The 40% rule is that your growth rate + your profit should add up to 40%. So, if you are growing at 20%, you should be generating a profit of 20%. If you are growing at 40%, you should be generating a 0% profit.
Here’s a common dilemma that all SaaS business owners face — should you pursue growth at all costs, or is it more important to make sure that your margins are healthy, and that you’re not losing money with each new customer that you bring on board?Enter the Rule of 40!If this is the first time you’re hearing aboutthe Rule of 40, this financial framework helps you weigh up your revenue growthagainst your margins. Using this framework, you can:. Understand the trade off betweengrowth and profitability. Benchmark the health of your SaaScompany, and.
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Demonstrate to potential investorsthat your company is worth putting money intoIn this blog post, we’ll walk you through howthe Rule of 40 works, and teach you how to calculate your Rule of 40 number.Read on to find out more! How does the Rule of 40 work?The Rule of 40 essentially reflects thetradeoff between growth and profit.Think of it this way: most SaaS companies havehigh customer acquisition costs, as you have to invest heavily in sales andmarketing in order to realize high growth. Those PPC ads that you run and thesales reps that they hire don’t come cheap, and as such, this eats into yourprofit margin.Companies in these situations are essentiallytrading profit for growth, in the hopes that you’ll eventually achieve amonopoly. Yes, you might be burning a ton of money on Customer AcquisitionCosts, but if you do manage to dominate your market, then this will give youthe power to realize higher margins in the future.What if your business has a low growth rate?Since these companies aren’t growing quickly, they have to compensate with highcash flow and high EBITDA margins if they want to be seen as attractive.
Thesecompanies aren’t likely to become the market leader anytime soon, but at leastthey can turn over a decent amount of revenue due to their higher profitmargins.Of course, if a company’s Rule of 40 number ishigher than 40%, that’s even better. This signals that the company is strong onboth fronts (growth and margin),meaning that it might be an excellent investment opportunity.
When should SaaS companies makeuse of the Rule of 40?Generally speaking, SaaS companies who are newto the market should NOT be overly concerned with the Rule of 40 but focus on“T2D3”, which we’ll cover in a separate post.If your SaaS business is in its early years,the goal is really to realize product-market fit, and to grow as quickly aspossible. There’s no one strategythat can guarantee you success, of course — but most experts advise SaaScompanies to pursue growth as their primary objective (even if this meansneglecting profits) during this period of time.Once your company hits a certain size – Feld,the first to introduce the Rule of 40, uses $1M MRR as an approximate cut offpoint, then it makes sense for you to pivot to focusing on achieving the Ruleof 40. Now that your company is more mature, it’s important to start hittingthat balance. Measuring your growth and profit rateIn calculating your Rule of 40 number, you’llhave to plug both your growth and profit rate into the formula.Now, there are various ways of measuring your growth rate, but one of the most straightforward methods is to use your. Some companies choose to look at total revenue, but if you offer one-time services on top of monthly subscriptions, then looking at will give you a more accurate picture.When it comes to profit, there are variousways you can measure this — including Earnings Before Interest, Taxes,Depreciation and Amortization (EBITDA), Operating Income, Net Income, Cashflow,etc.So which profit metric should you use? Itdepends, assuming you run your service from AWS or a similar cloud platform, werecommend using EBITDA — since your COGS scales with your revenue, and yourgross margin is pretty consistent, this metric should be sufficient.When it comes to the time period, you can addrigour to your estimations by looking at the Rule of 40 using both quarterlyand year-to-date (YTD) measurements (benchmarking these against the previousyear).
Taking both these measurements gives you more data, and this minimizesmonth-to-month fluctuations and increases the reliability of your findings. A final word on the Rule of 40Regardless of whether you’re keen on gettingmore investors on board, or you simply want to benchmark the performance ofyour SaaS business, the Rule of 40 is an excellent gauge that you can use.If you need help hitting that magical “40” number, consider consulting with a Virtual CFO from ABEL to learn how to increase your growth rate and/or profit margin. Our Virtual CFOs can help you identify opportunities to grow your business and revenue, and restructure your finances to optimize cash flow.Sources:Post navigation.