It's a financial framework that measures revenue growth vs profit margins. The Rule of 40 determines the health and/or attractiveness of your business. To CFO’s, it adds financial discipline to your decision-making process.
How to Calculate the Rule of 40
Rule of 40 = growth % + profit margin
If revenue growth is 15%
and profit margin is 20%
Your rule of 40 number is 35%
Can you have negative inputs? Yes, that’s the meaning of the Rule of 40.
Increase growth or profit to reach 40% or higher.
Growth Input
For revenue growth, you can use either recurring revenue growth or total revenue growth. If subscription revenue comprises 80% or more of your total revenue, I am more inclined to use recurring revenue for growth.
Profit Input
For profit margin, it is common to use EBITDA margins in private SaaS companies. EBITDA is a common financial metric and important in the SaaS.
E - earnings
B - before
I - interest
T - taxes
D - depreciation
A - amortization
Public co's tend to use FCF.
Margin Input
Why use EBITDA in the rule of 40?
EBITDA tries to place companies on a common playing field, stripping out interest from debt, differences in taxation, and differences in accounting policies (CapEx) to approximate operating cash flow in the long-run.
Why does the Rule of 40 matter?
It indicates the balance between growth and profitability. It helps both SaaS operators and investors.
It helps you:
Determine if you have an attractive profile
Reinforces the ROI thought process
Enhance financial decision-making
When to measure the Rule of 40?
There is a lot of debate on this one. Some say above 10M ARR. Some say above 25M ARR.
I believe if you have built out the major departments in your biz, it’s time to think about tradeoffs and capital allocation.
To learn more about the Rule of 40 and how to use it in your SaaS business, check out this
post: thesaascfo.com/rule-of-40-saa…
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