SaaS companies who want to measure their overall health often turn to the Rule of 40%. The Rule of 40 is an easy way to understand how your profitability and growth are measuring up. It states that the combined profit margin and growth rate should equal 40% to be considered healthy.
For instance, if your company is generating a profit of 19%, the company should grow at a rate of 21%. If your company is losing 10% of its profitability, you should have a growth rate of 50%.
Many companies are now embracing the Rule of 40 to balance their profitability and growth and remain competitive. And in this guide, we’ll explain what it is and everything you need to know to get started.
The Key Drivers of the Rule of 40
The Rule of 40 is calculated by:
Growth Rate is a key component of Rule of 40 and can be measured using either ARR or MRR growth. Though subscription-based companies will benefit more by measuring their growth rate on a monthly basis. Companies with a higher percentage of growth rate than profit invest more in marketing, customer acquisition, research, and development in order to achieve more profit in the future.
There are multiple measures of profitability, including cash flow, cash from operations, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), and more. EBITDA tends to work best for SaaS businesses since they are able to measure profits without having to include interest, taxes, depreciation, and amortization. Established businesses tend to have higher profitability and can rely less on growth but still need to have balance to be considered healthy.
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Formula for the Rule of 40
Growth Profit Ratio (GP Ratio) = Growth Rate + Profit
For example, MRR growth % + Annual EBITDA % together should equal at or above 40%.
Around 2015, venture capitalists began to popularize the Rule of 40 as a health check for SaaS companies. The metric allows for an adjustment between short-term profitability and long-term growth investments making it ideal for many organizations.
Who should follow The Rule of 40%?
The Rule of 40 proves to be beneficial to more mature companies with a $1M MRR. For startups or companies that haven’t reached that benchmark yet, you should focus on other things such as product-market fit and T2D3.
Also worth noting is that this often applies to software-based SaaS companies since they have higher margins compared to other subscription-based companies.
Benchmarks of the Rule of 40
Certain benchmarks define the financial health of organizations that choose to use the Rule of 40, such as:
1. Below 40%
If your rate is below 40%, you don’t have enough profit or growth to make up for the other. And based on this metric, you’ll need to reanalyze and possibly optimize your growth and profit efforts.
2. Equal to 40%
As a startup, your goal is to get to 40% with your growth rate and profit combined. Meeting this benchmark will impress potential investors and venture capitalists.
3. Above 40%
When your growth rate and profitability exceed 40%, you’ll be seen as very desirable to investors and will have some wiggle room to invest more into growth without worrying that you’ll have to sacrifice your profits.
How to Meet the Rule of 40?
Companies can meet the Rule of 40 at any stage in their lifecycle. It’s an achievable metric for software companies to sustain profit and growth even with fluctuations. In most cases, investors will ensure you’re meeting this metric before committing. And they’d also prefer to see you meet this goal for a sustainable amount of time. Here are some ways to meet the Rule of 40 SaaS:
Expanding your customer base will help increase the growth rate. Companies can go into a hypergrowth mode by developing ways to acquire and serve more customers and investing in research and marketing. This will stabilize efforts beyond the 40% mark.
2. Increased Profitability
Increasing profitability is another way to meet the Rule of 40, even when your growth is slow. If the margins increase, it is possible to expand the product or service to make more profits. Increased profits also lead to better brand value and more spend on research, sales, development, and marketing.
3. Customer-Centric Innovations
Creating customer-centric solutions will also help you meet the Rule of 40. Customer success is the most effective customer-centric solution for SaaS businesses to grow and improve profits. It aids in retention and leads to increased overall growth. It also allows you to automate functions that can help you scale your CS as you grow.
4. Improved User Experience
To give users the best experience, it is important to make the platform suitable for them. To do so, it’s necessary to make the features, look-and-feel, webpages, design, format, etc., work for your users to succeed in the long run. If it’s optimal and consistently improving, it can lead to loyalty, growth, and increased profits. And this will result in less churn and higher customer satisfaction.
Bottom Line: Balancing Act for Investments
When you think about it, isn’t everything in business based on achieving a balance? The Rule of 40 is a useful SaaS metric that calculates the trade-offs between revenue growth and profitability. The Rule of 40 provides in-depth insight into how sustainable and profitable a SaaS business is and its potential for the future. 24
And building a customer-centric organization through customer success is one of the most effective ways to do so affordably and efficiently.
Niyathi is an experienced content marketer with a love for SaaS tech products. She reads a lot (mostly fiction) and is a huge news junkie. Niyathi loves exploring different forms of inbound marketing and taking on challenges.
Published January 15, 2021, Updated June 06, 2022