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Rule of 40 for SaaS Companies

What is the Rule of 40 for SaaS Companies?

Software as a Service businesses are dependent on customer retention to maintain income. Companies naturally grow revenue faster if it continues to acquire and retain customers compared to just focusing on the existing customer base. Determining the rate of growth is therefore important to understanding the health of the SaaS platform. Hence, the Rule of 40.

What is the Rule of 40?

The Rule of 40 states a software company’s combined revenue rate and profit margin must be at or above 40%. Above this level, SaaS companies are at a sustainable growth rate. By comparison, companies that are below this level may be experiencing cash flow or liquidity troubles. The Rule of 40 is a dependable standard to hold SaaS companies to because the SaaS sector maintains high margins between 70% and 90%. This makes comparison, regardless of business cycle and operating structure, generally easier to conduct. 

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Rule of 40 Formula

The calculations discussed are all a part of Generally Accepted Accounting Principles (GAAP) and should be consistent from company to company on how they are calculated after certain time periods. All of these values should be easy to derive from the most recent yearly income statements a company has. The formula is pretty simple and is defined as:

SaaS’ Growth Rate + the SaaS’ Profit Margin > 40%

There can be some troubles depending on whether the company measures its revenue growth using monthly or annual recurring revenue. The profit margin is commonly calculated using the margin of Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) of a given period.

Monthly Recurring Revenue (MRR) = Total Number of Active Accounts * Average Revenue per Account (ARPA)

Annual Recurring Revenue (ARR) = MRR * 12 months

Growth Rate = (Current Year Value - Last Year Value) / Prior Year Value
EBITDA Margin (%) = EBITDA / revenue

Despite all these provided values, there is still some room for debate regarding what stage the rule should be applied to and its general reliability as a metric for SaaS companies. However, this threshold is simple enough to calculate and accurate enough to find popularity.

Rule of 40 Graph

Why Do SaaS Companies use the Rule of 40?

Companies need a general benchmark to determine how profitable they are and how much growth they need.  Ideally, the Rule of 40 is to help decision-making in both the short-term and long-term, especially for SaaS businesses and companies that rely on a subscription-based model.

Establishing How Much Breathing Room a SaaS Company Has

What matters is that the 40% threshold is met regardless of how the growth rate and margin add up.  Ideally, a healthy company would have an even split of a 20% growth rate and a 20% profit margin or some combination of both positive values.  Though it should still be a sign of concern, if the company is either flat or negative in either category, it’s still acceptable if the other category is high enough to compensate.  The main concern should still be when the combined rates fall below 40% and what factors are causing this drop.
 
 

Establishing The Company’s Ability to Invest

Depending on the surplus above that 40% margin, companies have the capacity to pursue additional growth to acquire a more extensive customer base. It is crucial to understand that profitability and growth rates play a crucial role in assessing the company’s potential to invest without compromising profit. Staying ahead of the curve is essential for maintaining momentum, especially in the competitive SaaS development marketplace where companies must retain audiences’ interest for sustained success. The Rule of 40 serves as a valuable tool in evaluating how much a company can grow while balancing profitability and investment strategies.
 
 

Showing Investors the Potential SaaS Opportunities

Even if the SaaS company isn’t profitable yet, the Rule of 40 does offer a quantifiable value for how much a company can create value as it grows.  With how nebulous SaaS companies can be in terms of their actual worth, investors want to be careful about applying funds to such companies when average annual revenue fluctuations can redefine a company’s value.

Determining a SaaS Company’s Greatest Potential

Regardless of the size of the company, SaaS companies should generally aim to expand their profit margin.  Smaller companies need something to point to that justifies their rate of growth and signifies they can turn a profit.  This metric helps for setting goals on how to attract customers and maintain margins to attract potential investors continuously.  Even larger companies within this industry need to focus on their margin growth lest they begin to deteriorate.  The Rule of 40 is especially beneficial for companies who have already obtained most of their possible market share and wish to stave off subsequent decline for as long as possible.

Striking a Balance

The pursuit of pure profit can clash with other necessary goals for the company. While maintaining profit margins is essential, it can seriously impede a company’s ability to achieve different goals like opening up new revenue streams. However, if a company attempts to add new methods of acquiring funds, those ventures will become new expenses in the process. Cutting revenue streams won’t necessarily fix this either and could potentially worsen profitability.
Controlling profit margins and achieving the Rule of 40 can be strategic goals for companies, particularly in the Software as a Service (SaaS) sector. To accomplish this, businesses must consider various factors, such as cloud infrastructure costs and the cost associated with each product feature. Cloud infrastructure costs play a significant role in SaaS companies’ operational expenses. Managing these costs efficiently can help improve profit margins. Maintaining a balance between the company’s cost of goods sold (COGS) and its recurring revenue growth rate is vital. This alignment ensures that the company generates revenue at a rate surpassing its operational costs. Understanding the relationship between costs and critical business metrics like the cost per feature, cost per customer, and cost per team is essential. By analyzing these metrics, businesses can gain insights into the efficiency of their operations and pricing strategies.
 

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Dolan Cleary

Dolan Cleary

I am a recent graduate from the University of Wisconsin - Stout and am now working with AllCode as a web technician. Currently working within the marketing department.


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