The Rule of 40

What is the Rule of 40?

The Rule of 40 is a SaaS (Software as a Service) metric that says that a company’s revenue growth rate, plus its profit margin should be greater than or equal to 40. Taking both revenue growth and profitability rates into account provides a nice holistic picture of a company’s health. 

Below is a visual of a Rule of 40 analysis for a made up company. The red bordered cells are the two inputs used in the calculation. In 2022, the company grew revenue by 22% over 2021. They also earned $21 profit against their $100 of revenue, which is a $21% profit margin. 22% revenue growth, plus 21% profit margin is a Rule of 40 result of 43%.

Since the business is above 40, it would be largely considered a healthy SaaS company.

The Rule of 40 is also useful as a benchmark to compare other companies against. It would be difficult to compare companies on elements like revenue growth or profitability alone because of how different those results can be depending on the lifecycle stage those companies are in. Young companies tend to have much higher revenue growth for example than more mature companies. Does that mean they are healthier? Not necessarily. If all the market cared about was revenue growth, a company could spend aggressively on customer acquisition and run large losses in order to boost revenue. Under a Rule of 40 framework, spending aggressively to boost revenue growth would likely come with a decrease in profit margin, which would lower their Rule of 40 result. 

Of course, there are many variations that could lead to a healthy Rule of 40 result, including a company that is not profitable. The chart below shows benchmarks of SaaS companies performance depending on their range of annual revenue. Businesses with lower revenue ranges tend to be younger, and growing quickly. This means their Rule of 40 result is largely skewed towards revenue growth, not profitability. See below.

Why is the Rule of 40 important?

The dynamics of the market have changed a lot in the last year and a half. Tech companies were growing fast in 2020 and 2021, and low interest rates made the markets flush with excess capital. Business valuations were growing aggressively, and the primary driver of these valuations was revenue growth. In 2022, as inflation fears became more prevalent and interest rates began to rise, the market realized valuations were too high, and many businesses saw sharp corrections in their value.

Since then, markets are putting more emphasis on profitability, or the ability to “survive” in an economic environment with much less options for raising capital. Companies with large financial losses are now at risk of liquidity issues. 

Given its evaluation of both revenue growth and profitability, the Rule of 40 has become a primary valuation driver of businesses today. Good performance on the Rule of 40, or a path to achievement on it, can provide access to capital, higher valuations, and other liquidity options that companies that are simply “growing at all costs” no longer have access to.

The chart below was made by Goldman Sachs. The dark blue line shows that valuations of companies were quite highly correlated with revenue growth as their valuation driver in 2021, and the Rule of 40 (the light blue line) had almost no correlation to driving valuations at that time. In the first half of 2022 though, we can see the Rule of 40 become more highly correlated to valuations than revenue growth.

Because a result of 40 or above is considered to be a healthy company, the Rule of 40 is also a useful framework to orient goals and execution strategy around, and measure progress against. It is useful to help us know what good looks like, so we have something to target towards.

How does a business improve their results?

Every business will have a different set of opportunities to improve their Rule of 40. These opportunities are generally a combination of focusing on core growth levers/metrics, making strategic investments, and improving operational execution and strategy.

Core growth levers and metrics: A business might ask itself how it can grow its subscriber base, or provide new features or upsell paths that will increase the average price its customers pay them. It might also look for ways to diversify and grow its revenue streams or pursue strategies to improve customer retention and reduce churn. Improving customer engagement and time spent using your products are other great ways to add stickiness, which reduces churn and helps with revenue growth. There are many more examples, but in short, companies should look for ways to improve the main drivers of success for their specific business model.

Strategic investments are another tool to improve results. Can a business make investments that will improve operational efficiency in the future, such as adding AI to customer support? Investing in customer acquisition or marketing efforts could increase the Rule of 40, as long as more revenue is being added than the corresponding cost of the marketing. Bolt on acquisitions of complementary businesses may also be a method to better results.

Operational execution and strategy are also important drivers for improving the Rule of 40. Is the business focused on the most important and highest impact initiatives? Are its employees productive? Does the company’s code or infrastructure have a lot of technical debt that is slowing down work? Businesses should also not overlook the role of managing expenses and leveraging economies of scale to get the best prices from its vendors. Sometimes companies who grow too quickly become relaxed in their discipline of reviewing expenses, which hurts profitability. Regularly reviewing/auditing expenses is a great way to ensure you are still using what you are paying for, and getting the best deal from it.

Ultimately, a best in class Rule of 40 result requires focus and achievement on specific business drivers and metrics, a willingness/ability to make strategic investments, and solid strategy paired with operational excellence.

I hope this post helped add some context and clarity for what the metric means and why companies should care about it.