Software-as-a SaaS companies are often rewarded by investors for hitting the “rule of 40” – a KPI that balances revenue growth versus profits. It is a popular rule of thumb to determine the health and attractiveness of SaaS companies and a relevant indicator for investors. However, only few SaaS players meet this threshold. Some SaaS players could perform better. 

Why and how to calculate the rule of 40?

By and large, the rule of 40 focuses on balancing the trade-off between growth and profitability. The objective of investors is to invest in SaaS players that have high growth, high profitability of combinations in between – with a “profit plus growth” greater than 40%. If a SaaS player achieves 40%, it is assumed to be attractive to investors. On the one hand, this seems simplistic (because it is), on the other hand the rule of 40 conveniently burns down SaaS companies’ operating performance into only one number.

There are different versions of the rule of 40, using different definitions of revenue, profitability, actuals vs plan figures, reported vs pro-forma figures, different time periods etc. But all those different flavors combine two inputs, some revenue growth and some definition of profit or cash flow margin. And to calculate the rule of 40, you add growth in percentage terms and the profit/cash flow margin.

For revenue growth, SaaS players can use recurring revenue (ARR) growth or total revenue growth. Recurring revenue is obviously more relevant, but we see both a lot of both in the real world.
For profit or cash flow margin, EBITDA margins (or a normalized version of EBITDA) are common, while there are good arguments to use cash flow margins instead.

How relevant is the rule of 40?

Pretty relevant. Although it is a rather shallow rule of thumb, investors do reward SaaS players with significantly better multiples if they consistently exceed the rule of 40. The rule has also gained momentum as a performance indicator for software businesses in general, beyond SaaS. As the chart below shows, the multiples for SaaS companies vary greatly, depending on company performance against the rule of 40:

However, a strong performance against the rule of 40 is difficult to maintain. According to recent research, only a surprisingly low fraction of SaaS players hit this operating performance marker. McKinsey&Company analyzed more than 200 software companies of various sizes between 2011 and 2021 and found that only 16% of businesses exceeded the rule of 40 over time (Link). Very consistent with these results, Bain & Company found in an older study that only 25% of software companies outperformed the rule of 40 for three or more years, and only 16% outperformed for 5 years (Link).

How does any of this matter?

The low fraction of SaaS players hitting the rule of 40 is at least an indicator for missed opportunity. If value creation – as represented by enterprise value and corresponding multiples – is among management objectives, focus on the rule of 40 should be part of strategy and management reports and discussions. While we believe that the rule of 40 is only a rule of thumb – although a popular one -, its relevance for investors should at least include it as a “sanity check” in any strategy session. It can also be used to x-check underlying operating performance drivers, e.g. if cost base – especially customer acquisition cost or recurring R&D spend required to keep the product(s) competitive – is aligned with (realistic!) growth plans and its drivers (recurring revenue, net retention rate, upsell, churn, and new customer acquisition).

All of this is relevant for actual performance, but even moreso for strategic and operative planning.

In all management reporting and discussions, we recommend to keep topline (ARR) growth, one of the two drivers of rule of 40 in management focus, as well as its drivers as drivers such as net retention rate and customer acquisition cost in management focus. We believe that these KPI should be part of any management report and discussion.

In strategic planning, it is crucial to set both ambitious and realistic targets for topline and acquisition cost, based on current performance and tangible performance improvement initiatives, rather than lump-sum adjustments year over year. Modeling net retention and marketing efficiency over time should be done bottom-up, wherever possible. Common sense and consistency checks should be applied , wherever possible and data is available. For example it is rare that a SaaS companies growths with 50% YoY for significant periods of time, if the total addressable market is expanding at a CAGR of only 10%. Overhead cost, especially for the product and tech teams, should be aligned with topline growth, based on a (realistic!) product roadmap. It can be recommendable to separate growth initiatives into separate “mini business cases”, depending on how well different initiatives can be separated on the cost (and revenue) side.