At its core, the rule of 40 focuses on the never-ending quest to balance the tradeoff between growth and profit. It’s hard to have a high profit AND high growth at the same time. There’s a trade off, and you need to determine where you fall in this equation.
If you are experiencing high revenue growth, it’s unlikely that you have high margins, because you are likely investing heavily in sales and marketing. On the flip side, if you have low growth, you’d better be generating high cash flow and high EBITDA margins to be attractive to your shareholders, investors, and potential acquirers.
It’s okay to be one or the other. Just recognize where you land in the tradeoff. The Rule of 40 metric helps you quantify the tradeoff between growth and profit. It’s grading you on the execution of profit versus growth.
You should measure the Rule of 40 when you’re a more mature company, for example when you’ve built out most of the common, functional departments within your SaaS company. Startups should not be measuring this, because in startup mode, it’s more about product/market fit, go-to-market strategy, and cash flow. The Rule of 40 depends on the stage of your company and your accounting policies. It is important to compare yourself with similar companies, especially around accounting policies. For example, a business capitalizing all development costs verses one that expenses all tech development will look different because the development costs would be disproportionately large in the second case and would be unlikely to meet the Rule of 40. However, from a cash-flow and investor perspective, the two businesses would be the same.
When you calculate the Rule of 40, you need to use a time period that’s truly reflective of your growth and profit margins. You could use Year-to-Date values, or you could calculate it on a trailing twelve month period over the prior twelve months and continue to roll forward the calculation each month. The advantage of the second approach is that it gives you enough data to minimize any month-to-month fluctuations that might make smaller measurement periods unreliable.
The Rule of 40 matters because it impacts valuations and returns. According to Bain and Co, software companies that can balance growth and profitability to consistently outperform the Rule of 40 have valuations (measured by the ratio of enterprise value to revenue) double that of companies that fall “below the line,” and they achieve returns as much as 15% higher than the S&P 500.
