In the adrenaline-fueled SaaS industry, where the obsession with metrics like MRR and CAC can be all-consuming, there’s a transformative rule that many overlook, yet it holds the power to make or break your business. Today, we’re pulling back the curtain on an underrated yet game-changing metric: the 40% Rule. Ignore it at your own peril; embrace it, and you might just find the golden key to sustainable success.
What is the 40% Rule?
The 40% Rule is a heuristic that suggests your SaaS company’s growth rate and profit margin should sum up to at least 40%. Essentially, this rule is a balance of two elements:
- Growth Rate: This is generally annual revenue growth, and it can include new customer acquisition as well as upsells or cross-sells to existing customers.
- Profit Margin: This is the portion of your revenue left over after all expenses. This includes operational costs, salaries, and any other costs your business might have.
In mathematical terms:
Growth Rate(%)+Profit Margin(%)≥40%
Why is the 40% Rule Important?
The 40% Rule serves as a check on sustainable growth. Here’s why it’s crucial:
The 40% Rule offers a glimpse into the company’s financial health. A low growth rate may suggest you’re not expanding fast enough, while a low profit margin might indicate you’re burning too much cash.
Investors love the 40% Rule. If your business meets or exceeds this threshold, you’re more likely to attract funding at favorable terms.
The rule pushes you to find a sweet spot between aggressive growth and profitability, steering you away from myopic strategies.
The key is recognizing when and how to apply the rule appropriately for your business.
As Aaron Levie, CEO of Box, once said, “You’re either a Rule of 40 company, or you’re not. And those that are, tend to win the long game.”
What Happens If You Don’t Meet the Rule?
- Cash Burn: High growth and low profitability can deplete your resources quickly. Think of it like driving a car at full speed with a leaking fuel tank.
- Stagnation: On the flip side, if you’re highly profitable but not growing, you’re like a sitting duck in a pond, waiting to be overtaken by faster, more agile rivals.
Pros and Cons
The 40% Rule has gained prominence in the SaaS industry as a helpful guideline for achieving a balanced and sustainable business model. However, while it does provide a convenient heuristic, it’s not a universal fit for every SaaS company. Let’s dive into the pros and cons to understand its applicability better.
- Financial Health Indicator: The rule offers a quick snapshot of your company’s financial health by forcing you to consider both growth and profitability—two critical factors for long-term success.
- Investor Magnet: Companies that meet or exceed the 40% threshold are generally seen as safer bets by investors, which could lead to increased funding opportunities at more favorable terms.
- Resource Allocation: It prompts a balanced strategy that can encourage judicious allocation of resources towards both customer acquisition and existing operations, preventing extreme tilts that could jeopardize stability.
- Goal Setting: The rule gives your SaaS business a clear, numeric target to aim for, facilitating better goal setting, planning, and performance assessment.
- Resilience: Companies that maintain this balance are generally better positioned to withstand market fluctuations and economic downturns, making them more resilient in the long run.
- Startup Struggle: Early-stage startups might find this rule challenging to meet. For them, focusing on profitability could stifle the growth necessary to capture market share. In the beginning, they may need to sacrifice profits to accelerate growth and achieve scale.
- Mature Company Trap: For mature SaaS companies that have already captured significant market share, the 40% Rule could encourage unnecessary spending in the pursuit of growth, leading to diminishing returns and potential unsustainability.
- Not Sector-Agnostic: Different SaaS sectors have varying norms for growth and profitability. What works for enterprise SaaS may not work for a consumer-focused SaaS company.
- Over-Simplification: Financial health is a complex construct influenced by multiple variables such as cash flow, debt levels, and competitive landscape. The 40% Rule simplifies this complexity into a single metric, which might miss other crucial aspects of business health.
- Potential for Misuse: The rule could be exploited to justify poor profitability in the name of growth or vice versa. If used incorrectly, it could even provide a false sense of security.
Real World Examples
Some recent examples of SaaS companies that meet the 40% rule are:
- Asana: The work management platform had a revenue growth of 61% and a free cash flow margin of 23% in 2022, resulting in a rule of 40 number of 84%.
- DocuSign: The electronic signature software had a revenue growth of 49% and a free cash flow margin of 31% in 2022, resulting in a rule of 40 number of 80%.
- HubSpot: The marketing and sales software had a revenue growth of 41% and a free cash flow margin of 21% in 2023, resulting in a rule of 40 number of 62%.
Some examples of SaaS companies that did not meet the 40% rule in those years are:
- Dropbox: The cloud storage service had a revenue growth of 12% but a negative free cash flow margin of -8% in 2022, resulting in a rule of 40 number of 4%.
- Box: The cloud content management software had a revenue growth of 10% but a negative free cash flow margin of -14% in 2023, resulting in a rule of 40 number of -4%.
- Eventbrite: The event management and ticketing platform had a revenue growth of 18% but a negative free cash flow margin of -25% in 2023, resulting in a rule of 40 number of -7%.
As we can see, this simple 40% formula provides a quick snapshot of overall SaaS health. Companies that ignore it often do so at their own peril. To thrive in the SaaS landscape, keep this 40% golden ratio in mind. It could very well be the secret sauce to your business success.