A Rule of 40 walkthrough

For SaaS businesses, I’ve found the rule of 40 to be a useful management tool. The basic idea is that as a SaaS business, you want your growth percentage plus your EBITDA percentage to be 40 (or better).  So if you’re growing at 50% per year, you can “invest” in growth by having a 10% burn (expense as compared to revenue). If you’re breakeven at 40% growth, that’s also great. But if you’re only growing 30% you’ll need at least a positive 10% margin to stay healthy.

I’ve found myself explaining this concept to lots of founders lately, so if you need a simple walkthrough of what the rule of 40 is all about, I hope this 8 minute video with examples is helpful.

There’s also a good argument that the “rule of 40” doesn’t really matter much until the SaaS business is at $15M-$20M+ in revenue run rate. Basically most successful SaaS businesses often post huge figures for rule of 40 ratios when they’re small mostly because they’re growing so fast and they usually burn money (within reason) in doing so. I think it’s a good habit to get into measuring the rule of 40 early on anyway. In fact, here’s a view only version of the spreadsheet I use in the video, in case you want to copy it for your own purposes. Please feel free to do so.

One concept I don’t really cover in the video (but should have) is the idea that you can use 40 as a “target” that’s ok to exceed. It’s useful to help you think about investing in growth vs generating more profitability. If you’re profitable with a 10% margin, but only growing at 25%, your rule of 40 calculation would yield 35.  So the question to ask would be “Can I re-invest my profitability of 10% to create at least 15% more growth?” By doing so, you’d end up at 0% margin but at least 40% growth This would place your rule of 40 calculation at 40 or better, which is more healthy than the original 35. This helps you think about growth vs profitability in the SaaS context, and in this case it is probably wise to reinvest over profitability with a SaaS business with lots of headroom.

I’d love your feedback in the comments and maybe I’ll use it to make a better walkthrough if needed. This was my first shot at a video walkthrough, so let me know in the comments if it’s helpful and how it could be better.

file under: Startups
  • Nate Schmidt

    Nice. After watching the valuation jump my mind immediately went to “wonder how this worked out for the founders?” I tried to guess when and how much money they needed to raise (and whether they could raise at their implied valuation), when they had to raise based on their burn, what the cap table looked like, etc. Might be fun to extend this sheet to project hypothetical raise amounts, cap tables, and outcomes for founders/investors, especially as they cross 40%/8x.

    • David Cohen

      the reason i have valuation at each point is to give a sense of the valuation they’d raise money at or exit at around that time. of course it’s not a science, there are many factors that go into the valuation multiple, but it certainly seems from looking at lots of data that if you’re 40 or better by this metric, you tend to get a premium multiple vs someone under it.

  • First, this is great. My initial reaction was, “I’ve ready Brad’s blogs, I know this. This seems too simple to need a spreadsheet.” But, after watching the video, there’s more detail than I expected and the valuation component is new and useful.

    Second, the formula in Row 10 is different (and more company-friendly) than what I had been using. I’ve been calculating the “Margin as a % of Revenue” as (TTM margin) / (TTM *revenue*). But, you’re actually calculating it as (TTM margin) / (Current *ARR Run Rate*). That’s makes sense, but, was a new learning. Thanks for sharing this.

    • David Cohen

      Yoav – thanks. The more company friendly formula is something I thought about when posting. There are various ways to calculate this, but in my experience you usually get credit for forward 12 months if there is enough consistency in the business. So while run rate is optimistic, it’s usually what I see being used. Of course, an acquirer or “buyer” more generally might argue that it’s trailing 12. i prefer to start with the case i want to build.

  • Rishi Tandon

    Initial days of SAAS product goes in building product and when it start generating revenue growth shoots based on percentage margin from zero to 4x and sustaining such growth percentage rate not easy , it comes down for next few years but eventually holding to 40% make it profitable as product matures & customer segment repeated.
    Thanks it’s good blog … Will incorporate in tracking growth of our Platform Twirll

  • Ping Lam

    不懂英文就是麻烦,每次都要用翻译