Rule of 40 SaaS: What is It and How to Calculate?

With so many product analytics available, it can be hard to figure out which metrics you should be monitoring. This guide will walk you through what the rule of 40 is, why you should track it, when to use it, and how to calculate it!

What is the rule of 40?

The rule of 40 is a principle stating that a SaaS company’s revenue growth and profit margin — when combined — should be equal to or greater than 40%. SaaS companies operating above the 40% threshold are generating sustainable profits, while those below it could run into liquidity bottlenecks.

Why should you track the rule of 40?

There are a few different reasons to track the rule of 40, but the main purposes are:

• Evaluating financial health. Because the rule of 40 is a reliable indicator of how healthy the business is — at least from a financial perspective — it can be used to diagnose problems or avoid cash flow issues in high-growth businesses.
• Guiding strategic decisions. Many founders are torn between accelerating growth and increasing profitability, with some settling somewhere in the middle. Using the rule of 40, you’ll be able to see which side of the equation you should focus on instead of guessing or erring on the side of caution.
• Benchmarking performance. The rule of 40 can also help you benchmark your SaaS business against the financial performance of other competitors in the same industry. This will make it easier to compare your revenue growth and profitability to other players in the space.

When to use the rule of 40?

Whether you’ve just reached the point of PMF or are one of the mature companies in the SaaS industry, there are multiple points where you’d want to use the rule of 40:

• PMF. Once you’ve achieved product-market fit and don’t have any immediate cash flow issues, you should start tracking the rule of 40. This will help you stay on the right path and ensure you don’t increase your burn rate too quickly in the pursuit of rapid growth.
• Health. You can also use the rule of 40 as a periodic measure of overall business health. This makes it easy to spot problems early and nip them in the bud while also being able to track how your revenue/profit has been changing over time.
• Acquisition. Finally, if you’re planning to exit your business and anticipate a nearby acquisition then the rule of 40 can be a great yardstick for increasing the enterprise value of your company. Optimizing your revenue growth and profit margin to get it above 40% will boost the valuation.

How to calculate the rule of 40?

Now that you know what the rule of 40 is, why you should track it, and when to use it, it’s time to go over how to actually calculate it. The formula for the rule of 40 only requires two inputs: revenue growth rate and profit margin.

We’ll walk you through how to calculate each one in the sections below!

Calculate your revenue growth rate

Calculating your revenue growth rate is fairly straightforward and you may already have this data available (if so, skip to the next section). Start by determining the timeframe, collecting revenue data for that period, and then using the revenue growth formula below to get the rate as a percentage.

Measure your EBITDA margin

Next, we need to measure the profit margins of SaaS businesses. This is usually measured as the EBITDA margin which stands for earnings before interest, taxes, depreciation, and amortization. Simply divide your EBITDA by your total revenue and multiply by a hundred to get the percentage.

Find the rule of 40

Now that you have both your revenue growth rate and profit margin calculated, it’s time to combine the two to get your rule of 40 number.

To calculate it, simply add your revenue growth as a percentage and add your profit margin to it, then see if the result is equal to or greater than 40. For instance, if your revenue growth rate is 20% and your profit margin is 18% then your rule of 40 number is 38% (20 + 18) which is slightly below the 40% target.

Here’s what the formula looks like on its own: Rule of 40 = Revenue Growth % + Profit Margin %

The rule of 40 calculation example for SaaS companies

Let’s look at a few realistic examples of (fictional) software companies that use the rule of 40:

Example #1: Lean.ly

Growth rate: 0%

Profit margin: 40%

Despite revenue plateauing, Lean.ly still qualifies under the rule of 40 due to its high profit margins. As such, the goal should be to make modest gains in revenue without compromising profitability (to avoid dropping below the 40% combined threshold).

Example #2: Burn.ly

Growth rate: 40%

Profit margin: 0%

On the opposite end of the spectrum, we have companies like Burn.ly that are growing at breakneck speeds but are yet to achieve profitability. This may be fine for VC-backed companies, but bootstrapped startups could run into liquidity problems if they grow this fast without turning a profit.

Example #3: Moderate.ly

Growth rate: 20%

Profit margin: 20%

A healthy SaaS company should aim to be somewhere in between (unless there’s a specific reason to favor one end of the spectrum that’s unique to your business). After all, this would mean that you’ve managed to avoid both stagnating revenue growth and profitability-induced cash flow issues.

The rule of 40 benchmarks

Once you have your company’s rule of 40 number, it’s time to benchmark the business to see which range it falls into:

• Sub-40. If a company is below the 40% threshold, then that means that neither revenue growth nor profit margin are high enough to cover for the other (should one of them fail). This puts you in a precarious situation where you should increase either or both to get above the threshold.
• Exactly 40. Those who just barely meet the threshold and find themselves right at the 40% mark will likely be able to satisfy potential investors. However, there is a higher risk (both for the current owner and anyone acquiring the business) of dropping below the threshold due to external factors.
• Above 40. Businesses that are above the 40% threshold are particularly attractive to investors. After all, they have more room to grow revenue without exhausting profitability. Businesses with revenue growth rates above 40% could also be forgiven for lower profit margins and vice-versa.

Tips to achieve the rule of 40 success

Knowing what your current rule of 40 number is can be helpful but far more valuable would be knowing how to get to the threshold — or even surpass it!

There are three strategies you can use to achieve the rule of 40 in your business:

• Set realistic growth targets
• Increase net retention rate
• Optimize sales/marketing

Let’s take a closer look at each of these in the sections below!

Be realistic with growth targets

One of the simplest ways to improve a company’s operating performance is to set growth targets that are based on realistic projections within your market. For instance, if your addressable market only grows at 8% then expecting a 30%+ growth rate isn’t realistic.

Focus on increasing the net retention rate

Focus your attention on improving customer satisfaction so you can create upsell opportunities and increase net revenue retention (rather than gross retention). You can do this by segmenting your at-risk customers and using NPS surveys to identify (then address) their most pressing issues.

Optimize sales and marketing cost

Using analytics dashboards to track the performance of your sales and marketing efforts will help you optimize the return on investment while reducing unnecessary costs. You’ll also be able to use this data to target segments with the highest returns so you can maintain a healthy profitability margin.

Other important metrics to track SaaS business health

There are a few SaaS metrics you can use to track your company’s revenue growth rate, profit margins, and other numbers worth monitoring. Here are the seven you should start with:

• Gross margin. Expressed as a percentage, the remaining revenue after subtracting the cost of goods sold (COGS).
• Monthly recurring revenue. The total predictable revenue generated from all active subscriptions to your business.
• Annual recurring revenue. If you find your MRR numbers being skewed due to customers switching to an annual plan, consider tracking annual recurring revenue instead.
• Expansion revenue. The amount of revenue resulting from account expansion — which itself is usually driven by upgrades, upsells, or cross-sells.
• Free cash flow. Also known as FCF, free cash flow is the amount of cash a company generates after subtracting cash outflows necessary for supporting operations and maintaining assets.
• Customer acquisition cost. The customer acquisition cost, often shortened to CAC, is the amount spent to acquire each new customer. (Aim for a 3:1 LTV:CAC ratio.)
• Lifetime value. Optimizing the lifetime value of your customers is one of the fastest ways to add enterprise value or market capitalization to private and public SaaS companies, respectively.

Conclusion

As you can see, increasing profitability or annual revenue and seeing your SaaS company’s growth rate increase is even more rewarding when you have a benchmark to compete against. Striving to hit or surpass the rule of 40 will help you build a healthy business and improve your company’s performance.

If you’re ready to improve retention, increase lifetime value, and streamline growth through advanced analytics, then it’s time to get your free Userpilot demo today!