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.

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