What is the Rule of 40 in SaaS?

What's the rule of 40 for SaaS companies? 

It's a guideline to help balance growth and profitability. Basically, if you add up your revenue growth rate and your profit margin, the total should be at least 40%. Hitting this mark means your company is financially healthy, sustainable, and attractive to investors.

The Rule of 40 can help you see if your growth rate is healthy and sustainable, acting as a checkpoint to decide how quickly you should scale your business. By following this rule, you can avoid the dangers of growing too fast at the expense of profitability. 

We'll walk you through everything you need to know about the Rule of 40 and how it can benefit your business.

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Step-by-step guide to calculate the rule of 40

Determine your revenue growth rate:

• Calculate the percentage increase in your company's revenue over a specific period (typically year-over-year).

Formula
Revenue Growth Rate (%) = (Current Period Revenue − Previous Period Revenue / Previous Period Revenue) × 100

Determine your profit margin:

• Calculate your company's profit margin as a percentage.

Formula:
Profit Margin (%) = (Net Profit / Total Revenue) × 100

Add the two percentages together:

• Combine the Revenue Growth Rate and the Profit Margin.

Formula:

Rule of 40 Score = Revenue Growth Rate + Profit Margin

Evaluate the result:

• If the sum is 40% or higher, your company is considered financially healthy and attractive to investors.

Example calculation

Let's say your SaaS company has the following financial metrics for the current year:

• Current period revenue: $10 million
• Previous period revenue: $8 million
• Net profit: $1 million

Step 1: Calculate Revenue Growth Rate

Revenue Growth Rate (%) = (10,000,000 − 8,000,000 / 8,000,000) × 100 = 25%

Step 2: Calculate Profit Margin

Profit Margin (%) = (1,000,000 / 10,000,000) × 100 = 10%

Step 3: Add the Two Percentages Together

Rule of 40 Score = 25% + 10% = 35% 

Step 4: Evaluate the Result

• With a Rule of 40 Score of 35%, your company is slightly below the 40% threshold. This indicates there is room for improvement to be considered financially healthy and attractive to investors.

How to calculate the weighted rule of 40?

The Weighted Rule of 40 is a variation that assigns different weights to revenue growth and profit margin, giving you a more nuanced view of your company's performance. This can be useful if your company prioritizes growth over profitability, or vice versa. Here's a step-by-step guide to calculating the Weighted Rule of 40:

Determine your revenue growth rate:

• Calculate the percentage increase in your company's revenue over a specific period (typically year-over-year).

Formula
Revenue Growth Rate (%) = (Current Period Revenue−Previous Period Revenue / Previous Period Revenue) × 100

Determine your profit margin:

• Calculate your company's profit margin as a percentage.

Formula
Profit Margin (%) = (Net Profit / Total Revenue) × 100 

Assign weights to each metric:

• Decide the weights you want to assign to the Revenue Growth Rate and Profit Margin. These weights should sum up to 100%. For example, you might assign 70% to growth and 30% to profit.

Calculate the weighted contributions:

• Multiply each metric by its respective weight.

Formula
Weighted Revenue Growth Rate = Revenue Growth Rate × Weight

Weight Weighted Profit Margin = Profit Margin × Weight

Sum the weighted contributions:

• Add the weighted contributions to get the Weighted Rule of 40 score.

Formula
Weighted Rule of 40 Score = Weighted Revenue Growth Rate + Weighted Profit

Example calculation

Let's say your SaaS company has the following financial metrics for the current year:

• Current Period Revenue: $10 million
• Previous Period Revenue: $8 million
• Net Profit: $1 million

You've decided to assign a weight of 70% to the Revenue Growth Rate and 30% to the Profit Margin.

Step 1: Calculate Revenue Growth Rate

Revenue Growth Rate (%) = (10,000,000 − 8,000,000 / 8,000,000) × 100 = 25%

Step 2: Calculate Profit Margin

Profit Margin (%) = (1,000,000 / 10,000,000) × 100 = 10%

Step 3: Assign Weights

• Revenue Growth Rate Weight: 70% (0.70)
• Profit Margin Weight: 30% (0.30)

Step 4: Calculate Weighted Contributions

Weighted Revenue Growth Rate = 25% × 0.70 = 17.5%

Weighted Profit Margin = 10% × 0.30 = 3%

Step 5: Sum the Weighted Contributions

Weighted Rule of 40 Score = 17.5% + 3% = 20.5%

Step 6: Evaluate the Result

• With a Weighted Rule of 40 Score of 20.5%, your company might need to adjust its strategy to improve either growth or profitability to reach a healthier balance.

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FAQs

How does the rule of 40 Work?

The Rule of 40 was built by venture capitalists (VCs) to evaluate the financial health and viability of growth-focused SaaS companies. This metric gives VCs a quick way to see how well a company balances growth and profitability.

For SaaS founders, the Rule of 40 helps determine if they're striking the right balance between making money and growing the business. For example, a company might focus on growing quickly even if it's not very profitable yet, and that could still be appealing to investors.

Here's a quick guide to how VCs view a SaaS company's Rule of 40 score:

• Less than 40: If your company has finished Series A or later funding rounds, a score below 40 is generally seen as a poor value.
• 40 or More: A score of 40% or higher makes a SaaS business attractive to VCs. The higher the score, the better, and if your company is just at 40, you should work on boosting that number.

Remember, there are different ways to hit a number above 40. A VC's decision to invest will depend on whether they prioritize growth or profitability, and just having a score over 40 doesn’t automatically mean you’ll get a high valuation.

Why is the rule of 40 crucial for SaaS companies?

• Holistic Financial Health Check: The Rule of 40 provides a quick snapshot of a SaaS company’s overall financial health, combining growth and profitability into one easy-to-understand metric.
• Investor Appeal: Venture capitalists use the Rule of 40 to assess potential investments. A company with a score of 40 or higher is generally seen as a strong candidate for investment.
• Balancing Act: For founders, this metric helps balance the trade-off between growth and profitability. It's crucial to know whether you're growing sustainably without sacrificing profitability.
• Strategic Planning: It serves as a strategic guide, helping companies decide when to push for growth and when to focus on improving margins.

Insights from a real-time case study: Zoom Video Communications

• Rapid Growth: During the COVID-19 pandemic, Zoom experienced exponential revenue growth due to the surge in demand for remote communication tools. Their revenue growth rate shot up dramatically.
• Profit Margin: Despite the rapid growth, Zoom managed to maintain a sound profit (margin) thanks to its scalable SaaS business model and efficient cost management.
• Rule of 40 Score: At the peak of its growth phase, Zoom's Rule of 40 score was exceptionally high, often well above 40. This made it a highly attractive company to investors, contributing to its soaring stock price and market valuation.
• Investor Confidence: The high Rule of 40 score gave investors confidence in Zoom's ability to sustain growth while maintaining profitability, reinforcing its position as a market leader.
• Strategic Adjustments: As the market began to stabilise, Zoom adjusted its strategy to balance growth with profitability, ensuring long-term sustainability.

Key takeaways

• The Rule of 40 isn't just a number; it's a tool that can guide a SaaS company's growth trajectory.
• Investors look at this metric to gauge the company's potential, making it crucial for securing funding.
• Real-life examples like Zoom highlight how a strong Rule of 40 score can drive investor confidence and market success.
• SaaS companies should aim to optimise both growth and profitability to meet or exceed the Rule of 40, ensuring they remain attractive to investors while growing sustainably.

Should early-Stage SaaS Companies Focus on the Rule of 40?

You might have heard that early-stage companies can sometimes get away with not hitting the Rule of 40. But does that mean they can completely ignore it? Not exactly.

Early-stage SaaS companies should definitely keep an eye on the Rule of 40 to see how they're balancing growth and profitability. However, it shouldn't be their sole focus. Trying too hard to meet the Rule of 40 early on might mean sacrificing necessary growth.

At this stage, most SaaS companies prioritize growth over profitability in their business plans. Relying too much on the Rule of 40 early on can give a skewed picture of the company’s financial health and attractiveness, potentially causing unnecessary worry.

For young SaaS companies, it might be better to use the Weighted Rule of 40 or other metrics to track progress. Save the standard Rule of 40 for when the company is more established and ready for a balanced approach to growth / profitability.

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How should a company shift its focus as it matures? 

As your SaaS company grows, you need to start balancing growth with profitability to meet market expectations. Initially, it's all about acquiring new customers and increasing ARR. But as you mature, you should focus more on profitability. 

This means looking at ways to reduce customer acquisition costs (CAC), improve retention, and increase revenue from existing customers. You can also reduce your cost of goods sold (COGS) and explore more profitable products. The key is that to be sustainable, you need to be profitable while growing, and the Rule of 40 helps you achieve that balance.

Why should you invest in customer success? 

Customer success is crucial for maintaining a good Rule of 40 score. Think of your business as a bucket. Your sales team pours in new ARR, but customer churn can make the bucket leak. Your customer success team helps plug these leaks by increasing retention (renewal ARR) and adding more water through upselling and cross-selling (expansion ARR). 

As you grow, customer acquisition costs (CAC) will rise, which can hurt your EBITDA. Investing in customer success helps you get more value from existing customers, which is cheaper and more effective than acquiring new ones. Research shows that a 5% increase in retention can boost profitability by 95%, making you more attractive to investors.

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How can automation help as your business grows?

Fast growth brings complexity, especially with international expansion, new products, and different business models. This complexity can slow you down and impact productivity. For example, expanding internationally means dealing with multiple currencies and accounting systems, which makes financial reporting a hassle. 

Automating these processes helps you quickly consolidate data and track key metrics like growth rate and EBITDA margin. Similarly, new pricing plans can complicate your financial models. Automation saves time and reduces errors, helping you stay on top of your growth and profitability.

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