Did you know that the rule of 40 is one of the best indicators of success in SaaS companies?
While there are multiple success metrics that vary in importance from one business to the other, certain metrics are generally accepted as indicators of success.
The best test of your SaaS management teams is arguably how well they are able to sustain high shareholder returns as the company grows. And maintaining sustainable growth is one of the most important steps for maximizing shareholder wealth.
So, let’s see how the rule of 40 helps you track your SaaS growth.
- The rule of 40 says that a healthy SaaS business has a total profit margin and growth rate of at least 40%.
- Over a given period, SaaS rule of 40 = Growth Rate % + Profit Margin %.
- There are different ways of measuring the profitability margin that can make a significant difference while calculating the RO40.
- The rule of 40 helps balance growth and profitability, attract investors and make well-informed short-term and long-term decisions.
- 40% is the benchmark that startups need to satisfy potential investors, while > 40% is the best percentage to maintain to ensure sustainable growth in the future and attract more funding.
- As companies mature and growth rates decline, the RO40 becomes even more important to balance growth and profitability better.
- There are several tactics you can use to boost your rule of 40, some of them include monthly recurring revenue and a good user experience.
What is the rule of 40 in SaaS?
This rule of thumb was popularized by Techstars Co-founder Brad Feld and has become more famous over recent years. SaaS leaders from all around the world use this metric to test their company’s growth against the standard.
Moreover, it’s one of the key metrics that investors check before deciding to put their funds into a business.
The rule of 40 says that a healthy SaaS business has a total profit margin and growth rate of at least 40%.
For instance, you may have a profit margin of 0% and yet have a growth rate of 40% quarter-over-quarter. This suggests that sometimes losing money doesn’t create any problem. Thus, investors can see an unprofitable company as a healthy one using the rule of 40. As long as a business earns enough revenue to counter the lack of profit, it’s on the right track.
On the other hand, if your company’s revenue growth rate is 60% or above while it’s losing 20%, it can still be considered a healthy business.
However, the rule of 40 is not a great benchmark for every business out there. It’s more reliable for businesses in the maturity stage than in the early stage.
This is because startups tend to have a volatile rule of 40 figures and favor growth vs. profitability.
How to calculate the rule of 40?
To calculate the rule of 40, add the growth rate to the profit margin over a specific time period.
SaaS rule of 40 = Growth Rate % + Profit Margin %
Suppose that you used your sales growth rate of 16% and your profit margin is 25%. According to the formula, your rule of 40 value is 41. So, your business is doing great.
However, if this value had been 35, you would’ve had to increase it to 40 to protect shareholder wealth and attract more potential investors.
How to measure growth?
There are several ways of measuring growth. Perhaps, the easiest way is to find the year-over-year (YoY) monthly recurring revenue growth.
You can use the total revenue anytime. However, it’s crucial to account for the recurring revenue, especially if you offer one-time services.
So, another way of measuring growth is using the total revenue growth rate instead of the recurring revenue growth rate.
The founder of “The SaaS CFO” Ben Murray said that it’s wiser to use total revenue if your subscription revenue makes up for less than 80% of your total one. For instance, it could give inaccurate results if you only use MRR or Annual Recurring Revenue (ARR) to measure the rule of 40, if professional services account for 30% of your revenue.
How to measure profitability?
The way you measure the profit margin will vary based on your SaaS business model. But it’s typically best to use the EBITDA formula to measure profitability. It’s especially useful for software companies that use cloud services to offer their products to customers.
There are many other ways of measuring the profitability of SaaS businesses. Some GAAP accounting practices include using net income, cash flow, operating income, and free cash flow.
But EBITDA is the most widely used metric out there for startups and SaaS businesses in particular. A non-GAAP metric, EBITDA translates into earnings before interest, taxes, depreciation, and amortization.
Operating expenses, salaries, and rent are expenses that must be subtracted from revenue. Note that you don’t need to subtract interest and tax expenses separately since they aren’t included in the revenue in the first place. But you must account for the depreciation and amortization.
The rule of 40 example
The table below measures the rule of 40 for DocuSign’s quarterly report (CQ4) in 2019.
The company’s YoY revenue growth rate for the quarter is 39.9%. But, its profitability margin differs significantly based on how you calculate it.
Of the 6 different ways shown below, the first half gives net profitability, where the profit margins are greater than 0%. The second half shows profit margins below 0%, which means the company operated at losses.
Adding the company’s growth rate to any of the positive profit margins would give a number above 40%. Using the other 3 ways would give numbers less than 40%, sometimes by a significant margin.
There’s no right or wrong way of measuring profitability because all the measures given below are valid.
Some of the measures are more conservative than the rest. These can make a great difference in deciding whether the performance of the business would hit the 40% threshold. For example, from “Cash From Operations” to “Operating Income”, the RO40 decreases from 13.7% to -17.6%.
Why is using the rule of 40 important?
The rule of 40 provides a benchmark for comparing the performance of one company to another. It also balances growth and profitability and helps businesses make well-informed short-term and long-term decisions.
Here are some critical advantages of using the RO40.
It indicates what trade-offs a SaaS business can afford
As long as your profit margin and growth rate add up to 40% or more, you’re on the right track. For example, you can afford to operate at a loss of 15% if you are growing at a rate of 55%.
You can use this metric to decide when to maximize profitability or growth at any specific stage of the business
Although early-stage SaaS companies focus more on growing than generating profits, they must be able to prove that they can make profits easily if they just slow down their growth. Thus, the RO40 is an important metric for maintaining a proper growth rate in the early stages.
Small businesses can use it to fine-tune their sales and marketing strategies to attract and retain more customers. They can maintain high enough returns to attract investors to fund their projects.
Furthermore, it helps mature businesses with large market shares to shift their attention to margin growth from expanding revenue. This is because growth rates start to fall in the maturity stage.
It helps evaluate a company’s ability to invest in a project without giving up profits
It’s challenging to maintain the growth rate and profit margin at 20% each because you can get stuck in a sub-scale model for longer than required.
In a competitive market, you have to ensure you gain the biggest possible market share to sustain your business. So, a RO40 number above 40% means that you have the potential for hypergrowth and drive retention without worrying about giving up profits.
Hypergrowth can help maintain your RO40 beyond 40 for much longer periods of time. You might need investors as a source of funds for hypergrowth, which is where the next benefit comes in.
Investors can use this metric to decide which SaaS company to invest in
Since venture capitalists are the ones who came up with this metric, it makes sense for investors to factor in the rule of 40 in their decisions.
The RO40 provides the benchmark that investors need to assess their investment opportunities. Whether a SaaS business is yet making profits or not, this metric helps investors figure out whether it can potentially create value for them.
Rule of 40 benchmarks
Here are some benchmarks that would determine the financial health of your SaaS company.
- Below 40% – This means that your growth and profits are not enough to cover for the other. So, you have to reassess and form new strategies to optimize profit or growth, depending on the business stage.
- 40% – This is the benchmark that startups need to satisfy potential investors.
- Above 40% – This is when your business is especially attractive to investors. You even have more room for growth without sacrificing profits.
When should you use the rule of 40?
Fast-growing startups, with volatile RO40 values, can gain enough market share to make up for the short-term losses. However, as the business matures and growth rates decline, you need to balance growth and profitability better.
According to Brad Feld, an American entrepreneur and venture capitalist at Foundry Group, a company becomes “mature” when it generates a minimum of $1 million in MRR. For Techstars, this translates to an ARR of $15-20 million. For other businesses, this might even require an ARR as high as $50 million.
Therefore, if you focus too much on the rule of 40 during the early stages, it can be harmful to your business down the line. According to Dave Kellogg, an expert SaaS investor and executive, many businesses focus on the metric too early, which harms growth and their valuations in the long run.
As businesses grow, the rule of 40 becomes more valuable as a benchmark for sustainable growth. Keep in mind that the metric is particularly useful when you’re seeking new venture capital funds.
2 ways to meet the rule of 40
Now let’s see some of the ways you can boost your RO40 figure to 40 or above.
- Improve your Monthly Recurring Revenue (MRR)
- Focus on user experience
Improve your Monthly Recurring Revenue (MRR)
To improve MRR, you need to address several areas, from reducing churn to pushing upgrades and more.
You can improve your MRR by focusing more on your customer acquisition efforts. However, you should be careful to not go all in and keep enough room for retention as well. High user retention can also drive your MRR in the long run.
Your existing customers are crucial for increasing your average revenue per account (ARPU). You can increase your ARPU or expansion MRR through upsells, cross-sells, and add-ons.
For example, you can make an upsell model pop up automatically when a customer performs a task that’s restricted by their free account or current subscription plan. You can add a visible CTA button to direct them to the solution.
Userpilot allows you to use contextual in-app messages to enhance customer satisfaction and drive your recurring revenue growth. You can create modals, checklists, tooltips, etc., code-free to introduce different customer segments to only the relevant features at the right time.
Focus on user experience
Customers remember their user experiences – both good and bad. Thus, it’s critical to make the experiences as valuable to users as possible.
There are 3 key steps for improving user experiences:
- Improve your onboarding
- Manage your feedback
- Monitor your customers.
Onboarding is essentially a continuous process of educating users on how to navigate your product and use its features to their maximum benefit. With Userpilot, you can personalize the onboarding experiences at different stages of the user journey to drive value.
For example, you can use interactive walkthroughs to guide users on how to use a secondary feature that’s relevant to their use case. This might encourage them to adopt the feature and stick to your product.
In an NPS survey, you can ask users how likely they are to recommend your product to others, such as in the example below. Your happy customers (promoters) score you 9 or 10, whereas the disengaged users (detractors) rate you 6 or below.
The NPS score is the difference between the percentage of detractors and promoters. Userpilot lets you build this survey and analyze the responses to know what pain points you need to address.
Wrapping it up
The rule of 40 is the key to unlocking sustainable growth. You need to maintain this number at a minimum of 40% to secure good growth and profit margins in the maturity stage. Investors look at this metric to deem you worthy of their funding.
Want to start improving your rule of 40? Get a Userpilot demo and see how you can drive growth.