If you are a SaaS business, it is important for you to learn about SaaS Rule of 40 because:
- It helps you the know the performance of your business
- Achieve a trade-off between profitability and growth
- Optimize costs to achieve the requisite growth rate
Cloud-based SaaS offerings have disrupted industries across the globe as the end-users embrace this enhanced technology. This means that such a disruption would require the SaaS business owners to optimize business performance and gain a deeper understanding of the growth drivers. Such an understanding will help them in enhancing their competitiveness and increasing their future financial success.
To have such an understanding, it is important for a SaaS business to value its company. However, company valuation is a challenging task, especially for tech companies. This is because they differ significantly in some of the basic aspects that are fundamental for the application of common valuation methods.
Note that traditional valuation methods are not designed for the characteristics of tech companies. Further, traditional GAAP accounting is not as useful for SaaS businesses as for many other industries.
This is partly because of the annuity nature of the revenues. In such a case, the sales costs are expensed upfront. However, the revenues are recognized evenly over the lifetime of the customer.
In the end, it all boils down to profitability and cash generation. Therefore, SaaS businesses review the ‘underlying profit’ and unit economics in order to assess the long-term viability of the business.
This means to know how well a SaaS business is performing, we have to use different financial metrics. One of the financial metrics that help in knowing the performance of a SaaS business is the rule of 40.
In this article, we are going to discuss what is the rule of 40 SaaS, the rule of 40 SaaS calculation, and the rule of 40 for a healthy saas company.
What is the Rule of 40 SaaS?
The Rule of 40 SaaS says that a SaaS company’s growth rate when added to its free cash flow rate should equal 40 percent or higher. Such a metric evaluates the relationship and balance between growth and profitability.
Note that there exists a trade-off between growth and profitability. That is, a business can either target profitability and reduce focus on growth. Or it can focus on growth at the expense of the short-term profitability of the business.
Thus, a combination of growth and profitability can help a SaaS business to understand the short-term impact of growth on profitability.
Accordingly, if a business is in its growth phase with an 80% growth rate, it is acceptable that it generates 40% margins. Likewise, if a company is in its maturity phase with a 20% revenue growth rate, it is acceptable that it generates 20% margins. Finally, if a business is in its scale and optimizes phase with a 40% growth rate, it is acceptable that it generates 0% margins.
Why is it important for a SaaS business to achieve a number equal to or higher than the rule of 40? It is because as per research, investors reward companies that are at or above the Rule of 40 having consistently higher enterprise value (EV) to revenue multiples. Moreover, the higher the number, the greater is the gain to the SaaS business.
Despite higher growth rates tracked in the SaaS segment, only a small share of SaaS companies are able to sustain growth rates above 30 to 40 percent.
As mentioned earlier, a SaaS business needs to sum up its growth percentage and gross margin percentage to obtain this number.
Rule of 40 SaaS Valuation
Valuing a tech company is complex as it differs greatly in some of the basic aspects that are fundamental. The traditional methods of valuation like Discounted Cash Flow Model (DCF), Comparative Company Analysis (CCA), and Comparative Transaction Analysis (CTA) are not reliable enough for the valuation of a SaaS business.
For instance, the biggest challenge with DCFs is that the growth rate is hard to predict. Further, negative FCFs or high reinvestments are not compensated enough in DCFs. Therefore, it is difficult to use DCFs for SaaS companies than mature non-tech companies. Likewise, the CCA or CTA techniques are challenging to use for valuing tech businesses. That’s because tech companies are new in the market and thus do not provide a reliable base of companies and transactions to use as comparables.
However, as per research, the valuation of many tech and high-growth companies are based on comparable companies in comparable financial market environments.
Thus, in this section, we will look at the possibility of valuing a tech or a SaaS business using multiple valuation methods. However, such a valuation is done based on the Rule of 40.
Note that the Rule of 40 is a rule of thumb that tech or SaaS businesses use to determine whether a business is performing or non-performing. Further, the Rule of 40 SaaS is nothing but the sum of the operating profit of a SaaS business and its revenue growth.
As per this rule, the rule of 40 number is nothing but the sum of a SaaS business’ growth percentage and the margin percentage. Accordingly, the two numbers of a SaaS business add up to 40 and the company is able to maintain this number over the years, then such a company is performing well. Further, such a number also indicates that the company will continue to perform in the future as well.
Rule of 40 SaaS Multiples
The rule of 40 SaaS multiples comprise of the following indicators or metrics:
- Revenue Growth + Operating Profit as a % of Revenue (EBITDA Margin)
- Gross Profit Growth + Free Cashflows as a % of Revenue (FCF Margin)
- Revenue Growth +Free Cashflows as a % of Revenue (FCF Margin)
Besides these combinations of growth and profitability, a SaaS business can also use revenue growth and gross profit growth as separate indicators.
I. Growth Metrics: Revenue Growth and Gross Profit Growth
The difference between revenues and gross profit of a SaaS business is whether the Cost of Goods Sold (COGS) is incorporated in the calculation or not.
Note that revenue refers to the total amount of money that a business generates through its operations. Whereas, Gross Profit refers to the difference between the revenues and the COGS of a SaaS business.
Here, COGS refers to the sum of all the direct costs used to provide a good or service to the end-user.
Such costs may include the cost of labor, other direct costs such as maintenance costs of the data centers or technologies used to develop the SaaS product. Note that COGS does not include indirect costs like selling and distribution costs.
Now, to determine a company’s value, businesses typically use company revenues to determine their growth rate. Further, a company’s value is based on its capacity to generate cash flows and the uncertainty associated with such cash flows. Also, both revenue growth and gross profit growth are related to a company’s capacity to generate cash flows. Thus, both these metrics seem to be the most appropriate multiples to value a SaaS business.
This is because revenue growth is a direct indicator demonstrating the amount of money a company generates without considering its costs. It is a relevant number that gives an idea about the performance of a SaaS business within no time.
On the other hand, the Gross Profit indicates the real performance of a SaaS business. This is because such an indicator signifies the amount of money that remains with the business after considering all the standard costs incurred for delivering a product or a service.
Say, for instance, a SaaS business generates decent revenues while selling all of its products at a loss. Since such a business is selling its products at a net loss, the revenue growth would not indicate the true performance or success of the business. In such a case, it is relevant to use gross profit margin as a performance indicator.
But here is a caveat. Relative to the gross profit growth, revenue growth is a more reliable indicator. Although it does not indicate everything about the business.
II. Margin Metrics: Operating Profit As A % of Revenue and Free Cash Flow As a % of Revenue
Operating profit as a percentage of revenue and Free Cash Flow as a percentage of revenue are the two margin indicators that are used to calculate the Rule of 40 for SaaS Companies.
Both these indicators signify the portion of revenue that remains after paying all the costs. Now, the major difference between these two margin indicators is that the Operating Profit includes capital expenditure (CAPEX). Whereas, to calculate the Free Cash Flows, a SaaS business has to deduct the CAPEX.
The challenge in calculating CAPEX in the case of SaaS companies is that it is quite difficult to differentiate between the expenses that form a part of CAPEX and the ones that do not.
For instance, enhancing software and information systems is typically considered an operating expense. If this is the case, then the operating profit of the SaaS business will be higher than what it actually is. This means that the value of the business that its operating profit indicates is less reliable.
Because of this shortcoming, investors tend to use Free Cash Flow relative to the Operating Profit. They believe that the Free Cash Flows of a business are more reliable as compared to its operating profit. This is because the Free Cash Flows of a business consider all the expenses and demonstrate the actual Free Cash Flow that remains with the business.
Besides this, there is another reason why Free Cash Flows are a better metric to use. And that is the tradeoff between growth and margin based on marketing expenses is used to lower margins and increase growth. Also, the Free Cash Flows of a SaaS business exclude even the marketing expenses. This makes it an even more reliable metric to use.
Key Rule of 40 SaaS Multiples
EV/Revenue and EV/Gross Profit are the key multiples that SaaS businesses use to compare the value of their business with the company value calculated using Rule of 40 indicators. Out of the two valuation multiples, the most widely used and generally accepted multiple is the EV/Revenue multiple.
This is because the revenues of a SaaS business are less vulnerable to accounting adjustments as compared to the Gross Profit. Therefore, it is wise to use EV/Revenue multiple over EV/Gross Profit to determine the value of a SaaS business.
Thus, SaaS businesses combine the Rule of 40 indicators and valuation multiples to compare their company valuation with the valuation calculated using market multiples. The combination of the Rule of 40 indicators and valuation multiple that gives the strongest relation is Revenue Growth + FCF as a percentage of revenue in combination with the TEV/Revenue multiple.
Rule of 40 SaaS Calculation
It’s easy to value a stable, money-making business preparing regular accounting statements, having a stable history, and a number of comparable firms. However, it is quite challenging to value young companies that are in the early phase of their life cycle.
Revenue Growth Rate
The Generally Accepted Accounting Principles (GAAP) have clear definitions with regard to revenue. Thus, a SaaS business can use its most recent income statements and calculate the changes in annual revenues.
There are different ways to measure growth rate. But the most commonly used method is year-over-year growth % based on revenue calculated as per GAAP guidelines. Note that revenue determined using GAAP guidelines offers the most consistent basis for comparison, especially for mature SaaS businesses.
Early-stage SaaS businesses have to consider the Monthly Recurring Revenue (MRR) or Annual Recurring Revenue (ARR) growth. These revenue-based financial metrics are the most appropriate when calculating the Rule of 40 number.
Note that in the case of early-stage SaaS businesses, the MRR and ARR recognized in the financial statements is not as consistent as the revenue recognized using GAAP guidelines.
MRR is a growth metric that enables SaaS or subscription-based companies to forecast their expected revenue for a given month. In other words, it is a measure of how much revenue a business generates from the subscription payments that subscribers or customers pay each month.
Likewise, Annual Recurring Revenue (ARR) is a key performance revenue-based metric that measures the amount of recurring revenue to be collected by a SaaS business over a period of one year. In other words, it measures the annual run rate of recurring revenue from the current install base.
There are various measures to determine the profitability of a business. These include free cash flows, total operating income, and earnings before interest, taxes, debt, and appreciation (EBITDA). All such measures are calculated as a percentage of the revenue, in this case, MRR or ARR.
Since there is no defined measure of profitability that must be used to calculate profitability margin percentages, evaluating such percentages are a bit difficult. As a result, evaluating and tracking the rule of 40 SaaS becomes difficult.
In other words, each measure of profitability gives different outcomes. At times, such differences in outcomes give meaningful information to the business owners. To make things simple and encourage comparability across companies, EBITDA is used as a measure of profitability. Note that EBITDA does not include stock-based compensation (SBC) costs.
Let’s consider an example to understand how to calculate the rule of 40.
Rule of 40 SaaS Example
The table below calculates the Rule of 40 for Amazon:
|Unlevered Free Cash Flow||-$14,300,000|
|Stock Based Compensation||$12,757,000|
|EBITDA excluding SBC||$27,203,000|
|Operating Income excluding SBC||$12,122,000|
|GAAP Revenue Growth (%)|
|YoY GAAP Growth Rate (%)||22%|
|Profitability Margin (%)|
|Cash From Operations||9.86%|
|Unlevered Free Cash Flow||-3.04%|
|EBITDA excluding SBC||5.79%|
|Operating Income excluding SBC||2.58%|
|Rule of 40 (Growth Rate % + Profitability Margin %)|
|Growth + Cash From Operations||31.56%|
|Growth + Unlevered Free Cash Flow||18.65%|
|Growth + EBITDA excluding SBC||27.49%|
|Growth + Operating Income excluding SBC||24.28%|
|Growth + EBITDA||30.20%|
|Growth + Operating Income||26.99%|
In the above table, the following formulas are used to calculate various profitability measures:
Cash From Operations % = (Cash From Operations/Revenue) x 100
Unlevered Free Cash Flow % = (Unlevered Free Cash Flow/Revenue) x 100
Unlevered Free Cash Flow = EBITDA – CAPEX – Working Capital
EBITDA excluding SBC % = (EBITDA excluding SBC/Revenue) x 100
Operating Income excluding SBC % = (Operating Income excluding SBC/Revenue) x 100
EBITDA % = (EBITDA/Revenue) x 100
Operating Income % = (Operating Income/Revenue) x 100
During the quarter, Amazon Inc. posted YoY GAAP revenue growth of 22%. However, the company’s profitability margin varies considerably. This depends on which profitability measure we consider for calculation.
All of the above six measures of profitability showcase that the company operated at a profit during the period ending December 2021. Combining Amazon’s YoY GAAP revenue growth % with the six profitability margins would indicate that the Company would clear the 40% threshold in the case of Rule of 40.
Note that there is no correct or incorrect answer. All of the above profitability measures are valid. However, each of the measures demonstrates a different story about the performance of Amazon during the period ending December 2021.
Also, it is important to note that some of the profitability measures calculated in the above table are more conservative as compared to the other measures. As a result, such measures can give insights to the various stakeholders regarding the company’s performance beating the Rule of 40 or not.
As demonstrated with Amazon Inc, the company owners may choose +5.30% Operating Income over +9.86% Cash from Operations to calculate the RO40 profitability contribution. This is because the operating income considers all the expenses that Amazon may have incurred in generating revenue growth.
Another way of creating a consistent basis for comparison between companies is to use EBITDA excluding SBC costs as a profitability measure. Note that measuring profitability using EBITDA resolves any differences in interest payments or depreciation of intangible assets while comparing companies.
Also, these payments are quite small for early-stage SaaS businesses lacking the cash flow to service outstanding debt. However, more mature companies like Amzon Inc have a significant amount of such payments. As a result, it may have a meaningful impact on the bottom line.
In addition to this, it is quite typical a thing to see many software companies issuing stock to employees. That’s because that’s the most readily available currency that software businesses have at their disposal. This is especially the case with businesses having exceedingly high cash burn.
Note that stock issued to employees and the SBC expenses can be meaningful for a business to measure. This is especially the case when a business has a bonus season. Therefore, it is important for SaaS businesses to deduct SBC costs from EBITDA as it provides a more consistent basis for comparison between companies over time.
How To Beat The Rule Of 40?
I. Set Realistic Growth Targets
It is commonly believed that SaaS businesses have been showcasing high rates of growth in recent years. However, the reality is quite different. As per research, only top-tier companies have a growth rate of more than 40%.
But many SaaS businesses continue to set very high targets for growth projections. Such businesses are unable to achieve the set growth rates quickly enough. It is quite obvious. Say, for instance, a business has a CAGR of 10%. It is impossible for such a business to achieve a growth of 30% in revenues in the short term.
If such a business wants to achieve this target, it would call for catering a larger market and being a few of the leading vendors in its space or segment. The reality is that only a handful of companies have such opportunities at a given point in time.
Thus, SaaS businesses that are able to beat the Rule of 40 understand such fundamentals. As a result, they set growth targets that are achievable and adjust their cost structures if need be. It helps such businesses to balance the Rule of 40 and invest in new, high-growth areas.
II. Seek Net Retention
SaaS businesses aiming to achieve higher growth rates focus equally on acquiring new customers and retaining the existing ones. To retain existing customers, they invest in specific postsales activities in order to increase cross-sell, upsell, and retention.
Besides this, such businesses also get the right people, tools, and analytics in order to support their customer-retention construct. In addition to this, the SaaS businesses aiming to achieve higher growth rates also keep their product pricing strong and offer necessary support to customers with regards to the product implementation.
All these efforts result in enhancing the customer retention rates for such businesses. In fact, SaaS businesses achieving higher growth rates also have higher multiples like EV/revenue. This happens because the net retention rate is a critical driver of growth and sales, as well as marketing efficiency.
Likewise, many SaaS companies growing at slower rates do not invest enough in customer success, customer care, and professional services. Instead, they focus heavily on gaining new customers. They do this because they know that existing SaaS customers typically do not pay extra for postsales support. So why invest extra sums of money in retaining the customers.
However, such companies bear heavy costs in the longer run. As a result, such businesses have more churn, lower cross-sell and upsell, and more pressure to enhance sales. Thus, SaaS businesses can prevent their existing customer base, gain scale, and efficiency. Provided they consider customer retention efforts as an investment in growth rather than as a cost center.
III. Optimize Marketing Spend
One of the major expenses that SaaS businesses have to incur is sales and marketing expenses. As per research, 50% or more of revenue in high-growth businesses is spent on sales and marketing.
This happens because of the nature of the SaaS business model where revenues are less than the amount of investment. Another reason for such high go-to-market expense ratios is that SaaS businesses are inefficient.
According to research, SaaS companies with strong EV/revenue multiples are able to recover their customer acquisition costs in less than 16 months. Whereas, the one low-tier SaaS player takes nearly 4 years to achieve the same. Besides this, top-tier companies also generate revenue growth 3.5 times faster than the bottom-tier ones.
This difference exists because top-tier SaaS companies optimize their sales and marketing performance in different ways. These include:
- Allocating sales and marketing resources based on future customer opportunity and not current revenue, giving high-growth customers the most coverage
- Obtain granular operating data from across the business and see the relationship between, sales and marketing activities and overall growth outcomes
- Innovate go-to-market propositions that scale efficiently
- Use advanced analytics and machine learning to build a predictive view of customer health
IV. Optimize Marketing Spend
Many SaaS businesses try to reach the peak of their initial S-curve without having an offering that is market-ready. As a result, the growth of such companies falls.
However, SaaS businesses that are able to maintain the Rule of 40 are able to maintain their growth momentum by quickly setting up new businesses relative to the other players. The leading SaaS players incubate new businesses quite thoughtfully. They have a deep undersyadning of their customer personas. Thus, based on such understanding, they select their microdomains.
Further, they supply their target customers with dedicated resourcing. Plus they deal with the operational and organizational go-to-market aspects of business with immense rigor. This means that if SaaS businesses need to create value and have long-term growth, they must develop the capability to build new lines of business quickly.