Considering your growth aspiration? How the "Rule of 40" might help
Setting a growth target as a CEO for your SaaS business can be challenging. What rate of growth; 30, 40, 50%, or more is right? How will a growth rate affect margins and profitability? Do I try and plan for growth or just go for it and see what happens? How do I benchmark our performance against others?
If you are in the process of rethinking what your growth target should be the “Rule of 40” may be a useful framework.
What is the Rule of 40 and why is it useful?
The Rule of 40 is a measure of how successful the organisation is. It is a figure derived from combining your revenue growth with your profitability. Ideally, this figure should exceed 40%. It is suggested that if this measure of performance exceeds 40% then the business is generating a sustainable growth rate whereas organisations, where the combined figure is lower, are more likely to face liquidity challenges.
So in practice, this might mean you are generating growth at 20% and profit at 20%. Or, if you are in a hyper-growth stage it might mean you are growing at 50% and not generating any profit at all.
Why is this useful
First off, the Rule of 40 was originally conceived by VCs as a means of assessing a firm’s potential for creating returns in the future. So it may be used by VCs and other investors as a basis for judging whether to invest in your organisation or not. Even if you are not considering this currently, you may like to be performing at this level in case it becomes an avenue worth pursuing in the future.
Secondly, if you have a combined growth and profitability rate of over 40% then it suggests that you have room for manoeuvre and change if necessary. Also, it provides a useful measure when benchmarking against competitors or similar growth organisations.
Finally, the Rule of 40 is a good way to plan your growth through stages. When you will focus on revenue growth and customer acquisition and when the mix can be changed to focus on margin and profitability.
As an SME you can use this measure to alter sales and marketing plans to attract, secure and service a rapidly growing customer base while keeping investors happy when profit margins at this stage might be lower.
How is it calculated?
I am sure you don’t need me to tell you how to calculate revenue growth rate, just bear in mind the various accountancy rules for what constitutes revenue in a SaaS organisation.
Profitability margin definition can also vary, but the most commonly used figure for the Rule of 40, is EBITDA (earnings before interest, taxes, debt, and depreciation).
Here is an example.
If a SaaS organisation generates £8 million in revenue in 2021 and £10 million in 2022, then its year-on-year revenue growth would equal 25% (2/8 multiplied by 100%).
From a profitability point of view, if in 2022 the EBITDA was £1.6 million then the profitability margin for the company would be 20% (1.6/ 8 multiplied by 100%).
So in this example, the company’s revenue growth plus profitability margin would equal 45% (25% plus 20%). This reveals that the company has “exceeded” the Rule of 40 and is potentially well-positioned for the future.
Of course, the next question might be, is your chosen growth target realistic given your business/market circumstances? This is obviously a significant question that needs to take into account a whole range of factors. Perhaps our "7 Step Programme for Restoring Growth" might help?
Benchmarking insights:
If you are interested in benchmarking your business performance against others here are some useful references with benchmarking data for SaaS:
Hubspot- Expansion SaaS Benchmarking study
SAAS CAPITAL - 2020 Private SaaS Company Growth Rate Benchmarks
Finmark - Metrics Benchmark Report