In my last post I talked about Annual Recurring Revenue (ARR) and why it was such an important metric for a Software as a Service (SaaS) business. Although ARR is the most important metric to keep track of, there are other metrics you definitely need to measure. In this post, we will take a look at one of those important metrics called the rule of 40. Let's take a look at the Rule of 40, how to calculate it, and why it's important.
What is the Rule of 40? Why Does it Matter?
The Rule of 40 is a combination look at your company's margins and growth. The Rule of 40 simply states that if a company's revenue growth were added to its profit margin, the total should exceed 40%. Since SaaS companies typically don't have a lot of overhead, their profit margins should be high. However, if you don't have high margins, it's ok...as long as you are GROWING.
The Rule of 40 is a great indicator that your business is healthy. Making profits? If yes, great! If not, are you growing? If yes, still great! If not, then your business might need some help. Ultimately, investors want to invest in a growing business that is profitable and the Rule of 40 shows them that you are at least on the right track. Even if you have -20% margins, you can make up the difference with exceptional growth of at least 60%. As your company matures, year over year growth will inevitably go down. This is the time that you optimize your business and improve your profit margins. I mentioned in my last post that ARR was a sign of stability, the Rule of 40 reinforces that stability.
How Do You Calculate the Rule of 40?
Like I mentioned earlier, the Rule of 40 has a growth component and a margin component. For the growth rate, the best value to use is year over year ARR growth. Take your current year's ARR, subtract your previous year's ARR and then divide by your previous year ARR. That's your growth rate. For a company less than one year old, quarterly or monthly recurring revenue can be used. Just make sure you call that out so investors aren't confused.
For margin, the best number to use is your EBITDA margin. To calculate simply divide your EBITDA by your revenue. Now add this number to the growth rate you calculated earlier and you have your Rule of 40. This number is always expressed as a percentage and generally evaluated in a binary fashion. Is your calculated percentage greater than or equal to 40% or not. If your not hitting the 40% number then your business isn't efficient or isn't growing. Either way that should cause concern.
Summary
The Rule of 40 is an excellent compliment to the ARR and definitely a metric you need to be measuring. It is a great indicator to the overall health of your business. If you are having trouble calculating the Rule of 40, feel free to reach out to us at InfleXion Point. We are happy to help!
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