The Rule of 40: Balancing Growth and Profit
The Rule of 40 is a metric that measures the equilibrium between sustainable growth and profitability for later stage companies. This principle has found resonance with many investors and analysts, particularly in the context of listed SaaS and tech companies.
Made prominent by Brad Feld, I’ve found it has relevance in later stage companies across the software, e-commerce, and digital services industries. For startups and early-stage companies that are looking to raise venture capital, the growth expectations are higher (see the T2D3 framework, linked at the end of this post), then once at scale, the Rule of 40 will often apply.
Here's how it works
Calculating Rule of 40:
Growth Rate %: The percentage increase in revenue compared to a previous period.
Profitability Margin %: The percentage of profit margin compared to a previous period.
The sum of these two components should ideally equal or exceed 40%:
Growing at 20% means generating a profit of 20%.
Growing at 40% can mean generating a 0% profit.
Growing at 50% might imply a loss of 10%, and so on.
Considerations
Calculating Revenue: This can be straightforward, using the current month, quarter, or year against the previous period for revenue (e.g. Annual Recurring Revenue or Monthly Recurring Revenue, as relevant).
Calculating Profit: This can be more complex and lacks a uniform approach. We tend to use EBITDA for simplicity. However, we’ve seen others use everything from EBIT to Net Income and Free Cash Flow. The relevant calculation will depend on the industry, the company’s maturity and the investor or buyer preferences in the situation.
Implications for Truly Great Later-Stage Companies:
They can sustain the Rule of 40 over a long duration (e.g. over many years)
They might even grow at "better than rule of 40," referred to as ‘a multiple of rule of 40’. For instance, a growth rate of 60% YoY and 20% profit margin represents a “2x” for Rule of 40.
Investors tend to reward later-stage companies aligned with or surpassing the Rule of 40 with higher valuations, particularly if the growth rate substantially outweighs the profitability margin (e.g., 30% growth and 10% profit might be rewarded with a higher multiple than 10% growth and 30% profit).
Final thought
The Rule of 40 is more than just a metric; it's a philosophy that aligns sustainable growth with profitability, helping later stage companies navigate towards being Truly Great.
