If you’re anything like the average SaaS business, you’re likely focusing on customer acquisition and retention as the primary way to push forward. Yet looking only at your growth rate without considering profit margins or clinging to the same development strategy no matter your results (or worse yet – not analyzing your results at all) can make you get stuck on one of the typical 1’s and 3’s milestones.
While you may have heard that hips don’t lie, we prefer to think that factual data is even more truthful, especially when it comes to SaaS success. Introducing – the Rule of 40, your gateway to building a healthy, data-based SaaS startup financial model. Treat it as the rule of thumb for smartly diverting your growth strategies to remain profitable in the long run – every SaaS company’s dream, right?
Read on to find out what this rule is about and how to tell whether you’re meeting the ideal industry benchmark. We don’t encourage skipping the theory on this one, but if you’re impatient, scroll down to our Rule of 40 calculator and practical financial modeling software solution.
The Rule of 40 is a popular software industry metric for measuring business development health. It states that a SaaS company’s growth rate plus profit margin should be 40% or higher. This means that, for example, if you’re growing at a 10% rate, you should generate at least 30% profit.
The term was coined by Brad Feld (or actually – an investor at one of his meetings), saying that the 40% rule is a “minimum point of happiness” for a healthy SaaS company (or any software business, for that matter).
Keep in mind that these numbers are just the tip of the iceberg of the key SaaS metrics you should measure; still, they’re a quick way to illustrate software companies’ operating performance and potential value.
The Rule of 40 formula is simple enough:
However, this can get confusing once you dive deeper, as finances often can, particularly for people just starting in the topic, so let’s explain.
The growth rate can be your year-over-year revenue growth of MRR or ARR. It paints a clear picture, reflecting the company’s ability to scale and capture market share.
The profitability margin is the percentage of revenue that remains as profit after deducting expenses. Brad Feld’s recommended baseline for calculation is EBITDA (earnings before interest, taxes, depreciation and amortization), but you can also use un-levered free cash flow, operating income etc.
Whatever you choose, this number is linked to your company’s operational efficiency and profitability.
Say your company generated $5.7M in 2022 and $8M in 2023. To get a growth rate, subtract the previous year’s value from the current year’s value. Then, divide the difference by last year’s value and multiply the result by 100 for a percentage. In this case, your company’s revenue growth rate – considering year-over-year ARR – is 40%.
($8M – $5.7M) / $5.7M x 100 = 40%
We’ll use this number as your company’s revenue growth rate.
Now for the profit margin.
Let’s say your EBITDA for 2023 was $400,000. To get the profitability margin, divide this by the ARR and multiply by 100 for a percentage. Your profitability margin would be 5%.
$400,000 / $8M x 100 = 5%
We’re almost there – now just put it all together.
40% + 5% = 45%
Congrats! Your result is 45%, so you exceeded the Rule of 40 threshold.
Don’t worry if some of your numbers are negative. You can still be on the right track, even if that’s the case. For example, when your growth rate is 50% and profitability margin -10%, the total is still an optimistic score of 40%.
The Rule of 40 creates a unified metric for measuring and comparing SaaS companies’ performance. It’s definitely not the only agency metric you should track, but it’s a good place to start. Here are a few of its advantages:
Brad Feld initially meant this metric for companies that see at least $50 million in revenue, extending it to those that achieve $1m of MRR.
While this isn’t a fixed divide, we still don’t recommend starting with it as a measure of success in small business financial management. Early-stage startups should prioritize dynamic growth over profit in their first development steps, which could mean erratic changes in their Rule of 40 results. For more mature companies, this growth-to-profit balance is a pretty good measure of their chances at sustainable success.
Overall, you can always use the Rule of 40 to gauge your sustainable success, but don’t treat it as your oracle. We encourage you to dive deeper to get transparency on your finances – we’ll discuss how in a second.
We created this valuation calculator to make things easier for you. Using it is as simple as filling in your data and updating market ratios relevant to your industry (don’t worry, we provide links to where you can find those).
That’s literally it. The template shows your total actual company value (including hardware and software values), Rule of 40 (of course), plus some more valuations. We included helpful comments to guide you whenever you get stuck on a tricky term.
As a team of experts in managing business finances, we have plenty more to offer than a valuation calculator to help you ace your growth game in the wildly competitive SaaS market.
Fuelfinance is your answer to the nagging question of how to do a financial analysis. It provides an all-in-one dashboard with your most important metrics and suggestions of KPIs that match your SaaS financial model, not just the Rule of 40 discussed in this article.
The full product combines cloud-hosted spreadsheets and access to a dedicated financial manager acting as your outsourced CFO. All financial data is pulled automatically from your accounting software via our smooth QuickBooks integration. This ensures all your revenue and expense information is always up to date while saving time and minimizing errors.
We make baseline and optimistic financial forecasts for your startup, so you don’t encounter any unpleasant surprises in the form of running out of cash. With all your data neatly organized and turned into scannable, visual insights, you can direct your energy to making wise business decisions. If you ever need help with those, our experts are there to help!
We also have something special up our sleeve for smaller, pre-seed stage startups that can’t afford (or just don’t need) this array of financial management solutions. Our free Bootstrap plan gives the leg-up you need, with tools for creating financial statements and financial planning in the familiar Google Sheets interface, with tutorials for inputting data. You can easily upgrade to get the QuickBooks connector or the help of our finance professionals.
If you remember just one thing from this article, let it be this – while the Rule of 40 is a good benchmark for assessing your growth and profit relation, it’s not a tell-all metric.
To better understand your SaaS business’ health, you need good financial analysis software such as Fuelfinance. The combination of a wide range of up-to-date insights and the help of a fractional CFO is everything you need to make data-driven, strategic decisions without ever running out of cash. Not to mention, investors are bound to be impressed with the detailed reports to back up your Rule of 40 result.
Schedule a demo to see exactly how Fuelfinance can support your growth.
The formula for the Rule of 40 is Growth Rate (%) plus Profitability Margin (%), which should add up to at least 40%.
To simplify the calculations, use your YoY MRR as the growth rate and EBITDA as the profitability margin.
The Rule of 40 is still applicable, particularly in the SaaS industry, because most SaaS companies typically see high margins. This metric serves as a simplified benchmarking method to assess sustainable growth. However, it’s not particularly informative on its own, so we suggest pairing this metric with more in-depth financial planning software tools.
The Rule of 40 strikes a balance, ensuring companies don’t sacrifice too much profitability for growth or vice versa. It’s also a benchmark for investors and stakeholders, showing long-term potential for good results. Overall, this rule gives a rough guide on reaching a sustainable business model while being easy to calculate.
If a SaaS startup had a $5M annual revenue in 2023, a YoY growth rate of 20% and the company’s profit margin was 15%, their result is 20% plus 15%, which is 35%. That means they didn’t reach the 40% threshold, aka their future looks a bit risky, so they should investigate their other SaaS metrics to identify where the issue lies.
Brad Feld, venture capitalist at Foundry Group and co-founder of Techstars, originally established the Rule of 40. He initially recommended it for SaaS companies that exceed their first $1 million in annual recurring revenue.
