Rule of 40 for SaaS
And why it’s flawed
Gun to your head: as an early stage SaaS business, assuming you have enough cashflow to operate the business, would you rather have: Growth or Profit? You have to choose one. Which would it be?
For anyone who has worked with the Rule of 40 concept, you might say that actually it doesn’t matter so long as either one is sufficiently high. Because that’s kind of what the Rule of 40 tells you to think. But I’m not so sure this is true.
The Rule of 40
This long held rule has been something that I’ve been aware of pretty much since I first got into SaaS. But it’s always one that I felt a bit sceptical about in part because growing is hard, reducing your costs to hit profitability feels relatively easier - just spend less. Plus is any decent investor going to be excited about your SaaS business that isn’t growing but is making 40% EBITDA?
Nevertheless, you’re told that from an investor and potential acquirer’s point of view, you have to abide by this rule to be taken seriously.
If you don’t know already, the Rule says that so long as your growth rate and profitability (or loss), when added together make 40, then you’re doing good. In summary:
Growth Rate + Profitability > 40
In part, this helps loss-making companies (as early-stage SaaS companies tend to be) get a handle on whether their growth is sufficiently high to justify how much they are losing in profit. And for that reason it’s very helpful. The normal business yardstick of your costs being less than your income go out of the window so how are founders supposed to know what is good?
As an example, if you are growing at 30% and your profit margin is 15% : that gives you 30 + 15 = 45. You’re at 45 - well done.
But you could be loss-making and still be OK. You could be growing at 100% YoY but making a 50% loss : 100 + (-50)= 50. You would be at 50 and still be above the magic 40 benchmark. At ScreenCloud in the early days when we were growing at more than 200%, hitting the Rule of 40 was a breeze no matter how much we were losing from a profit perspective.
However, if you are doing 20% profit (pretty good for any ‘normal’ business) but you are only growing 10%: 20 + 10 = 30. You are under 40 so in the danger zone.
Is Growth interchangeable with Profit?
But the question for me here is ‘Is Growth as valuable as Profit?’. Would a 30% growth/10% profit company be just as good as a 10% growth/30% profit one if they both had the same ARR? Because this is exactly what the Rule of 40 implies. It basically says, it doesn’t matter how that number is comprised so long as you are at 40 or above.
I’ve written before about the current sentiment that capital efficiency is more important than growth. And I think this has had an impact on SaaS businesses. But I think of it more of a correction to the ‘growth at all costs’ sentiment that I witnessed in 2020/21. It’s also set against a backdrop of investment being harder to come by and companies potentially running out of money as they scale. A few years ago they could rely on the fact that they would have ready access to more capital as they needed it.
But I’m gonna go out on a limb here and say, unless you are going to run out of money sometime soon, growth trumps profit. I’d rather have a 30% growth/10% profit SaaS business than a 10% growth/30% profit. In fact I’d rather have 100% growth and 60% loss if my cash reserves were sufficient to keep the business operational.
So while the Rule of 40 isn’t terrible: having only a 15% YoY growth against a 5% loss isn’t great, for example. Its assumption that every percentage of growth has the same value as every percentage of profit on the Rule of 40 see-saw is wrong. This is especially true as you get closer to breakeven.
Got any evidence, Mr Hart?
Yes. This is more than just a gut feel. Growth is more important in the long-term. Sam Bondy and Byron Deeter from Bessemer Venture Partners have written about the value of growth over profit from a valuation point of view.
As they explain, the difference between growth and profit is that profit has a linear impact on value but growth has a compounding one. Looking at numbers over time and how that correlates with public market valuations they say that even in tight markets, growth trumps profit by a factor of between 2x and 3x!!
So, in actual fact growth is worth 2-3x as much as profit. On the Rule of 40 see-saw, each percentage of growth could be 3x as heavy as profit. In effect, it makes the new formula:
(Growth Rate x 3) + Profit > 40
With the new rule, a company doing 20% Growth but only 5% Profit gives you (20 x 3) + 5 = 65 and gets past that magic 40 number easily.
But one that has those numbers the other way round and doing 5% Growth and 20% Profit, (5 x 3) + 20 = 35, isn’t looking so rosy.
Because the growth multiples are higher especially with earlier stage SaaS businesses, a good company would probably be at around the 50 mark and really good ones at 70+. At a later stage, 40 would still be a good number.
What does this mean?
Even in a capital efficient world (where pressure is on to spend each dollar wisely), this shouldn’t be at the expense of growth unless you need to conserve cash. (To be clear, running out of cash is way more disastrous than slower growth!) But if the judgement was more ‘should we end the year $200k down, but 20% more growth, or should we get to a positive EBITDA and hit lower growth numbers?’ then, if you have the reserves, go for growth every time.
