R-40 Profile picture
16 Oct, 15 tweets, 3 min read
time to go over a foundational concept in SaaS, which I named my account after:

what is the "rule of 40"?
put simply, the rule of 40 is a measure of a company's efficiency

if you are growing quickly, are you spending too much to do it and thus the growth is "hollow"?

if you are growing slowly or shrinking, are you making enough money to provide returns to shareholders?
example second order interpretations are:

how good are mgmt. and their operational model? a more efficiently run business would generally indicate better mgmt.

how good is your product? the best products "sell themselves", so the marginal cost of growth is lower
another product-oriented interpretation is:

how good is your architecture?

do you have multiple, disparate platforms, perhaps due to unintegrated M&A? are you weighed down by an abnormal amount of technical debt?

these characteristics increase R&D spending, but unproductively
gross margin is also a huge driver

how much does it cost you to deliver your product and how does this change with scale?

I'll probably write a whole separate thread on them, but $SHOP and $SQ's scores look even more impressive on net vs. gross revenue
I say "in SaaS" because that is what I know

I am not sure if this applies in other industries, but if it were to, I would imagine the businesses would need to also have recurring revenue, high incremental margins, and high margins at scale
my view on the calculation itself at a point in time is:

organic growth rate + FCF margin - typical annual share dilution %
organic because acquired revenue is not growth

FCF because all "Adj. EBITDA" is not created equal

share dilution because, though it isn't a cash expense, it is a direct drag on growth
at this point, I think about the "40" part more as the brand of the metric and a target for companies below it, rather than a ceiling

as software business models evolve, we are seeing higher possible "scores" on this metric (see $CRWD, $ZM, $DDOG, etc.)
bottoms-up-oriented sales motions driven by developer-focus and free trial/freemium go-to-market strategies are lowering the marginal cost of sale

microservices, serverless, and many other infrastructure innovations are lowering the unit costs of development
the higher your score the better, like all benchmarks

why settle for just 40?
like any metric though, it should not be taken on its face as gospel and is more to represent what the "steady state" of the business is

businesses go through transitions and changes which can obscure what their "true" rule of 40 is
my favorite example is SaaS transitions

revenue goes down quickly as license converts into subscription, but does not rebound until the ratable revenue recognition has caught up

but costs stay the same, so it has the effect of "compressing" both growth and margins concurrently
another recent example is $ZM

though, yes they are growing 300%+ on GAAP and their margins went way up, that is not (at least I don't think) a steady state profile of the business

for lack of a better option, their rule of 40 is probably better looked at on pre-COVID numbers
the rule of 40 to me is a way to assess the actual "asset quality" of a business

companies that score higher with a higher contribution of growth to the metric should be worth more, all else equal

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More from @ruleof40

15 Oct
some of the comments on my $FSLY thread highlight a dichotomy in non-quant, active public tech investing style:

thematic growth vs. fundamental analysis

this case study is a good illustration of what can go right and wrong for each
the “thematic growth” or “story” style centers on finding a business with a high-conviction, long-term growth story and a mgmt team one thinks can execute against it

valuation metrics are largely ignored, or seen as inconsequential compared to the opportunity
fundamental investing focuses on what the business is today, who is running it, and what you are implicitly paying for in the future at today’s price

new products are often captured in a sustained-growth forecast, which is reflected in a nosebleed multiple (like most SaaS today)
Read 11 tweets
14 Oct
seems like a good day to do a thread on CDN / $FSLY:

$FSLY is a CDN infrastructure service, not SaaS and, to a lesser extent, sells value-added software

this is why their gross margin is similar to public cloud providers
a CDN (content delivery network) is the "network" layer of the traditional storage/network/compute pyramid that makes up a public cloud offering

CDNs put servers in major geos to make large files (e.g. video/photos) load faster, since it is placed closer to you
$FSLY's pitch is: simple UX for developers which lets them build a CDN into an application with minimal code. they are riding the developer first, bottoms-up wave

this is similar to why developers love AWS (among the thousands of reasons)
Read 13 tweets
28 Sep
public and private investors still look at SaaS companies quite differently

when i moved from software PE to a software hedge fund a few years ago, a few things stuck out to me as odd that are the "norm" in public SaaS investing
if i had to summarize the biggest difference in one tweet, it would be this slide from 's analyst day 2 weeks ago

i haven't met a private investor who looks at RPO or billings, and for good reason: they mean almost nothing Image
now that a few public companies report ARR, we can compare that against these other metrics

take for example. Here are the growth rates of billings and ARR for the last 8 quarters:

Billings: 58%, 0%, 9%, 17%, 15%, 36%, 6%, 12%
ARR: 27%, 25%, 26%, 24%, 23%, 23%, 21%, 19%
Read 7 tweets
17 Sep
Seeing confusion comparing to , so here is how I see it:

at 16x ann. rev growing 30%, -30% FCF margin
at 15x ARR growing 50%, -15% FCF margin

If a public software business is "declining" and it's not , they probably have an accounting issue
has had two accounting issues since moving to ASC 606 revenue recognition in FY2019:

1) Subscription licenses recognized upfront vs. ratable
2) multi-year billings moving to annual (double ding on upfront recognition)

This is why their GAAP "growth" is inaccurate
This mostly manifests itself in their financial statements as "Accounts receivable, non-current" on the balance sheet

The changes in this item represent revenue that has been recognized, but not yet billed (the opposite of deferred revenue)
Read 6 tweets

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