What is The Rule of 40 for SaaS and Subscription Business?

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What is The Rule of 40 for SaaS and Subscription Business?

Vaishnavi Shah

Published August 15, 2022

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With 73% of businesses planning to switch all systems to SaaS, the industry is becoming fiercely competitive. This is why, to beat the competition, companies must scale their operations and focus on innovating. 

One of the best ways to do that is to raise capital for product development and look for dynamic partners who can help you grow your business. 

But for most SaaS and subscription businesses, figuring out the correct valuation methodology is overwhelming. There is no vanilla approach to doing this. While traditional valuation methods are helpful, understanding other indicators of success is vital for looking at the long-term viability of the business. 

One of the essential valuation metrics in the SaaS space is the rule of 40. This rule gained prominence when Brad Feld, a successful venture capitalist, wrote an article in 2015 on it and discussed how SaaS companies should build successful business models. 

Let’s discuss the rule of 40 for SaaS businesses in detail and how to calculate it for your enterprise. 

The Rule of 40: Why It is Important for SaaS Businesses?

Before discussing the rule of 40, you should ask yourself- How would you define a successful SaaS business? 

Because for most business owners, success looks different. And this can lead them to the unprofitable SaaS business model trap. This trap is where a business has an impressive revenue and a year-on-year growth rate but lacks profitability. A classic example of this model is when X company does 80 million in revenue with a 59% year-on-year growth rate. The only thing is that they lost 55 million. 

From the above example, we can conclude that company X does not have a healthy balance between growth and profitability. It focuses only on growing, making its business model unsustainable in the long run. 

This is where the rule of 40 in SaaS comes into play. 

It states that a healthy SaaS company should have combined growth and profit rate of up to 40% or more. So, if you are growing at 40%, your profit should be 0%. Similarly, if you are growing at 30%, your profit percentage should stand at 10%. With this rule, you are not compromising your growth or profit and keeping a healthy balance between the two.  

But Does This Rule Work for Early Stage Start-Ups?

While the rule of 40 in SaaS is considered a benchmark, a compelling argument by experienced SaaS executive and angel investor David Kellogg presents valuable insights. 

In his research paper, he states that while the rule of 40 does have merit, many companies target it too early and end up losing opportunities to generate growth and retain customers. This can hurt their valuations. So, early-stage SaaS companies should look for other relevant metrics and benchmarks to determine their valuations. The simple yet effective rule of 40 is more suitable for mature SaaS companies. 

How to Calculate the Rule of 40 in SaaS?

From the above discussion, one thing about the rule of 40 in SaaS is relatively simple- It wants you to continue growing at scale while focusing on profitability. 

The Rule of 40= Growth+Profit= 40% or more. 

For calculating the above, you need accurate data. So, let’s learn how to calculate the two critical drivers of this rule: growth and profit margin!

For calculating the above, you need accurate data. So, let’s learn how to calculate the two critical drivers of this rule i.e. growth and profit margin for better clarity!

  • Growth

In the competitive SaaS industry, consistently performing and growing at scale can be challenging. Doing proper revenue analyses and comparing it with market growth rates can help you figure out what’s working with your customers and what your competitors are doing. To calculate the growth rate, you can use the formula below to know how fast or slow you are growing. 

Growth Rate Formula= Current Revenue-Past Revenue/ Past Revenue*100

  • Profitability Measurement

Calculating the profit margin can be tricky as there is no set methodology for it. Most companies usually rely on the EBITDA method. That is dividing the gross profit by the revenue and multiplying it by 100. 

Benchmarks of Rule of 40!

Now that you know how to measure the rule of 40, let's look at how investors use it to gauge your company's financial health. 

  • Above 40: Investors are attracted to SaaS companies that can maintain their growth rate and profitability margins above 40%. But this also means you may have to reassess your strategy and look for new ways to sustain this impressive growth. 
  • Between 20-30: Being at this stage is ideal. Investors may look at your portfolio and think favorably. 
  • Below 20: Investors may think your profits and growth rate aren't enough to cover the other. It is time to look for strategies to become more efficient and profitable. 

How Are Leading SaaS Companies Utilizing the Rule of 40?

No matter which industry it is, every company has its own unique challenges. Yet some players emerge as winners. Whether you are an entrepreneur struggling to improve your product offerings or an enterprise looking to gain market share, here are some valuable patterns the big SaaS players use to stay at or above the rule of 40!

  • Focusing on User Experience

SaaS leaders have mastered the fundamentals. They understand the value of customer experiences and do their best to set high standards. From creating a personalized onboarding process to monitoring digital touchpoints, leading SaaS players constantly experiment. They know that focusing on granular details and prioritizing user experience can help them survive the fierce competition.

  • Realizing Realistic Targets

Setting high sales goals and achieving them is the pipe dream of every SaaS company. But the reality is that lofty goals and unrealistic expectations never helped anyone. A recent study by McKinsey states that high-growth SaaS companies set their revenue targets by analyzing their existing portfolio over three years and then deciding on what is achievable organically. 

  • Boosting Operational Efficiency

Operational efficiency is a powerful growth engine for every business. It includes identifying and implementing processes to eliminate the time-to-market products and save resources. Continuous streamlining, process automation, and adopting an agile mindset can help you boost efficiency. Another way successful SaaS companies enhance operational efficiency is by using data analytics to identify and prevent potential issues. 

Create Greater Value for Your Business Today!

Over the past seven years, the SaaS industry has grown by more than 500%. In such a high-growth industry, getting ahead of the curve is becoming exceedingly important. Thankfully, the rule of 40 in SaaS can help you gauge your performance and attract potential investors. Whether you are growing or are at a mature stage, this benchmark will help you reinvent your strategies to achieve your goals. 

If you are looking for more tips and resources to grow your business, you can check out our blogs here! Also, if you need help scaling your business, we have the perfect cloud solutions to set you up for success. Feel free to drop us a mail for any queries!

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