Finding the right balance between growth and profitability is fiercely debated in the venture community and inside every boardroom. It’s nuanced and can depend on so many factors, including your specific industry submarket, your cash position, competitive landscape, personal goals, risk tolerance, and overall health of the capital markets.
The Rule of 40 is a framework to help you think through balancing growth and profitability and will also give you greater insight into how investors think about the value of your company.
1. What is the Rule of 40?
The Rule of 40 is a financial benchmark used in the tech sector (most commonly in SaaS) to evaluate the performance and health of a company by balancing its growth and profitability. According to this rule, a company's growth rate plus its profit margin should equal or exceed 40%.
The growth rate is typically measured as the percentage increase in revenue over a specific period, usually year-over-year. Profitability can be calculated in various ways, but it's often looked at in terms of EBITDA margin, free cash flow margin, or net income margin.
For instance, if a company has a revenue growth rate of 30% and an EBITDA margin of 10%, the sum is 40%, which means the company meets the Rule of 40. As we all know, high growth rates are often celebrated, but they can sometimes come at the expense of profit. Conversely, a highly profitable company might be seen as not investing enough in growth. The Rule of 40 suggests that companies achieving this balance are on the most solid footing.
2. Why does it matter?
Venture-backed companies need to grow quickly (to justify their upfront capital investments) and they need to burn cash in order to do. And ultimately software companies need to be profitable once they’ve reached scale. The rule of 40 aims to guide both the operator and the investor on assessing the right combination of growth and profitability as the company scales.
For you the operator:
- The Rule of 40 can give you another perspective on trade-offs from key operational decisions. For example, if a few more hires will reduce your profitability by 10%, but increase your revenue growth rate by 20%, then the Rule of 40 would imply that’s a good trade.
- Companies in the top quartile for the Rule of 40 carry valuation multiples that are 3x higher than companies in the bottom quarter. So positioning your company to meet and beat the Rule of 40 can result in significant financial reward for you and your shareholders. And at a minimum, being fluent on the topic and knowing that investors care about it will help navigate investment conversations better.
3. It’s just a metric, so don’t stress (too much)
It’s not the end of the world if you don’t meet the Rule of 40. McKinsey found that only one third of software businesses met the Rule of 40. And Bain found that only 40% of SaaS businesses achieved the Rule of 40 in 2017 and only 25% outperformed it for more than three years from 2012 to 2017. At the end of the day, its just a short-hand metric that is designed to help you think through your growth vs. profitability strategy.
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