Growth and profitability often feel like a delicate balancing act in the software world. You must find the right balance between growth and profitability. But how do you know if you’re on the right track? The Rule of 40 is the key to unlocking this mystery.
The Rule of 40 is like a compass for your business. It helps you chart a course to success. It’s a fairly simple equation, combining your company’s growth rate and profit margin or cash flow. The magic number you’re aiming for is 40. This would signal that your SaaS company is growing at a sustainable rate and generating healthy profits – an excellent way to attract investors.
Think of it like a recipe for the perfect cake. Growth is the sugar, and profitability is the butter. You can’t have too much of one or the other, or your cake will be either too sweet or too greasy. But when you get the right balance, your cake becomes irresistible.
Enough about cake.
Read on to learn the essentials of the Rule of 40 in the SaaS industry and what you can do to ensure your SaaS business aligns with the rule.
Let’s start with the basics.
What Is the Rule of 40 for SaaS?
For SaaS, the rule of 40, or RO40, is a rule of thumb for analyzing the health of your business. A sum of growth rate and profit margin of at least 40% indicates a healthy SaaS business.
The rule of 40 was popularized in the SaaS industry in 2015 by Brad Feld, Techstars co-founder and author of the popular Feld Thoughts blog. According to Feld, “the minimum point of happiness” for maturing businesses is a 40% rate. Anything at or better than 40% is great.
SaaS business owners all over the world use this rule to test their company’s growth.
According to the rule of 40, if you have a profit margin of 0% and a growth rate of 40% quarter-over-quarter, your business is in good health. Even with the lack of profit, over the given time period, your business doesn’t suffer as long as it grows at a high enough rate.
Investors will see your company as a good investment opportunity, thanks to the rule of 40. Data from McKinsey also shows that software companies that hit the rule of 40 get rewarded with a higher enterprise value/revenue percentage than those that don’t.
Say your company’s revenue growth rate is 50% while it’s losing 10%. According to the rule of 40, it can still be considered a healthy business.
So, as long as your profit margin and growth rate add up to at least 40%, your business is in good shape.
How To Calculate the Rule of 40 in SaaS
According to the Rule of 40, you can calculate your business’s health rate by considering the two key metrics: the growth rate and profit margin. The benchmark combines those two rates into a singular number.
If your company has been operating for over a year, calculating your revenue growth should be straightforward:
- Monthly Recurring Revenue (MRR) = Number of Active Accounts x Average Revenue Per Account (ARPA)
- Annual Recurring Revenue (ARR) = MRR × 12 Months
- Growth Rate = (Current Year Value – Prior Year Value) ÷ Prior Year Value
The profit margin, in the corresponding periods of time, is a rather broad term that can describe various financial metrics. The EBITDA margin (earnings before interest, taxes, depreciation, and amortization) is the most commonly used metric.
EBITDA Margin = EBITDA ÷ Revenue
Let’s say your company generated 10 million USD in revenue in 2021 and 12 million USD in revenue in 2022. Your year-over-year revenue growth comes at 20% (2 million ÷ 10 million x 100%).
Take your company is using EBITDA as its primary “profitability” metric. If the EBITDA for 2022 was 3 million USD, the profit margin would be 30% (3 million ÷ 10 million x 100%).
For 2022, your company’s revenue growth plus profitability margin equals 50% (20% + 30%). This means that your company is doing great as it passed the rule of 40.
If, however, the result was below 40, you would have to take appropriate actions to increase it to keep your shareholders happy.
Why Is the Rule of 40 Important?
The RO40 gives the SaaS industry strategists a benchmark for comparing the performance of similar software companies. It shows the growth and profitability of a business in a more balanced way. Most importantly, it helps software companies like yours make well-informed business decisions.
For business owners, there are some important benefits of using the rule of 40 for their SaaS business model. Here are some of them:
1. Shows What Trade-offs You Can Afford
If your RO40 value drops below 40%, look at your growth plan to decide where to implement the necessary changes. This could mean adjusting your marketing budget, reducing customer acquisition costs, boosting customer retention, reducing customer churn, etc.
You can use the rule of 40 metrics to decide when to focus on the growth of your business. New companies tend to favor growth vs. profitability. Fast-growing startups can grow on the market just enough to make up for the short-term losses.
But, as the business matures and the rapid growth slows down, you need to balance the two rates better.
2. Helps To Decide When to Shift Things
Keeping a growth rate and profit margin at 20% each is not a healthy strategy if you want to grow your company. You can get stuck in a sub-scale model for longer than required.
In a competitive SaaS market, companies must work toward gaining the biggest possible market share to sustain their businesses. Securing your RO40 rate above 40% means that your company has the potential for hypergrowth and growth of its customer base without sacrificing profits.
Boards are increasingly engaging leaders on this benchmark. Essentially, if your company is not reaching the benchmark of the rule of 40, then your leaders aren’t doing their job as a management team.
On the other hand, the leaders who can turn the rule of 40 in their favor are on the way to a winning proposition for the organization.
3. Attracts Investors
Boards aren’t the only stakeholders keeping a close watch on Rule of 40 performance. Reaching Feld’s benchmark of 40 proved to be a reliable indicator of a healthy company and, thus, an attractive investment.
The number is one of the key metrics that investors look at when deciding whether to invest funds into your business or not.
The RO40 gives investors a benchmark to consider their investment. As you can see from the examples above, your SaaS business doesn’t have to make big profits to stand as a great investment opportunity as long as it’s growing at a relevant rate.
When To Use the Rule of 40
As your business grows, the rule of 40 becomes more valuable. This metric is particularly useful when seeking new opportunities to secure investment funds.
SaaS startup companies usually focus more on growing their new business than generating profits. However, they should be able to prove they can make profits easily when slowing down their growth. In this case, reaching the benchmark of the RO40 is vital for keeping a sustainable growth rate in the early days.
Small businesses can use it to adjust their SaaS marketing plans and sales strategies to acquire a new customer base and retain more customers. Keeping high enough returns will help attract investors and secure growth.
The rule of 40 is even more reliable for businesses in the maturity stage than those in the early stage. According to Feld, you can call your company “mature” when it generates a minimum of 1 million USD in MRR.
For mature companies with large market shares, using the RO40 helps to shift their focus to margin growth from expanding revenue at the right time. This is important because, in the maturity stage, growth rates start to fall.
Focusing on the rule of 40 too early can be harmful to your business in the long run as it can harm growth and your valuations.
The Rule of 40 Benchmarks
To determine the financial health of your SaaS company, the rule of 40 indicates three benchmarks.
Any rates lower than 40% mean that neither your growth nor your profits are high enough to cover for the other. If this happens, you’ll need to analyze your current strategies and introduce new ones necessary to optimize either your profit or growth.
A 40% rate benchmark would satisfy stakeholders.
But the ultimate goal is to go beyond 40%. Going above 40% makes your business an excellent investment opportunity. It means that you have more room for growth while making profits.
How To Beat the Rule of 40
If you want to run a successful SaaS business, you need to work toward your company’s revenue growth and manage profit margins at the same time. You can continue to grow as long as you’re actively pursuing and enhancing at least one of these goals at a time.
There are many ways to boost your RO40 figure. Here are the two main ones:
1. Increase Your Monthly Recurring Revenue
You can boost your MRR by investing your efforts into customer acquisition tactics. Having a well-optimized website, improving your SEO, and publishing high-value content are just a few examples of effective customer acquisition strategies.
At the same time, you should look after your existing customers, as high user retention can also drive your MRR in the long run. The income from your loyal customers is critical for increasing your average revenue per account (ARPU).
Upsells, cross-sells, and add-ons can help to increase your ARPU. And, as a result, the expansion of your MRR. You can look after your existing customers through a solid email marketing strategy.
A good way to upsell is using automated popups whenever your customer clicks on something that’s not included in their current subscription plan. It’s an easy way of introducing extra features of your product to an existing customer.
Here’s an example of such a popup window in action:
From there, you need a visible CTA button, like the one above, to direct users to the solution, which is just a few clicks away.
2. Improve Your Customers’ UX
Remember that your competitors never sleep. Fail to provide professional services and an excellent customer experience, and your customers find someone else who will. That’s why it’s critical to make your clients’ user experiences as valuable as possible.
Anything from your product, website, and payment gateway to your customer support and the software product itself must be seamless.
One easy way to improve your customers’ UX is by improving your onboarding processes. Onboarding means providing content and solutions to educate and navigate your users on how to go around your product. You should provide an outstanding onboarding experience at every stage of the user journey to drive value.
Encourage your users to participate in surveys and use those to collect valuable user feedback. Place a popup window on your website like this one:
Let your customers have a say in shaping your product, website, and other processes. This will help with customers trusting your firm and improving customer experience.
Rule of 40 in SaaS FAQ
The Rule of 40 in SaaS is a financial framework that balances revenue growth versus profit margins. The framework states that if a company’s revenue growth rate is added to its Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), the total should exceed 40%.
SaaS companies need to show fast growth rates to maintain investor confidence. Maintaining investor confidence is critical for future funding rounds. There’s more to it, of course. Go through the article for additional insights.
By this point, you have learned that the Rule of 40 is a handy measuring tool when evaluating the health of your SaaS business.
So you know why it’s important for your business, how to calculate your score, and when to use it to find a balance between your future growth and profits. You can use it to establish a plan to become a successful SaaS product provider in your niche.
Using the above tips on how to beat the rule of 40 can help you reach the desired benchmarks and attract investors who can help you steer the company toward attaining its full potential.
Want help improving your SaaS company’s RO40 rate? Get in touch with us for a free SEO audit that will help you generate more leads for your company.
Nico is the founder of Crunch Marketing, a SaaS marketing agency. He works with enterprise SaaS clients like Writer, Right Inbox, and Surfer SEO, helping them scale lead generation globally across EMEA, APAC, and other regions.