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What is Rule of 40: Why it matters to Finance leaders

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The Rule of 40 is a widely used financial tool to gauge the performance and success of SaaS companies. It takes into account both revenue growth and profit margins to provide a simple and straightforward evaluation of the company's health.

Balancing growth and profitability is vital for SaaS businesses and software startups. While it's essential to grow quickly and increase the customer base, high profits are necessary to sustain the business. The Rule of 40 SaaS helps companies navigate the ever-changing market by balancing the relationship between growth and profitability.

In this blog, you will learn about the Rule of 40, how to calculate it, and how to apply it to your SaaS business. Get a clear understanding of this valuable non-GAAP metric and how it can help you keep your business flexible and successful.

How to calculate the Rule of 40

The Rule of 40 is a straightforward metric calculated using two key inputs growth and profit margin.To find the Rule of 40, a company can simply add the growth in percentage terms to the profit margin. The term is called the Rule of 40 because preferred outcomes should be greater than or equal to 40. A high Rule of 40 number shows a profitable and growing company. For growing SaaS companies, an outcome below the 40% mark will be worriesome to investors.

For example, if a company's revenue growth is 12% and its profit margin is 18%, the Rule of 40 number would be 30% (12 + 18). 

This number comes under the target of 40%, which means the company may not be considered attractive.

To be considered attractive, the total of growth and profit margin must be 40% or higher. This means that either growth or profit margin must be increased to reach the target.

Why does the Rule of 40 matter to companies and investors?

The Rule of 40 provides investors with a benchmark for evaluating the performance of SaaS companies, both in terms of growth and profitability. Both businesses and investors can make informed decisions with the help of this metric. Here’s how:

Helps determine trade-offs

The Rule of 40 allows SaaS companies to gain the right balance between growth and profitability. A Rule of 40 value of 40% or more indicates that a company is on the right track since the growth rate and profit margin add up to 40% or more. For instance, if a company has a growth rate of 55%, it can afford to operate at a loss of 15%. Let’s see how this works.

If a company XYZ has a growth rate of 55% and a profitability margin of -15%, the Rule of 40 value would be:

= 55 + (-15)

= 40

In this example, we can observe that the company has a growth rate of 55% and is operating at a loss of 15%. However, when these two values are added together, we get a Rule of 40 value of 40%. This means that the company is still on the right track, in that, it can afford to operate at a loss of 15% as long as it continues to grow at a rate of at least 55%.

Aids decision-making

The Rule of 40 lets companies prioritize between growth and profitability, depending on the stage of the business. SaaS companies that are still in their early stages tend to focus on growing their revenues. However, it's important for them to be able to demonstrate the ability to make a profit. The Rule of 40 helps such businesses maintain an appropriate growth rate in the early stages.

Helps small businesses curate strategies

Small businesses can use the Rule of 40 to modify their sales and marketing strategies so that they can attract and retain more customers. This helps them achieve high returns and further attract investors to fund their projects.

Assists mature businesses in shifting focus

Mature businesses that enjoy larger market share can make use of this metric to shift their focus from revenue expansion to margin growth. This is mainly because growth rates may start to decline as a company reaches the maturity stage.

Supports investment decisions

The Rule of 40 helps companies gauge their ability to invest in projects without compromising on profitability. Maintaining a growth rate and profit margin of 20% each can be challenging and may result in stagnancy for an extended period. A Rule of 40 value above 40% indicates the company’s potential to achieve faster growth and its ability to drive retention without sacrificing profits.

Helps investors pick the right companies

Venture capitalists created the Rule of 40, and it is used by investors to evaluate investment opportunities. The Rule of 40 provides a benchmark for investors to assess the potential of a SaaS business to create value, regardless of profitability.

Which businesses should use the Rule of 40

The Rule of 40 is applicable to both start-ups and well-established businesses. However, focusing too much on the Rule of 40 in the early stages of a business can hurt it in later stages. As a company grows, the Rule of 40 becomes more crucial in measuring business success and also in getting funding from investors by helping companies find a balance between growth and making money.

Thus, it's more useful for larger companies that have higher profit margins and slower growth rates. By using the Rule of 40, such companies can attain faster growth and maintain sustainable performance in the long run. 

How Rule of 40 helps CFOs balance competing goals

The Rule of 40 is a key performance indicator that can effectively be used by CFOs of SaaS companies to measure profitability and growth. It can help CFOs balance competing goals by enabling them to

  • Create efficiencies: By simplifying processes, establishing automation, and eliminating duplication, CFOs can work towards better sales efficiency and increased profitability.
  • Improve customer retention: By considering the Rule of 40, company CFOs may find it easier to focus on creating a positive customer experience. This can further reduce churn and upgrade the product/service being offered to optimize net retention.
  • Improve LTV/CAC ratio: Rule of 40 can assist in increasing the value being delivered to existing customers as companies can learn to create efficiencies through effective investments. This can minimise churn and increase the Customer Lifetime Value to Customer Acquisition Cost or LTV/CAC ratio.
  • Develop new products: Company leaders can consider capitalizing on market opportunities by selling new products and expanding into alternative markets to boost profitability.
  • Monitor expenses: Expenses such as R&D play a crucial role in the early stages of a start-up. While these are important, they can eat up the company’s profitability if left unmonitored. Rule of 40 can help companies keep a close watch on such expenses.

CFOs can use Rule of 40 results to chalk out the financial planning and analysis exercise for a company. With financial planning and analysis software, they can effectively manage the budgeting, forecasting, scenario testing, reporting, and analysis processes all in one platform. Vareto simplifies financial planning, reporting and decision-making with its innovative design and data analysis. 

In the ever-evolving world of SaaS, it's more important than ever for CFOs to have a clear understanding of their company's financial health. The Rule of 40 can be useful in this regard as it offers a holistic picture of a SaaS company's financial performance. By focusing on this rule, CFOs can make strategic decisions that drive both immediate and long-term success, ensuring the company’s stability and growth in the future.

FAQs

What if a SaaS company does not meet the Rule of 40?

If a SaaS company does not meet the Rule of 40, it may indicate that the company’s growth and profitability are not balanced. In the long run, this can lead to financial instability forcing the company to re-evaluate its financial strategy.

How can SaaS companies improve their Rule of 40 score?

To improve their Rule of 40 score, SaaS companies must focus on increasing growth and profitability by revisiting their pricing strategy, better cost control, and taking fresh revenue-generating initiatives. 

Is the Rule of 40 applicable to all SaaS companies?

The Rule of 40 is a widely used metric among SaaS companies, especially by companies that are in early growth stages or that have unique business models. Company CFOs can consider the requirements of their company to determine whether the Rule of 40 can be a useful metric for their financial evaluation.

How often should SaaS companies consider Rule of 40 score?

SaaS companies must try to check their Rule of 40 score frequently. A quarterly or annual review can be considered ideal. This way company CFOs can monitor the financial performance and make necessary adjustments to improve the score.

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