cannot may face issues with cash flow and liquidity.

The concept was first popularized in February 2015 by venture capitalist Brad Feld. In his famous blog post titled “The Rule of 40% for Healthy SaaS Companies”, he shared how he first learned about this rule from a late-stage investor. In the same meeting with them was Fred Wilson, whose blog about the Rule of 40 also became quite famous, but Brad Fled is considered the one who popularized it.

According to this theory, investors can determine the financial health of companies and decide on their suitability before investing in them. While the investor considered only companies with an annual revenue of $50 million were suitable for it, Brad Fled believes that this rule also applies to companies earning an annual revenue of $1 million.

Simply put, the Rule of 40 applies to early-stage SaaS companies that are not yet profitable or barely profitable to still get a reasonably higher valuation if their growth rate can neutralize their burn rate. Combining a company’s recurring revenue growth rate and profit margin actually helps companies get investors to boost their business and even investors can avoid downside risks.

Understanding the Rule of 40

Calculating the Rule of 40 requires this formula for all businesses:

Rule of 40= Recurring Revenue Growth (%) + EBITDA Margin (%)

While the formula might seem very straightforward, all business owners will agree that it is not so. You need a close and in-depth review of your figures and company performance to determine the metrics required.

The Rule employs two key metrics:

1. Recurring Revenue Growth (%): The recurring revenue growth rate of a company (ARR or MRR)
2. EBITDA Margin (%): Calculating the profitability from the ratio of EBITDA and recurring revenue in percentage.

SaaS companies that can score 40% and above after the calculation, and considering the key metrics, are regarded to be in a favorable position and achieve sustainable growth and profits.

Example of Applying the Rule of 40

Now that you know how to calculate for the Rule of 40, let us look at some examples.

Say, there are four SaaS companies in a specific industry: A, B, C, and D. Now let’s take their metrics as a case study in a particular financial year:

1. Company A has earned 40% profits but 0% growth.
2. Company B has 0% profit but 40% growth.
3. Company C has achieved 20% growth and 20% profit.
4. Company D has earned 50% growth but incurred a 10% loss.

Now, let us look at these metrics in the form of a table:

MetricsCompany ACompany BCompany CCompany D

Recurring Revenue Growth (%)0402050

Profitability (%)40020-10

Final: 40%40%40%40%

As we can see in the above table, in all the instances, all the companies have managed to maintain a minimum of 40%, and therefore they adhere to the Rule successfully.

Rule of 40: Use Cases

Did you know, the Rule of 40 becomes useful for both investors and CEOs? It becomes an important metric to evaluate the health and performance of SaaS companies. Let us look at some of its uses and importance:

• Helps Businesses Maximize their Valuation: The Rule of 40 often works in favor of early-stage SaaS businesses that are yet to be profitable. This metric can still help them maximize their valuation for funding rounds with investors and venture capitalists. Not only new companies, but mature SaaS businesses can also benefit from it.
• Evaluate Business Health: While evaluating for The Rule of 40, you have to evaluate two key metrics for your company: the profit margin and the growth rate. This helps you look into your overall business performance, and financial health, and identify concerning issues.
• Helps in Benchmarking: When you are evaluating The Rule of 40, you can benchmark your performance against other businesses and competitors and evaluate your strengths and weaknesses.

Benefits of the Rule of 40

Now that we have understood the use cases for the Rule of 40, let us get to know some of its benefits as well:

• Determine Your Business’ Financial Health: When you add the growth rate and profitability rate for the Rule of 40, you will get insight into the financial health, determining the success of your business. In this way, you can understand the progress you have made and make important decisions to boost your business.
• Helps Attract Investors: Do you know who usually uses the rule of 40 to determine successful businesses? Investors! If you are looking for venture capitalists to invest in your business, then you should focus on reaching a score of 40 percent or higher. This will help you demonstrate a profitable business model for potential investors.
• Focus on Growth and Profitability: Following the rule of 40 helps you to not only focus on growth but also profitability, and make informed decisions to boost your business.
• Helps You Focus on Long-term Goals: The rule of 40 helps you take decisive steps for your business, and hence allows you to look at the long-term goals for your company. When you are aiming for a 40 percent or higher score, you have to prioritize sustainable growth and profitability, and short-term goals take a back seat. However, this will drive you to focus on building the foundation of your future growth and success.

Best Practices for Applying the Rule of 40

Are you wondering how the fast-growing businesses and competitors keep up with maintaining their 40% mark? As we know, it is quite challenging and not easy at all, but what is business without a little risk? Let us take a look at some best practices that high-growth businesses apply to maintain the Rule of 40.

• Set Achievable Revenue Growth Targets: While the SaaS space is filled with success stories of how some companies have achieved sky-high growth rates in recent years, it does not have to be the same for everyone. Rather than dreaming of such high growth rates, you must focus on setting achievable and realistic revenue growth targets. You can focus on a sustainable growth rate set across two to three years and make informed decisions to stay consistent and grow at your own pace.
• Optimize on the Marketing Spend: Most SaaS businesses spend the most expenses on sales and marketing, which amounts to 50 percent or more of revenue in businesses with high growth. Most of these high-growth businesses follow some effective strategies to maintain the ratio. They employ strategies like allocating sales and marketing resources based on future customer opportunities and not just current revenue, innovating go-to-market propositions that can be scaled efficiently, and taking the help of advanced analytics and machine learning to study customer health and behavior, which in turn helps drive sales.
• Focus on Customer Retention: When your target is achieving more business growth, then you should focus on caring for and retaining your existing customers while trying to acquire new ones. You can consider investing in specific postsales construct to improve on retention, cross-sell, and upsell, and also source the right tools, strategies, and analytics to ensure the same. Qadd this with a favorable pricing point and top-notch product, and you can improve your retention rates and deliver sustainable yearly growth.
• Prioritize Building New Businesses Quickly: Most SaaS businesses face many challenges while trying to maintain consistent business growth, and building and scaling new businesses quickly becomes essential to maintain the balance and momentum.

Final Thoughts

Starting a new business and maintaining its growth can be very challenging. However, following the Rule of 40 can help you look into some of the key metrics of your business and determine its overall financial health and success. We hope this blog will be helpful for you, and that you can achieve success in all of your business aspirations!