Evaluating Business Sustainability: What Is Rule 40 and How Does It Work?

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Rule of 40
Close-up of a modern business team using tablet computer to work with financial data

If you have your own company, then you are going to have to be on top of things all the time. The Rule of 40 is a SaaS financial ratio that would allow you to compare the growth of your revenue and your profitability, which is needed in expanding your company. 

Who invented the Rule of 40?

The Rule of 40 was popularized by Brad Feld and Fred Wilson, 2 venture capitalists, back in 2015 by their blog post. There was a late-stage investor who was there in the same board meeting who articulated the rule to them for the first time. The rule is that if you are a venture that is backed by a SaaS company, then everything should be equal to 40 percent, your annual revenue growth rates, and your operating profits. 

Why Is the Rule of 40 Important?

1. Effectively pushes a healthy balance between growth and profit

There is now the tradeoff between being profitable and the ability to continually grow that companies are paying more attention to. You should show them that you value both since you are not supposed to have to choose between the two in the first place. 

You would be able to create this stable and sustainable growth with a decent profit when you are using the Rule of 40, hence giving the perfect balance between the two. 

Making sure that you are sustainable is important, so even though there may be slower growth or you are going to have fewer profits, in the end, it’s going to be worth it. Sometimes playing the long game and staying in the game much longer is better than falling short in the end.

2. It speaks the language of the investors

If you are relying on just common metrics, especially when you are talking about the future growth of your company and looking for possible investors that would help you make your company so much more successful, then they won’t simply do. 

You just talking about how much your company had grown or showing them what the customers had been talking about your products would not mean anything if you do not have the proper receipts and your table barely has any substance. 

You are going to need the Rule of 40, which is not really that complicated anyway. When you are in a meeting with any potential investor or anyone who would be able to help you with your investment strategy, just bring this out and show them why you are worthy of their time and money. 

3. You would be able to get into the competitive market

There is a lot of competition in the market right now, and you are going to have to keep up if you want to stay on top of things. 

So you are going to have a proper diagnosis because you would not stay healthy if you do not consider all of the measures. From your profitability to the common metrics, you are going to have to stay level. 

Recognizing the problem would have to be the best way for you to solve the problem, and the Rule of 40 would be able to give you that discipline regardless of how big your market is. 

You are going to have to know what your weaknesses are and what your company excels in, then adopting the Rule of 40 would be easy and it could even become your primary business healthy metric.

How To Calculate the Rule of 40?

1. Finding the right revenue growth input

If you are looking for the best growth metric to work with for the Rule of 40 calculation to work, then the MMR would have to be the best one. This is because the majority of the SaaS revenue usually comes from the subscription pricing models. 

2. Choosing the accurate profit measurement

When you are choosing the accurate profit measurement that works for you, then it would depend on your SaaS business model. The EBITDA (earnings before interest, taxes, depreciation, and amortization), which is a non-GAAP revenue metric, would usually be the best option.

What Are the Benefits of Using this Metric?

The main benefit of using the Rule of 40 is that it gives all of these investors a way to help measure your business, which could eventually help in increasing your funding rounds and your IPO. You would be able to see a big difference in the valuations when you do eventually beat the rule of 40 consistently. 

You would get higher revenues and have a higher value, effectively maximizing the valuation of your company but also giving this strong balance between profitability and growth. This would help give one of your investors, or future potential investors, a higher feeling of trust.