SaaS | 5 MIN READ

The Rule of 40 for SaaS Companies: All You Need to Know

The Rule of 40% is a metric to determine the health of SaaS businesses using revenue growth & profitability. Find out how.

Niyathi Rao
Jan 15, 2021

Rule-of-40-for-SaaS

Rule of 40 SaaS

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. The rule 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 in order to balance their profitability and growth and remain competitive.

The Key Drivers of the Rule of 40

The Rule of 40 is calculated by:

Growth rate %

Growth rate is a key component of Rule of 40 and can be measured using either ARR or MRR growth. Subscription-based companies will benefit more by measuring their growth rate on a monthly basis, however. 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.

Profitability %

There are multiple measures of profitability including cash flow, cash from operations, EBITDA, 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.

Formula for the Rule of 40

GP Ratio = Profit + Growth Rate

For example: MRR growth % + Annual EBITDA % (Earnings before interest, taxes, depreciation, and amortization) together should equal at or above 40%.

As long ago as 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 of maximum benefit while calculating the financial health of young companies who may not have a proven track record in the industry, particularly for stakeholders, investors, and potential acquirers. In fast-growing companies, investors may not worry much about the profitability initially. For larger companies, it can be tough to maintain a steady annual profit, but as long as there is growth, it can be considered healthy.

This most often applies to SaaS companies, as they can have huge margins as compared to other companies. There is less cost of goods sold for software companies often making the margins higher.

The rule of 40

Benchmarks of the Rule of 40

There are certain benchmarks that 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 are don’t have enough profit or growth to make up for the other and the overall health of your company is poor. At this point, there are low expectations on growth, revenue, and profit.

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 are higher than 40%, you have surpassed the goal and will be seen as very desirable to investors and will have some wiggle room to invest more into growth and not fear losses in profit. It is quite challenging to reach that level of business profits and maintain it.

How to Meet the Rule of 40?

Companies can meet the Rule of 40 at any stage in their life cycle. It is an achievable metric for software companies to sustain profit and growth even with fluctuations with one or the other. Investors will typically ensure you are meeting this metric before committing and would prefer to see you meet this goal for a sustainable amount of time. Here are some ways to meet the Rule of 40 SaaS:

1. Hyper growth

Expanding your customer base will help increase growth rate. By developing ways to acquire and serve more customers and investing in research and marketing, companies can go into a hyper growth mode. This will stabilize efforts beyond the 40% mark.

2. Increased profitability

Another way to meet the Rule of 40, even when your growth is slow, is by increasing profitability. If the margins become higher, 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.  Customer Success aids in retention and leads to increased overall growth. It also allows you to automate functions to help you scale your Customer Success 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 the user experience is optimal and consistently improving, it leads to loyalty, growth, and increased profits. This will lead to 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 very useful SaaS metric that calculates the trade-offs between revenue growth and profitability. The Rule of 40 gives deep insight into how sustainable and profitable a SaaS business is and gives insight into its potential for the future. Building a customer-centric organization through Customer Success is one of the most effective ways to do so affordably and efficiently.

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Originally Published January 15th, 2021, Updated February 10th, 2021

Niyathi Rao

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.

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