The Rule of 40 Why SaaS Executives Should Be Obsessed with It

Nine times out of ten, if you ask a founder or CEO of a SaaS company what their main priority is, they will respond in one word: "growth." Why is clear to see. Everyone enjoys bragging about how quickly their business is expanding, and in recent years, investors have rewarded businesses that can generate significant growth.

The most recent Cloud Quarterly study from Batteries, however, indicates that times are altering. Growth still matters, of course. Yet, it is not the only factor to consider. Investors are choosing a more controlled and sustainable approach over "growth at any cost" as of late. Sure, they want to see expansion, but they also want it to be supported by responsible leadership and a clearly defined route to profitability in these difficult circumstances.

The most intelligent SaaS CEOs of today are therefore preoccupied with the "Rule of 40" rather than expansion.

Why is the Rule of 40 so important to the top SaaS leaders?

The key is to gradually increase economic value (EV). In order to illustrate the "Rule of 40" and the variation in economic value (also known as valuation) across companies based on where they sit on the Rule of 40 graph, numerous VCs and growth equity firms (including Batteries, which is the main owner of Maxio) have produced papers on the topic. Volition Capital's Viewpoint, which is available here, is one that I really appreciate. Battery's most recent research looked at and plotted a number of publicly traded companies on a Rule of 40 Graph, which amply demonstrated the increase in EV for those in the green zone (high growth and higher EBITDA).

Knowledge of the Rule of 40

You can use the Rule of 40 to assess whether your emphasis is too much on growth at the expense of profitability. It operates by multiplying your profit margin by your current 12-month growth rate (expressed in percentage terms). If the outcome is 40 or above, you're in the clear; if it isn't, you're doing it incorrectly.

In other words, if your growth rate is 80% annually, you can afford to have a profit margin that is as low as - 40%. If your business is expanding at a 40% annual pace, you can afford to run at a loss-making level. And if your profit margin is 20% or greater, you're doing OK even if your growth rate is only 20% annually.

That is a considerable departure from accepted wisdom. Many SaaS companies have long believed that if they are reporting annual growth rates of 80%, 100%, or 120%, nobody will question their route to profitability, and if their growth rates go down by 20% or 30%, nobody will notice how profitable they are.

Not every Rule of 40 company is the same.

But, given the recent market volatility, it is definitely not a favorable profile to have an 80%+ growth profile and -40% EBITDA. Batteries claims that the economic slump has increased the importance of the Rule of 40. The wisest course of action is no longer to rely on hypergrowth to lead you to a significant exit. Founders are being forced to conserve money and increase their runway as VC funding wanes. Because of this, slow, sustained growth that is accompanied by a reasonable degree of profitability is more important than rapid growth at any costs.

How this affects you

The Rule of 40 demands many things from various parties, including:

Investors must make sure they are conducting their due research and funding long-lasting businesses. Expansion without a clear road to profitability is useless, much like spending cuts that are implemented at the expense of current or potential revenue sources. It is crucial to have steady, sustained growth that is supported by wise monetization and spending practices.

Entrepreneurs must make sure they have access to the appropriate financial indicators. Of course, burn rate is crucial, but don't ignore the money pouring in. You must manage growth and expenditure concurrently and make sure you have data-driven insights into indicators like recurring revenue growth, client attrition, etc. if you want to get a handle on your Rule of 40 compliance.

Workers need to be aware that disciplined growth is the new standard and that new or different types of spending, as well as spending that is reduced or more carefully measured, may be required. That doesn't imply that the business is in a panic or about to run out of money; rather, it indicates that it is developing and preparing for the long term.

What links these things together? The financials and KPIs that allow you to accomplish not just growth but durable growth at a sustainable pace are the focus of this obsessive attention to the nuts and bolts of your expanding firm. In today's rapidly evolving SaaS world, you can only simultaneously unlock growth and profitability with real and ongoing visibility into and control over these essential indicators.

A fresh strategy

The Rule of 40 is the new playbook for enduring SaaS enterprises, to sum up. Making informed, data-driven decisions that will offer their businesses true lasting power should be the main emphasis of investors, entrepreneurs, and workers. This entails creating a strong road to profitability as well as the financial toolkit you need to unleash the next level of growth.

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