July 22, 2020

Metric Deep Dive: Rule of 40

What is the Rule of 40?

The rule of 40 is a benchmark that states the sum of a company’s growth rate and profit margins should exceed 40%.

It’s used by investors to assess the health of your business.

It measures the tradeoffs between balancing growth and profitability. Since it is a high-level performance metric, companies start to use the rule of 40 once they reach $1M ARR.

How to Calculate the Rule of 40

This is a simple one, you need your growth rate and profit margin.

Formula: Rule of 40 = Growth Rate + Profit %  

Rule+of+40+-+Formula+Calculation.jpg

Growth Rate

We recommend using total revenue as your growth rate input since the majority of companies use total revenue vs. ARR or MRR. This will allow you to compare your performance against others in the industry.

However, if you find ARR or MRR to be a better representation of your revenue - use it and tell the right story.

Formula: Growth Rate = (Current Year Revenue - Previous Year Revenue) / Previous Year Revenue

Rule+of+40+-+Growth+Rate+2.jpg

Profit Margins

We recommend using EBITDA % because it eliminates the difference in non-operating payments that companies face such as interests, taxes, depreciation, and amortization.

There are other metrics you can use for your profit margins input like operating income, free cash flow, net income, etc. Be careful that each metric measures profitability a little bit differently - some may be more conservative and others may or may not take into account all factors such as taxes.

Don’t have the confidence these numbers are right on your financial statements? We build tailored financials so you can make informed data-driven decisions. Explore what KPI Sense can offer you here.

Why is the Rule of 40 Important?

The rule of 40 shows investors the sustainability of the business model, think of it as a health check. Investors can gauge whether the company is focused more toward growth or profitability and if there is a path to profitability.

Rule of 40 Benchmarks

Below 40%

Your company is considered unhealthy at this rate with low expectations of revenue or growth.

Equal to 40%

This is just right - investors will be impressed with this benchmark and label your company as healthy.

Above 40%

Not only is this impressive but it will get investors to throw their money at you. Be careful though, it's a challenge to continue at such a high level.

How to Improve your Rule of 40

The higher your rule of 40 sum is, the better.

Hyper Growth

When increasing growth rate, you will want to invest in the channels that will expand your customer base.

  • Invest in your research and development and sales and marketing channels
  • Develop your product/platform to serve more customers
  • Create adjunct services/goods to reach a broader market
  • Expand your platform to serve different regions if location specific

Profitability

If your company already has high profit margins, trying to increase profitability over growth might be the best option for you. Efficiency and user experience is crucial when improving profit margins.

  • Farm existing customer base for upsells and expansion revenue
  • Tweak pricing model for higher margins
  • Expand your service/product to adjunct markets
  • Develop customer centric innovations
  • Improve user experience by engineering better features on your platform
  • Reduce spend in your sales and marketing channels with the lowest ROI
  • Streamline and automate functions to cut back on expenses

Increasing growth or profitability will help you improve your rule of 40 sum. If you reach or even exceed 40% - congratulations, you’ve reached a benchmark that many companies may never see in their lifetime. Maintaining a 40% sum or higher is even harder to do year after year.

Check out this infographic from Bain and see how many companies continue to beat the rule of 40 after 3-5 years.

Screen Shot 2020-07-22 at 10.48.51 AM.png

Rule of 40 for Early Stage vs. Late Stage Startups

Like other SaaS metrics, context is key.

Early Stage Startups - growth focused

Early stage startups tend to focus on growth to establish themselves in the industry. Typically, these startups do not have high profit margins because their mindset is on hyper growth and customer acquisition. With large-scale investment in research and development and sales and marketing, the customer acquisition cost brings profit margins down.

It’s okay to have low profit margins - even negative margins - as long as you combat this with high growth rates.

Say a company has a growth rate of 70% and profit margins of -5%. The negative margin makes it seem as the company is in an unhealthy state. However, when using the rule of 40, the sum comes out to 65% which exceeds the 40% benchmark. This company’s growth rate would make it attractive to potential investors.

Late Stage Startups - profit focused

As much as a company can invest in hyper growth, growth will naturally start to slow down. Later stage startups who experience this tend to pivot toward increasing their profit margins. They have already secured their extensive customer base, so they transition to becoming as efficient as possible.

A company with 10% growth rates, but 35% profit margins is still attractive to investors because of the rule of 40. Their rule of 40 sum would be 45% - investors would still find this company worthy of investment.

T2D3 Approach

Focusing on growth is natural for an early stage SaaS startup. Especially when trying to fundraise VC money, many founders will follow the T2D3 approach to reach hyper growth.

The T2D3 approach states that you should triple your size/revenue for two years and then double that for three years in a row. Once scale is achieved, founders can then start looking at the rule of 40 and maneuvering their way toward profitability.

T2D3 approach fans believe that profitability comes after the business model is perfected. The growth stage is the right time to work on market-fit and cash flow.

Brad Felt popularized the rule of 40 back in 2015. Read more in his thoughts on the rule of 40 and the T2D3 approach.

Whether you plan on focusing on profitability or growth using the T2D3 method, the rule of 40 is a great metric to keep your company balanced as long as it is above the 40% benchmark. However, at the end of the day the rule of 40 it's just one metric in a sea of dozens more. The rule of 40 does not have the final say in your company’s valuation, but it does give good insight to the sustainability of a business.

TL;DR

The rule of 40 is a framework that measures the tradeoffs between a company’s revenue growth and profitability. If the sum of the growth rate and the profit margins is at least 40%, then the company is considered healthy. If the sum of the inputs exceeds 40%, the company will be more attractive in the eyes of investors.


Get Started Today

Get Started