The Rule of 40 in B2B SaaS companies is used for benchmarking, harmonizing profitability and growth, and informing both long-term and short-term decisions.
But there is more to the Rule of 40 than that.
Read on to understand what this number is all about and how beneficial it can be to your B2B SaaS business.
The B2B SaaS technology industry is valued at more than $145B and is projected to grow by another 40% over the next two years.
Image via Gartner
To determine the overall health of their businesses and remain competitive, SaaS companies use the Rule of 40.
So why should you care about this rule?
What Is The Rule Of 40?
The Rule of 40 is a key principle in the B2B SaaS industry that says that a company’s total revenue growth and profit margin should be more than or equal to 40% when added together.
This means that SaaS companies with combined revenue growth and profit margin of more than 40% are getting profits at a sustainable rate.
On the other hand, companies below 40% are likely to struggle with cash flow or liquidity challenges.
Simply, the Rule of 40 is a great metric of success.
Moreover, this rule can help companies to determine whether they have overcome the startup peril and are trying to retain users to build a strong user base.
Does The Rule of 40 Apply to SaaS Companies Only?
Yes. This rule applies to companies that offer software as a service (SaaS) only. So if you use subscription billing as your payment model, you may apply it to your business.
Often, Software companies have huge profit margins of up to 80% or even 90%.
To put it into perspective, this rule applies to mature companies making up to $1 million in monthly recurring revenue.
Initially, the rule applied to SaaS businesses with over $50 million in annual revenue until Brad Feld, the pioneer of the Rule of 40 recommended using it for your business if you achieved the $1M MRR benchmark.
The Key Components of the Rule of 40
The key components of this rule are:
- Growth Rate: The growth rate of a company can be evaluated using annual recurring revenue(ARR) or monthly recurring revenue(MRR).
- Profitability: Profitability can be measured either using cash flow, earnings before interest, depreciation, taxes, etc.
The Rule of 40 Benchmarks
This rule is a crucial component of any SaaS strategy. However, for B2B companies offering recurring billing platforms, it can be difficult to know whether you have reached the benchmarks required to apply this rule to your company.
Here are the benchmarks to determine whether you can apply the Rule of 40 to your SaaS company.
1. Equal to 40%
When your growth rate and profit margin combined are equal to 40%, your company becomes attractive to investors and venture capitalists, thus you can start to use this rule.
2. Below 40%
If your company’s growth rate and profit margin combined are below 40% you cannot apply this rule since your profit and growth cannot make up for each other.
3. Above 40%
When your company’s growth rate and profit margins exceed 40%, it becomes more desirable to investors and venture capitalists thus you can invest in growth without worrying about running out of profit.
The Benefits of the Rule of 40
As mentioned above, the Rule of 40 can be used to benchmark, balance profitability and growth, and also inform both long-term and short-term business decisions.
But that’s not all.
Here are four reasons why the Rule of 40 is considered the SaaS magic number:
1. It Can Offer Guidance to What Tradeoffs a Company Can Afford
You can consider your SaaS business healthy in terms of profit if you have a 20% growth rate and a profit margin of 20%.
Equally, your business is healthy if you reach a growth rate of 40% with a 0% profit or vice versa.
However, if your growth rate and profitability are below 40%, you need to assess your SaaS metrics to uncover any potential issues like churn, cost of goods sold, and more.
2. It Helps You Know Whether You Can Invest Without Sacrificing Profit
With a combined profit margin and growth rate of more than 40%, you can continue investing in your business without worrying about running out of or overstretching profit.
3. It Helps Investors to Uncover High-Quality SaaS Investment Opportunities
The Rule of 40 doesn’t benefit SaaS business owners but can also help investors know whether a company is worth investing in or not.
4. It Can Help You To Determine When To Capitalize on Growth or Profitability at Any Given Moment
You can also use the Rule of 40 to determine whether to focus more on margin growth instead of expansion.
Startups can also use this metric to leverage sales and marketing strategies that attract and retain customers while generating sufficient profit margins to attract investors to fund their growth.
The Rule of 40 is the SaaS magic number. It can help business owners to assess trade-offs between profitability and revenue growth.
It provides you with in-depth insights into how profitable and sustainable your business is as well as its potential for future growth.
Author Bio – Reena Aggarwal
Reena is the Director of Operations and Sales at Attrock, a result-driven digital marketing company. With 10+ years of sales and operations experience in the field of e-commerce and digital marketing, she is quite an industry expert. She is a people person and considers human resources as the most valuable asset of a company. In her free time, you would find her spending quality time with her brilliant, almost teenage daughter and watching her grow in this digital, fast-paced era.