The Rule of 40 and How to Calculate it

Learn all about the Rule of 40, a key metric that Startup founders, Investors, PE and VC firms look at to balance growth and profitability.

Balancing growth with profitability is key for startups, and the 'Rule of 40' is a critical benchmark in this journey. This article unpacks the Rule of 40, highlighting its importance for startups and investors, and delineates what numbers signify healthy financial performance. It's an essential read for startup founders and investors alike, offering insights into achieving sustainable success in the competitive world of tech and SaaS.

The Rule of 40 is a financial principle used primarily in the assessment of SaaS (Software as a Service) and other subscription-based companies. It serves as a benchmark to evaluate the balance between growth and profitability. The rule states that a company's combined revenue growth rate and profit margin should equal or exceed 40%.

The Rule of 40 - Importance for Startups:

• Balancing Growth and Profitability: For startups, especially in the tech and SaaS sectors, rapid growth is often prioritized, sometimes at the expense of profitability. The Rule of 40 provides a balanced perspective, encouraging not just growth but also efficient operations.

• Sustainability: This rule helps startups to gauge the sustainability of their business model. A startup growing quickly but burning cash unsustainably may find itself in jeopardy if funding dries up.

• Investor Attraction: Startups adhering to this rule can be more attractive to investors, as they demonstrate a healthy balance between aggressive growth and prudent financial management.

Use by Investors, Venture Capitalists, and Private Equity Firms:

• Evaluating Investment Opportunities: Investors use the Rule of 40 as a quick health check to evaluate potential investment opportunities. It helps them identify companies that are growing sustainably.

• Performance Benchmarking: It serves as a benchmark for performance, aiding investors in comparing companies within the same industry or stage of growth.

• Decision Making: For venture capitalists and private equity firms, this rule can influence decisions on where to allocate capital, especially when choosing between high-growth and high-profitability ventures.

The Formula

Rule of 40 = Revenue Growth Rate + Profit Margin

Growth Rate = ARR in % annual YoY Growth

Profit Margin = EBITDA margin % = EDITDA / Revenue

What Makes a "Good" or "Bad" Number:

• "Good" Number: A "good" number is when the sum of a company's growth rate and profit margin meets or exceeds 40%. For instance, if a company has a 30% growth rate and a 10% profit margin, it meets the Rule of 40 and is considered to be in a healthy state.

• "Bad" Number: Conversely, a "bad" number is when the combined rate falls short of 40%. For example, a company with a 20% growth rate and a 10% profit margin only reaches a combined total of 30%, suggesting that it may need to either accelerate its growth or improve its profitability.

Company Maturity Matters

• The Rule of 40 will be more accurate for mature companies who have figured out their business model

• For startups whose model is still in flux, this number will not be as accurate and you will need to balance with other KPIs

• Alongside this rule, operational rigor, realistic growth targets, and strong focus on customer retention are key to a SaaS company's success. Additionally, board involvement in monitoring and incentivizing adherence to this rule is becoming increasingly common.

In essence, the Rule of 40 offers a quick, albeit not comprehensive, assessment of a company's performance. It's a useful guideline for startups to strive for a balance between growth and profitability, which is crucial for long-term success and appealing to discerning investors.