It’s been something I have been using for several years now. When I analyze a SaaS company, should I focus on its profit margins or growth rate?

Some CEOs push for expansion at all costs. After all, high-growth companies always seem to do better than slower-growing ones. But this can take them down the wrong path if the expansion is done at the expense of profitability.

So how do I balance the two aspects? Enter the rule of 40 (RO40). A performance metric, the RO40 is based on the premise that a company’s growth rate and profit margin should equal at least 40%.

The Rule of 40’s Core Drivers

This assessment indicator concentrates on two things:

1) Growth rate (%)
2) Profitability (%)

We’ll take a closer look at both of these concepts.

Growth Rate

To determine your firm’s growth rate, you can use either recurring revenue or gross revenue growth rate.

I always prefer recurring revenue because it’s constant and reliable. It tells me the specific amount of revenue that my firm is earning from those clients who are on a subscription; hence, giving me a more accurate evaluation.

If the recurring revenue is constantly increasing, it shows that efforts to expand the venture are paying off.

Profitability

Although there are many metrics for determining a company’s profitability, the most commonly used is Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). It sums up the net profit and payments made on interest, taxes, depreciation, and amortization.

The reason why this indicator is preferred is that it gives an accurate assessment of the SaaS company’s financial health. More specifically, it shows its ability to meet debt obligations.

How to Calculate the Rule of 40

Illustration

Here is an simple example

Acme Start up June YTD

                     2020        2019

Recurring Revenue    37,000        28,000
COGS                 15,000        10,500
Gross Margin         22,000        17,500
OpEx                 14,000        12,000


EBITDA                8,000         5,500

 

2019: EBITDA =5,500/28,000 = 20%

2020: EBITDA =8,000/37000 = 22%

If the growth rate in 2020 is 21%

Then the rule of 40 is: 21% + 22% = 43%

Since it’s above 40%, it shows this SaaS company is balancing its growth and profitability well.

Conclusion

The rule of 40 is a metric that makes it easy for a SaaS company to balance between profit margins and growth rate. It does this by summing up the value of profitability and growth rate. An outcome that is 40% or higher indicates that the firm has a good balance, and vice versa.

What I like most about this framework is that it leaves room for adjustability and creativity for SaaS project development.

For instance, you can decide to focus solely on growth while keeping the net profit margins stable. As an illustration, the growth ratio can be 30% and the net margin at 10%. The important thing is that you never go below the 40% benchmark.

This model also helps SaaS companies plan for the future. Keeping abreast with the current growth rate and profitability allows you to map out strategies for the next business cycle.

That said, the rule of 40 is not a sufficient metric for assessing business health. So rather than rely on it exclusively, it should be used alongside other indicators to give a complete picture.