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May 31, 2022

If you’re a SaaS company, then you know that the road to success can be a long and winding one. There are so many different factors to consider and it can be tough to keep track of everything. That’s why it’s important to have guidelines like the Rule of 40 SaaS.

What is the Rule of 40 SaaS? This rule is essential for any SaaS company that wants to achieve success. It states that your growth rate plus your profitability should equal at least 40%. So if you’re growing at 20% and profitable at 20%, then you’re on track!

But if you’re growing at 30% but not yet profitable, then you need to reevaluate your strategy. The bottom line is that the Rule of 40 is a great way to measure whether or not your SaaS company is on track for success. If you want learn more about this guideline and how it can benefit your business, read on!

The Rule of 40 Saas

The Rule of 40 is a simple way to determine if a company is a healthy and growing business. The rule states that for a company to be successful, it must have a combined growth rate and profitability percentage that equals at least 40%.

According to Brad Feld, a co-founder of Techstars, the Rule of 40 is an important metric for SaaS businesses to maintain a healthy growth rate and profit margin. The rule states that a company should have a combined growth rate and profit margin of 40% or more. This means that even if a company is growing at a rate of 40% quarter-over-quarter, it can still be considered healthy as long as its profit margin is 0%.

By that logic, there are times when losing some money is no big deal.

An investor may look at a business that is losing money as a healthy one if it makes enough money.

If your growth is more than 60%, you could be losing 10% or 20% and still be considered healthy. However, the 40% rule is not the benchmark for all companies.

While sacrificing profits for growth is a strategy that many startups use, that doesn’t mean you need to sacrifice your profit for short-term gains.

The 40% rule helps you figure out how much of your revenue comes from recurring subscriptions. Knowing this metric can help you maximize the value of your startup.

When Should You Track the Rule of 40?

The rule of 40 is more accurate for established businesses than startups.

Venture-backed companies tend to have more volatility in their revenue, so you’re aiming for the $100 million mark.

A few large customers signing on could spike your growth, but if it’s not sustainable, you could find yourself spending too much on marketing, sales, and research and development.

But growing companies can make up for early losses of profits by capturing a large share of the market.

As your business grows, you’ll eventually need to strike a balance between growth and maturity. But what does “maturity” really mean?

Mature means that you have $15 million to $20 million in revenue annually.

Some people believe that in order to adhere to the Rule of 40, a SaaS company should have close to $50 million in annual revenue. However, focusing too much on this metric during the early stages of business development can actually lead to negative consequences. This is because it may cause businesses to make strategic errors.

But as companies grow, it can be a valuable benchmark for sustainability. Many SaaS companies make the mistake of targeting compliance with the Rule of 40 too early on in their development. This can lead to sacrificing growth and ultimately damaging the company’s valuation by failing to deliver high levels of growth.

While the Rule of 40 may not be perfect, it can be a useful metric for larger, more established companies to gauge their sustainability.

But, as your company grows, it can be valuable to have a benchmark of sustainable practices.

And it’s important to track if you are preparing for another round of VC fundraising.

How Do You Calculate the SaaS Rule of 40?

To calculate the SaaS Rule of 40, simply add together the growth rate percentage and profit margin for a given time period. This will give you a quick indication of whether a company is sustainable in the long term.

When Do SaaS Companies Utilize the Rule of 40?

New companies should be wary of the Rule of 40. Instead, they should focus on their T2D3.

This method requires you to triple your revenue and size for two years straight. Then have it double for the next three years.

Only when you have completed all the necessary steps will you be able to utilize the Rule of 40%.

SaaS companies can use the Rule of 40 once they have at least $1 million in MRR.

However, Tomasz Tunguz believes that applying the Rule of 40 to startups can be misleading.

In some cases, such as the 2010 Workday case, the percentage can be even higher than 100% or 189%. Tunguz suggests that a more strategic approach would be to wait until the fifth or sixth year when a business has acquired at least $50 million in revenue.

But, some experts say that it’s best to focus on growing your customer base for now.

If you’re developing a software-as-a-service (SaaS) company, you’ll want to focus on finding its market fit and growth as soon as possible.

While there is no foolproof method for creating a successful startup, most entrepreneurs agree that focusing on growth is the best course of action.

While growing your customer base is important, most experts say that for startups, you should focus on increasing your revenue.

How Many SaaS Companies Qualify for the Rule of 40?

rule of 40 saas (Source)

Approximately 29% of all SaaS companies with an annual run rate of over $5 million meet the Rule of 40 criteria. This means that out of a sample size of 173 SaaS companies, 50 qualified.

2 Ways to Reach the Rule of 40

Now let’s look at some ways you can increase your Rule of 40 qualifications.

To improve your recurring revenue, you need to reduce customer turnover, push upgrades and upsells, and more.

Your monthly recurring revenue (MRR) can be increased by focusing on your acquisition strategies. But, be careful not to neglect your customer retention.

User retention rates are important, as they can help drive up your MRR.

You can offer an up-sell when customers perform tasks that are restricted with a free or basic membership. This will show the value of upgrading their account.

You can include a call-to-action (CTA) that directs them to the upgrade. This will make it simple for them to find the upgraded account and purchase it.

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Design custom popups and overlays that introduce specific user groups to relevant features of your product.

Deliver targeted content to different groups of users using app onboarding tools like Appcues.

Users will remember their interactions with your company – good or bad. So, it’s imperative to make these interactions positive and valuable to the end-user.

How to Improve User Experience

If you want to improve your user experiences, there are 3 key steps you can take:

  1. Improve your onboarding process to help new users get up to speed more quickly and easily.
  2. Manage customer feedback effectively to ensure that you’re always aware of what your users think and feel about your product or service.
  3. Monitor your customers’ behavior closely so that you can identify any potential issues early on and address them before they cause major problems.

Onboarding is the process where new customers are educated on your product’s features.

Personalize your users’ experience based on their stage in the customer journey.

Interactive walkthroughs are a perfect way to show your users how to use a secondary feature of your app that is relevant to them. By doing this, you encourage adoption and retention.

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NPS surveys and churn surveys are a great way to collect valuable feedback from customers. By participating in these surveys, users can help improve the product and keep track of their satisfaction levels.

rule of 40 saas (Source)

The Net Promoter Score (NPS) is a great way to measure how satisfied your customers are with your company. You can ask them to rate how likely they are to recommend you to others, and you can use their responses to better improve your product.

Promoters have a score of 9 or 10 while Detractors rate your company from 0 to 6.

How Software Firms Can Outperform the Rule of 40

rule of 40 saas (Source)

It can’t be done.

Every company has its own unique challenges when it comes to profits. For example, one business may have trouble marketing its products effectively while another may be struggling with the reliability of its equipment.

Most businesses are following a few common trends in their sales processes.

Investing in Customer Satisfaction

The most valuable thing to a company are their customers. A business should focus on keeping customers happy, rather than acquiring new ones.

Customer satisfaction is just as important, if not more important than implementing customer service technology, creating customer-focused strategies, and enforcing pricing and billing disciplines.

By doing so, you can ensure that your consumers are happy with your product or service, which in turn will lead to repeat business and referrals.

When marketers shift their focus from hunting to farming, they’ll need access to the right data.

It’s important for companies to focus on marketing to their existing clients effectively. There are many ways to do this, such as by implementing an inside sales team and outsourcing to partner channels depending on their value. By doing this, companies can improve customer satisfaction while also reducing costs.

Productivity in Engineering

When companies grow, their engineering departments often need to expand.

Product teams must be careful to align the priorities of new feature development with the maintenance of existing features. This can be a difficult task, as technical debt can sometimes slow down productivity.

Portfolio management is important in order to keep groups focused on their goals and on productivity.

Having clear objectives is vital, as it sheds light on how busy engineering teams spend their time.

Roles within an engineering department can be streamlined to support leader developers and clarify site strategy. This, in turn, allows for the refocusing of tools toward creating what is necessary for a cost-effective manner.

Performance in Operations

As your business grows, so does its complexity. New technologies, new customers, and new markets all introduce additional complexities to a business.

Process integration and streamlining can help you become more productive in the long run.

This can reduce the number of products, by simplifying the multiple business structures and sales channels.

This will also help you clarify who in your organization is responsible for what so that you don’t have to deal with unnecessary layers of management and overlapping duties. Ultimately, this can lead to an increase in productivity over time.

The 40% rule is a benchmark that many companies aim for. Some want to reach this level in revenue, while others may simply want to hit this target in the number of customers. The rule provides valuable insights into a company’s overall performance and profitability.

Measuring success at the division or department level is just as important, if not more so, than measuring it at the organizational or companywide levels. This will give you a more accurate understanding of which areas are succeeding and which need improvement.

Conclusion

The Rule of 40 SaaS is a great guideline for any software company that wants to be successful. If you can maintain a growth rate plus profitability of at least 40%, then you’re on the right track! This rule is essential for measuring your company’s progress and making sure that you’re heading in the right direction. So if you want your SaaS business to succeed, make sure to keep the Rule of 40 in mind!

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