The Rule of 40 is a popular SaaS metric for evaluating business sustainability.
It uses a profit margin and growth rate to show how well an organization balances growth and profitability.
Plus, it helps CFOs identify which to focus on.
But you might be wondering...
What's the formula?
And why is the Rule of 40 so important?
We'll answer those questions (and more) in this article. Keep reading.
- What is the rule of 40 and why does it matter for SaaS companies?
- How to calculate the rule of 40
- How to use the rule of 40 to improve your company's financial health
- Conclusion: Final thoughts on the rule of 40
What is the Rule of 40? Why does it matter (especially for SaaS companies)?
The Rule of 40 states that a company's growth rate plus profit margin must be ≥ 40%.
The balance of these two figures helps serve as a quick way to identify the company's operating performance, as well as your potential value to investors.
Identified by Techstars founder Brad Feld in 2015, as the “minimum point of happiness,” using the Rule of 40 as a baseline metric for annual growth allows companies to focus on key strategies to either:
- Increase profits while not increasing growth, or
- Focus on growth rates while taking in lower a profit margin
It's more common for companies to have high revenue growth rates and lower profit margins or vice versa.
Let's look at two examples:
- Company A has a growth rate of 35% and profitability margins of 10%. Together those make 45%, which fulfills the requirements of the Rule of 40.
- Company B has a growth rate of -5% but a profit margin of 45%. Since the sum of these terms still equals the needed minimum of 40%, this is a healthy performance balance.
For most startup companies, the Rule of 40 is not a strategy to start measuring success with.
Why? Maximizing rapid growth is a significant priority over driving profits during the initial development, and their Rule of 40 numbers will be more volatile during this time.
Startups should look at other metrics like their cash runway and net dollar retention.
But once established, the Rule of 40 provides a goal for measuring future growth and operating performance.
What is in the Rule of 40 Formula? How do you calculate it?
The formula for the Rule of 40 is as follows:
Rule of 40 = Growth Rate (%) + Profitability Margin (%)
While you can't use the Rule of 40 to determine if your company is experiencing enough growth or sufficient profitability, you can use it to evaluate the balance of the two measurements.
Companies that can maintain a healthy balance of growth and profitability as they ramp up and mature stand the greatest chance at ongoing success.
The Rule of 40 is used as an effective standard for reviewing the performance of SaaS industry companies as it creates an “apples to apples” metric to use across the board.
While the metric seems easy enough to calculate, determining which figures to use for growth rate and profitability can create confusion. So let's take a look.
Rule of 40 = Growth Rate (%) + Profitability Margin (%)
The first calculation of the Rule of 40 formula is the growth rate. And it's easy to know what to use: year-over-year growth rate of monthly MRR.
This prevents weird things from happening since you use a subset of GAAP revenue.
Rule of 40 = Growth Rate (%) + Profitability Margin (%)
The second calculation of the Rule of 40 formula is the Profitability Margin. Unfortunately, since there's no GAAP standard of profitability, it's a little harder to know which metric to use.
We recommend using EBITDA, but you can also consider the following:
- Cash from operations
- Net change in cash
- EBITDA margin
- Un-levered free cash flow
- Operating income
Without an agreed-upon measurement, there isn't a “right answer” when deciding which figure to use in calculating the Rule of 40.
A standard way to look at profitability is to use EBITDA while excluding stock-based compensation costs.
This provides a level playing field when analyzing and comparing figures by stripping away interest from debt, depreciation of intangible assets, and differences in taxation and accounting policies to approximate its operating cash flow.
Rule of 40 Calculation example: Netflix
How is Netflix stacking up when it comes to the Rule of 40?
Let's start with their 2019 figures, pre-pandemic.
Netflix had a net profit margin of 9.26% as of December 31, 2019. They also reported a growth rate of 31% in their Q4 shareholder letter.
At this point, the company was on pace with the Rule of 40 metric: the two figures adding up to almost 40%.
Now let's look at their current numbers—post-COVID and with increased competition from several other streaming services.
As of June 30, 2022, their net profit margin grew to 16.42%...but their growth rate was only 8.56% since the past year. These two numbers add up to about 25%...not 40%.
The fact that the revenue growth rate went down isn't surprising. As companies mature, they trade off a focus on growth and shift towards a focus on profit—keeping steady at the rule of 40.
With growing competition, current inflation, and other economic impacts from the pandemic, Netflix saw losses on both sides of the formula.
What will Netflix do in the future? What should all companies do if they're to meet the Rule of 40 as they mature? How can they set themselves up for long-term growth?
Let's take a look.
How to use and improve the Rule of 40 for SaaS businesses and beyond
SaaS companies often use the Rule of 40 to keep their focus on profitability and growth.
Rapid (revenue) growth may be the primary goal for early-state SaaS startups.
Getting the word out about the new service and recruiting a large number of subscribers helps get cash flow in the door so the company can continue on the road to success.
Then, as most SaaS companies leave the “honeymoon phase” and transition into an established, mature business, the goals begin to shift.
With a solid customer base established, mature companies know that growth is slowing and that curve will continue to flatten.
When a SaaS company sacrifices rapid growth, they achieve a lower Rule of 40 unless they start prioritizing revenue.
To keep the Rule of 40 around the 40% mark, leadership knows they need to update the business model to prioritize profitability by:
Creating More Efficiencies
As the early phases of business wind down, engineering teams begin juggling the demands for new features and the maintenance requirements to keep end-customer experiences positive.
Operations also experience a similar shift as the hectic stages of high growth plateau.
Revenue growth slows, and profitability needs to pick up the slack to keep pace with the Rule of 40. It's at this time that revisiting the sales strategies is crucial.
Similarly, it's important to understand how teams divide their time and what tasks use the most resources.
Where possible, encourage each team to dedicate most of their time to the established priorities to increase sales efficiency and, thus, profitability.
In a healthy business, this may mean simplifying processes, setting up automation, or reducing existing duplication.
Of course, you must also keep an eye on your current liabilities.
Using FP&A Software to Create Efficiencies
How do you do this? By using the best financial planning and analysis software out there.
Financial Planning and Analysis Software (FP&A) helps teams manage the financial planning, budgeting, forecasting, scenario modeling, reporting, and analysis in a company…all in one platform.
Cube provides a cloud-based FP&A software platform that helps finance teams plan more, report faster, analyze smarter, and collaborate everywhere. It eliminates the manual work and provides the real-time insights finance needs to guide the business forward with speed and agility.
What makes Cube so compelling is how it pairs the flexibility and familiarity of your spreadsheets with the control & speed of performance software. Cube gets you up and running in days, not months, which means faster time to value at a lower cost.
Improving Customer Retention Efforts
As time progresses, the number of new customers signing up for a company's service will slow.
So it becomes risky to rely on, seek out, and sign on new customers as a revenue growth strategy.
By focusing on building a great experience for the existing customer base, the business can reduce its expenses for new customer efforts and increase its profitability by reducing churn.
Churn and revenue retention
The cost of having a high churn rate can be anywhere from five to 25 times more expensive to acquire new customers than it is to retain existing ones. How do you calculate churn?
Gross revenue retention is a strict measure of the value we've retained from our existing customers…but it doesn't account for any growth.
Net revenue retention is a more complete picture of the revenue we've retained from our existing customers, but it hides what's going on in the business because it can obscure and cloak a churn problem.
Measuring and cross-referencing both figures helps you identify your business's strengths and weaknesses and understand its customer acquisition cost.
Upgrade what they offer to current customers to optimize net retention or invest in improvements for customer support or professional services.
Aside from calculating revenue churn vs. customer net retention, another way to evaluate customer retention is by tracking revenue retention.
This supports scenario planning efforts and measures the ongoing sustainability of a company's existing customer life cycle to further strengthen a business's ability to be more profitable over time.
Improving NDR (Net Dollar Retention)
Increase the value delivered to existing customers and support their business success in any way possible.
By investing in customers and providing strategic solutions that create efficiencies within their business, customers move from buyers to brand ambassadors.
As their loyalty grows, it's easier to sell expansions (and grow NDR) and reduce churn.
This is also one of the best ways to increase the LTV/CAC ratio, or the measure of customer lifetime value (how much do you expect to earn from this customer?) against the cost to acquire them as a customer.
Develop New Products
Selling new products helps capitalize on market opportunities and increase profitability.
Instead of focusing solely on the target market for the core product, expanding the business's reach into adjacent markets can help grow the customer base while also increasing what existing customers purchase.
That said, the cost of developing new products is often prohibitive,
Keep R&D Expenses in Check
R&D is responsible for some of the most significant growth out of the gate because their discoveries help fuel audience engagement and excitement for the product.
While the associated costs play a crucial role in the beginning stages of a start-up, substantial breakthroughs can slow as the company matures.
This is why it's essential to know when to reduce the R&D budget.
Developing new features and differentiating the existing product line can help increase sustainable growth and profitability. However, reigning in these expenses becomes necessary as those efforts become less impactful on the bottom line.
Final Thoughts on the Rule of 40
Now you know not only how to measure your revenue growth and profit balance, but you also learned how to strategize to strengthen those balances.
This formula allows for the unification of factors into a focused benchmark so that all departments and investors have a common performance goal.
The next steps are up to you. Calculate your Rule of 40 and see what your profit and growth look like now.
We know that getting all your data in one place to calculate the Rule of 40 can be a pain. And how do you know it's all up-to-date and clean?
Cube helps FP&A teams solve problems exactly like this. Book a quick demo with Cube today.