The 40% Rule
The Rule of 40% is just a way to measure the health of your business. It takes into account two critical metrics: growth and profit.
The simple rule formula is:
If you are growing at 20% and your profit is 0%, it would be good to adjust the business model similarly if you’re making 40% but not generating any profits or losing 10%. This means that something needs to change.
If you’re doing 40% of your business, then that means it is a healthy operation. If you are achieving more than this amount, well, congratulations!
Growth Rate and SaaS Funding Interest Rate
There are a lot of ways to measure growth, but the easiest one is probably just year-over-year MRR. It’s important to compare total revenue as well because you have services that only happen once every so often, and those need consideration too.
Profit
You can measure profit in many different ways. One option is to use GAAP accounting, but the most well-known and used metrics for startups are EBITDA.
Companies can use earnings before interest taxes to measure profits without considering other factors such as interest, depreciation, amortization costs, or taxes.
If you use a cloud provider to host your product or solution, COGS will align with revenue and maintain gross margin. If self-hosting, EBITDA might not be the best metric because of equipment purchases, debt financing, and leasing.
Profit vs. growth
A key takeaway from this article is that it’s not just about the money. If you’re growing, your goal should be to grow faster than your competitors because if one company dominates a market in software (such as SaaS), they will likely continue dominating for years.
There are many reasons why a SaaS company can fail in the first few years, but one of them is high customer acquisition costs. To combat this problem, you need to ensure that your marketing budget is as big as possible to have more customers and create an early monopoly.
In his book Zero to One, Peter Thiel talks about how startups should be looking for ways to create monopolies. This is different from companies that work in a perfect competition market with product differentiation and fighting over small pieces of the pie based on price.
When is it appropriate to apply the SaaS Funding Interest Rate Rule?
A general rule of thumb for startups is to triple your size in two years and then double it again the following three. After that, you should be focusing on profit by only investing 40% of total revenue back into growth.
Brad Feld, a venture capitalist, and entrepreneur, said that the Rule is designed for SaaS companies at scale – meaning $50 million in revenue. But he points out that it can also be applied to small businesses with about $1 million MRR.
Who should pay attention to the SaaS Funding Interest Rate rule?
After reading the post, ask yourself, “Does this Rule only apply to SaaS companies? What about any other subscription business?” The answer is yes. It applies for a simple reason: most of these businesses are software-based.
The Rule of 40 is a common way for venture capitalists to calculate whether or not they should invest in a company. This Rule balances growth and profit, even if there isn’t any yet. A score between 30-40 means that the business has failed this test; however, scores above 60 are considered outstanding.
Investors are less likely to care about profit when a company shows rapid growth. This can be seen in companies that invest a lot of money without worrying too much about profitability — because they’re focused on the long term.
The Rule of 40 applies to startups and established businesses. Larger, more mature companies typically have a slower growth rate but higher profit margins. It’s not uncommon for these larger companies to outperform the Rule in one year, but maintaining that same level of performance on an annual basis is difficult because once they’ve matured, it becomes hard to keep their momentum.
How Do SaaS Companies Achieve Their Goals?
Companies that are successful in all life cycle stages use a variety of strategies to be able to do so. This includes businesses that only focus on the early stage and those that specialize in later phases.
Strong SaaS Funding Interest Rate growth
A lot of companies that grow past the Rule of 40 do so because they can increase their profitability as a company. They invest in R&D and look for ways to expand quickly while also making money.
Profitability
Businesses such as Oracle, which have been around for a while and are established in the industry usually don’t grow quickly (with their growth rate at 10% or less), but they tend to be more profitable. Large businesses can increase efficiency and use their large salesforce to expand an existing customer base, renewals, and find new business models.
Balanced Approach
Many SaaS businesses aim to strike the right balance between profitability and growth. These companies, such as Adobe, are established with well-marketed products that have shifted from a time license model to subscriptions. Most of these companies’ R&D spending does not reflect an attempt at innovation because they’re more focused on refining their original product.
Median GP Ratio
Median Gross Profit Ratio for SaaS Publics by Year
The median data of the company’s progression around year six seems to support that a 40% rule can be used as an indicator for later-stage companies.
It’s also interesting to see that early-stage SaaS companies often generate a return on investment of over 100%, which is usually because the company needs to grow as fast as possible, and profits can be sacrificed.
Median GP Ratio by Company
The data provided by GP Metrics shows that this company has not been able to sustain the 40% growth rate over several years. This chart represents how their public market investors have responded since they provided information about themselves.
As an early-stage startup, it is important to better understand the unit economics before later stages investors get involved. It can be helpful for later on when you are trying to find your way.
Conclusion
The Rule of 40 is a quick way to measure the performance of SaaS companies. The calculation can be used to understand how well an organization performs as a whole and by product family or business unit within that company. It’s helpful because it allows businesses to quantify their goals and achieve excellence at a smaller level.
SaaS and other cloud computing companies can be difficult to compare with traditional software vendors because of the different business models. The Rule of 40 helps businesses understand growth-profitability metrics and where they stand against competitors.
