Rule of 40

Extracted Attributes

• Formula

  Annual Revenue Growth Rate (%) + Profit Margin (%)

• Limitations

  Considered a rule of thumb or heuristic rather than a definitive financial law

• Popularized By

  Brad Feld

• Strategic Purpose

  Balancing growth and profitability for capital allocation and strategy

• Benchmark Threshold

  40% or higher (Sum of percentage growth and percentage profit margin)

• Primary Application

  Software as a Service (SaaS) industry performance measurement

• Valuation Correlation

  Strong correlation between Rule of 40 score and company valuation multiples

Timeline

• David Sacks discusses the Rule of 40 as a key metric for B2B SaaS during the All-In Podcast Episode 162 live from Davos, Switzerland, contrasting it with B2C models. (Source: fb009ead-fe3d-4f58-bfc8-0a9d2c19cec9)

  2024-01-19

Rule of 40

The Rule of 40 is a common financial heuristic used to measure the performance and health of software as a service (SaaS) companies. It states that a healthy SaaS company's annual revenue growth rate and its profit margin should add up to 40% or more. The rule provides a high-level view of a company's sustainability by balancing two critical, and often competing, objectives: rapid growth and profitability. It is widely used by venture capitalists, public market investors, and company executives to assess the trade-offs in capital allocation and strategy, particularly in determining whether to invest more heavily in growth or to focus on operational efficiency.

Web Search Results

• Rule of 40 - Wikipedia

  The Rule of 40 is a common financial heuristic used to measure the performance and health of software as a service (SaaS) companies. It states that a healthy SaaS company's annual revenue growth rate and its profit margin should add up to 40% or more. [...] The Rule of 40 allows for flexibility in a company's strategy. A company can achieve the 40% benchmark through different combinations: High Growth, Low Profitability: A company growing at 60% YoY with a -20% profit margin meets the rule (60% + (-20%) = 40%). This is common for earlier-stage companies in a high-growth phase, aggressively investing in sales, marketing, and product development to capture market share. Moderate Growth, Moderate Profitability: A company with 20% YoY growth and a 20% [...] The Rule of 40 is not just a backward-looking metric but also a forward-looking strategic tool. Studies have shown a strong correlation between a company's Rule of 40 score and its valuation multiple. Companies that consistently outperform the 40% benchmark tend to achieve premium valuations. Management teams use the rule to guide decisions on capital allocation. For example, if a company's score is well above 40%, it may justify further aggressive investment in growth. If the score is below

• The SaaS Rule of 40 Explained | CFI - Corporate Finance Institute

  The Rule of 40 is a commonly used metric in the Software-as-a-Service (SaaS) industry. The rule says that the sum of the revenue growth rate and the profit margin should be 40% or higher for a well-performing SaaS company. The 40% threshold was created as a quick benchmark to determine if a company is balancing growth with profitability since a high investment in growth can reduce profits. [...] ## What is the Rule of 40? The Rule of 40 is a financial metric widely used in the Software-as-a-Service (SaaS) industry to assess the performance of a company. The formula itself contains only two metrics: 1) the revenue growth rate and 2) the profit margin. The Rule of 40 says that the sum of the revenue growth rate and the profit margin should be 40% or higher. [...] ## Why is It Called the Rule of 40? The Rule of 40 derives its name from the idea that a SaaS company’s combined growth rate and profit margin should equal or exceed 40%. This 40% threshold was established to provide a quick benchmark for balancing growth and profitability since a high investment in growth can reduce profit margins.

• The Rule of 40 (Brad Feld) | SaaS Formula + Calculator

  The Rule of 40 is a mere rule of thumb to analyze the health of an SaaS business, with regard to its growth rate in recurring revenue and profit margin. To accurately interpret the SaaS KPI metric, 40% is the baseline figure at which the company is considered healthy and in good shape. If the percentage exceeds 40%, the SaaS business is likely in a favorable position to attain long-term growth and profitability. [...] The Rule of 40% For a Healthy SaaS Company (Source: Brad Feld) ## Rule of 40: SaaS Valuation KPI Metric The Rule of 40 states that if an SaaS company’s revenue growth rate is added to its profit margin, the combined value should exceed 40%. In recent years, the 40% rule has gained widespread adoption as a popularized measure of growth by SaaS investors. [...] The Rule of 40 ties the trade-off between growth and profit margins to prevent the single-minded focus on growth in lieu of cost efficiency, which is frequent in the SaaS industry. The 40% rule implies that early-stage SaaS startups either barely profitable (or unprofitable) could still be reasonably priced at a high valuation multiple if their growth rate can offset their burn rate.

• Rule Of 40: What Is It, How to Calculate It, & Examples

  The Rule of 40 is an investor’s calculation for assessing the efficiency of a privately held SaaS (software as a service) company. The definition of the Rule of 40 is that software companies are most efficiently run (and therefore, more attractive for investment) when the sum of their year-over-year growth rate percentage and its profit margin percentage is at least 40%. Like this: > YoY Growth % + Profit Margin Percentage = 40% (or more) ## Why is the Rule of 40 important? [...] The Rule of 40 has become a popular metric for CEOs, investors, and boards to assess software companies, along with other metrics like ACV calculations, burn rate, and more. The Rule of 40 is a simple calculation that can give CEOs and investors a quick assessment of a company’s financial efficiency. [...] As stated above, the Rule of 40 definition means that a company’s earnings and growth rate must add up to at least 40%. If the company’s earnings and growth rate add up to less than 40, it is a sign that the company needs to increase one or both metrics to operate efficiently compared to peers and to become interesting to possible investors. > 15% Growth rate + 35% EBITDA = 50 > > Company has strong earnings > 65% Growth rate + -10% EBITDA = 55 > > Company has strong growth

• Hacking Software's Rule of 40

  The Rule of 40—the principle that a software company’s combined growth rate and profit margin should exceed 40%—has gained momentum as a high-level gauge of performance for software businesses in recent years, especially in the realms of venture capital and growth equity. Increasingly, software industry executives are embracing the Rule of 40 as an important metric to help measure the trade-offs of balancing growth and profitability.

• Instance Of

  Q832161