billy-russell

Billy Russell - FP&A Strategist

July 2022 - min to read

The Rule of 40: What is it and why is it so important?

The Rule of 40: What is it and why is it so important?

The Rule of 40 has become a popular metric used in the SaaS industry for evaluating business sustainability. It uses a combination of profit margin and growth rate to showcase how well the organization is balancing its growth and profitability.

Plus, it helps identify which factor the business should focus on at any given stage. Ready for it?

Since teams generally aim for either heavy growth or substantial profits, this measure seeks a kind of harmony among the two figures. Companies strive to hit a goal of 40% (hence, the Rule of 40).

But how do you complete these calculations, and why is it so important to the health of a business? Let’s review.

Contents

  1. What is the rule of 40?
  2. How to calculate the rule of 40 formula
  3. How to use and improve the rule of 40
  4. Final thoughts on the rule of 40

What is the Rule of 40? Why does it matter? 

The Rule of 40 is when a company’s growth rate is combined with its profit margin (free cash flow) to ideally equal a total of 40% or higher. The balance of these two figures help serve as a quick way to identify the overall health and success of your company, 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 profit margins

Usually, the Rule of 40 will result in an interchange between growth and profit, since it’s rare to have both be equal or high at the same time. When balancing out the equation, it’s more common with high growth revenue to have lower profit margins, or with low growth to have higher profit margins. 

For example, your company could have a growth rate of 35% and a profit margin of 10%, resulting in a total of 45%, fulfilling the requirements of the Rule of 40. 

Equally, you could have a growth rate of -5% but a profit margin of 45%, still equaling the needed minimum of 40%, and therefore be considered a healthy performance balance.

For most startup companies, the Rule of 40 is not a strategy to start measuring success with. 

Why? Maximizing 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. 

But once established, the Rule of 40 provides a goal to eventually utilize 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 the Rule of 40 cannot determine whether a company is experiencing enough growth or sufficient profitability, it can be used to evaluate the balance of the two measurements. Companies that can maintain a healthy balance of growth and profitability both as they ramp up and as they mature stand the greatest chance at ongoing success.

The Rule 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 some confusion. So let's take a look. 

Growth Rate 

Rule of 40 = Growth Rate (%) + Profitability Margin (%)

The first calculation of the Rule of 40 formula is the growth rate. To keep the growth rate consistent across the board, it’s best to use GAAP revenue in the calculation. GAAP revenue is very standard and creates consistency in the Rule of 40 calculation growth rate. 

Growth rates can be used not only in the Rule of 40, but to also help identify areas for improvement and compare revenue growth rates to the potential data of competitors). 

This growth rate refers to the monthly recurring revenue (MRR) or annual recurring revenue (ARR) as opposed to the gross or net revenue of the company, because the latter are based on profitability measurements.

Calculating and understanding your SaaS magic number using Monthly Recurring Revenue will help to determine when your company is ready for additional growth or if there are specific areas to optimize and improve prior to launching new growth plans. 

Profitability Margin:

Rule of 40 = Growth Rate (%) + Profitability Margin (%)

The second calculation of the Rule of 40 formula is profitability margin. The profitability margin figure can muddy the proverbial waters in the Rule of 40. While using a GAAP standard for measuring the growth rate is easy, there is no such standard in profitability. 

But, here are some options that can be used:

  • Cash from operations
  • Net change in cash
  • EBITDA
  • 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. The important part is to understand that each figure will yield a different result. 

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 flows.

Rule of 40 Chart

Let’s help visualize this with a handy Rule of 40 chart that used MRR growth and EBITDA margin: 

Source 

And nothing makes something easier to understand than a real-life example. 

Rule of 40 Calculation Example

Netflix went public in mid-2002. What had started as a delivery service where subscribers could choose several movies each month for delivery to their doorstep grew into a full-fledged entertainment streaming service, effectively ending the era of movie rental chain stores. 

While competitors like Redbox attempted to keep pace and offer consumers a quick and easy way to cheaply rent and watch the movies that they wanted, Netflix blazed a trail to the new normal which we are all accustomed to today. 

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 right on pace with the Rule of 40 metric, with the two figures adding up to almost exactly 40%. 

Now let’s look at their current numbers – post COVID and with increased competition from a number of other streaming services. As of June 30, 2022, their net profit margin grew to 16.42%...but their growth rate was only at 8.56% since the past year. These two numbers add up to about 25%...not 40%. 

The fact that the growth rate went down isn’t surprising. As companies mature, they shift from a focus on growth towards a focus on profit – keeping steady at the rule of 40. But with the 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 find themselves struggling to meet the Rule of 40 as they mature? Let’s take a look. 

How to use and improve the Rule of 40 

SaaS companies often use the Rule of 40 metric as a way to align their focus in regards to profitability and growth. 

In the early stages of a business, rapid growth may be the primary goal. Getting the word out about the new service and recruiting a large number of subscribers helps get cash in the door so the company can continue on the road to success. 

Then as the company leaves the “honeymoon phase” and transitions into an established, mature business, the goals begin to shift. With a strong customer base established, the business knows that growth is slowing and that curve will continue to flatten. 

Less growth means a lower Rule of 40 metric, unless companies start prioritizing revenue. To keep the Rule of 40 metric around the 40% mark, leadership knows they need 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 growth reach a plateau and employees can objectively see the flaws in their processes.

Growth slows, and in order to keep pace with the Rule of 40, profitability needs to pick up the slack. It’s at this time that having a clear set of priorities is crucial. Similarly, it’s important to understand how teams are dividing their time and what tasks are using up the most resources. 

Where possible, encourage each team to dedicate the majority of their time to the established priorities in order to increase efficiencies and, thus, profitability. This may mean putting an emphasis on streamlining processes, setting up automation, or reducing existing duplication.

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.  That makes it risky to rely on, seek out, and sign on new customers as a revenue 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. 

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 really going on in the business because it can obscure and cloak a churn problem. 

By measuring and cross-referencing both figures, a business can identify their strengths and weaknesses and when the time is right for acquiring new customers, upgrade what they are offering to existing customers to maintain retention, or invest in improvements for customer support for retention and acquisition of customers.

Aside from calculating revenue churn vs. customer retention, another way to evaluate customer retention is by tracking revenue retention. Doing this helps to not only support scenario planning, but also to measure the ongoing sustainability of a company’s existing customer base to further strengthen a business’ ability to be more profitable over time. 

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 becomes easier to expand on the products or services they’re willing to purchase and reduce churn. 

Ready for less calculations? Determine gross & net revenue retention easily with this free template!

Develop New Products

Once a strong customer base is established and the stages of intense growth are in the past, developing new products will help bring profitability figures up. 

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.

Keep R&D Expenses in Check

R&D is responsible for some of the largest 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 important to know when to reduce the R&D budget. Yes, developing new features and differentiating the existing product line can help increase growth and profitability, but 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 growth and profit balance, but you also learned how to strategize strengthening those balances. This formula allows for the unification of factors into a focused benchmark so that all departments and investors have a shared, 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. Which factor do you think needs more focus, at this time, for strengthening your balance? What strategies do you plan on trying first to raise your Rule of 40?  

Maybe you’ll improve efficiencies and customer experiences to increase retention and revenue? 

Or maybe you’ll implement more R&D to help expand your services and reach out to new markets and facilitate more growth?

Want to make this simpler? Get your demo with Cube today and we'll talk about how we can help! 

Sources cited: