The Rule of 40 is a common metric used by private equity investors and strategic buyers to measure the performance of SaaS companies. Measuring the trade-off between profitability and growth, the Rule of 40 asserts that a successful SaaS company’s growth rate and profit margin should add up to 40% or more.
Calculating the Rule of 40:
The Rule of 40 calculation considers two key financial metrics: growth rate and profitability margin. Revenue growth and EBITDA margin are most commonly used to gauge a company’s profitability and growth. The EBITDA margin strips out differences in interest expense and tax treatment, making EBITDA margin the best indicator for profitability when comparing SaaS businesses. However, you may find that some use net income or cash flow as other measures of profitability, and ARR growth instead of revenue growth.
Rule of 40 = Revenue Growth + EBITDA Margin
Insights on Rule of 40
The Rule of 40 can be a useful metric when comparing SaaS companies. In addition to measuring, this metric is also a normalizing factor. For example, a company can reach 40% on a Rule of 40 basis in many ways. A company can have 20% revenue growth and 20% EBITDA margin; 0% revenue growth and 40% EBTIDA margin; or 40% revenue growth and 0% EBITDA margin. Some companies may sacrifice profitability to grow, while others may be uber profitable but have not invested in growth factors such as Sales and Marketing. Using this calculation allows buyers and investors to normalize these factors across financial profiles. Yet, it fails to guide management on how to best balance the often competing priorities of rapid growth and increased profitability.
Software Equity Group recently convened a group of private equity investors to understand what they are looking for in potential SaaS investments (see the full webinar). When asked specifically about the Rule of 40 and whether the preferred weighting was towards growth or profitability, the consensus was that growth was more important for smaller SaaS companies.
Adi Filipovic, Principal & Co-Founder of Resurgens Technology Partners, conveyed that the Rule of 40 had limited value to management on a standalone basis. As a rule of thumb, it did not provide sufficient guidance on what was most important—how a company should trade-off growth and profitability.
According to Adi, “The smaller the company, the more one should put weight on growth. Ultimately, you want to get to a different level of scale for a lot of reasons, based on who’s going to acquire the company, as well as to give yourself a chance to be really profitable.” (Watch Response in Webinar)
The Weighted Rule of 40
Given buyers’ preference for growth over profitability, especially for smaller companies, there is an increasing shift towards a weighted Rule of 40. The weighted Rule of 40 gives twice the weighting to growth than it does to profitability.
Weighted Rule of 40 = (1.33 * Revenue Growth) + (0.67 * EBITDA Margin)
This new weighting aligns with the increased focus on growth, particularly for smaller SaaS companies, prioritizing growth over profitability as they work to achieve scale. It also provides better guidance as to how management should think strategically about pricing and resource allocation.
As companies grow to scale, they will be challenged to maintain the same outsized growth rates. As such, they should consider an alternate weighting that prioritizes EBITDA margin over growth. A revised weighting for mature SaaS companies provides improved guidance on how management should formulate strategic and operational objectives.
Weighted Rule of 40 for Public SaaS Companies
As evidenced by SEG’s 2021 Annual SaaS Report, investors favored SaaS companies with higher Weighted Rule of 40 percentages. Public SaaS companies scoring greater than 40% on a Weighted rule of 40 basis posted a median EV/Revenue multiple of 22.4x. These high-performing companies include Okta, Adobe, Zoom, Twilio, and Datadog. Further, each cohort above 10% on a Weighted Rule of 40% basis posted greater median EV/Revenue multiples compared to 4Q19, indicating that investors favored growth stocks in 2020.
The Rule of 40, a well-known and often used metric, is a popular tool for SaaS companies for comparison purposes. As strategic buyers and investors increasingly look to growth and net retention as key indicators of valuation, a Weighted Rule of 40 is also an effective tool for SaaS companies to focus their resources and boost their future valuation.
If you would like to discuss your company’s growth or profitability metrics, don’t hesitate to reach out.