Rule of 40 for SaaS: Tips and Tricks for Healthy SaaS Development
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SaaS companies need some metrics, such as customer and revenue churn, customer health score, and lead-to-customer rate to analyze their success. Just like any other product, the software relies on statistics and various economic indicators to define their place and role in both the market and economy. Such an analysis is a reliable way to check if your SaaS solution is healthy or whether it requires changes.
The first people to talk about and discuss the rule of 40 back in 2015 were Brad Feld, Techstar’s founder, and Tomasz Tunguz, a famous venture capitalist. As for now, the larger part of SaaS companies has adopted it even though it was introduced only a few years ago.
Tunguz and Feld claim that a simple formula for the evaluation of the SaaS business should be used. This rule of thumb includes only 2 parts: growth percentage added to the profit percentage of your company should make up 40% in total. For example, when generating a profit of 30%, your growth ratio can be 10% but they will still add up to 40%.
But why is this principle so important? Does anything else have to be considered apart from profit and growth? As a SaaS design agency, we know very well how much product managers care about metrics.
Growth vs Profit
At first, let's get into growth and profit ratios and how to calculate them. With different ways to measure these numbers, each enterprise has to decide on its own way of calculations.
The growth rate is defined as the percentage change from one time period to another. It is most often measured by year-over-year (YoY) or by monthly recurring revenue (MRR). However, some companies consider by growth the increasing number of employees or even market share.
The profit margin percentage is the amount by which sales revenue exceeds your business costs. To calculate it, you should use EBIDTA which can be deciphered as earnings before interest, taxes, depreciation, and amortization. Currently, most software companies rely on this principle to find out their net margin without considering taxes.
Don't worry if all these metrics sound overly complicated: it is hard to explain all in one article. That is why we made a list of top books on SaaS metrics.
The rule of 40 is quite a challenge for enterprises that are in the game for a few years already. Their growth ratio might fall down but they remain profitable.
The most successful companies rock this principle due to high profitability. For example, Adobe, a computer software corporation, was founded almost 40 years ago. Adobe balances its growth and profit, with the last one reaching 23,71% as of 2019. Such figures demonstrate the enterprise’s steady development and progress year after year.
At the same time, startups, in most cases, have no revenue right after the launch and throughout the whole introduction stage of the SaaS solution life cycle. Nevertheless, they still have all the chances to fit in within a 40% margin as the growth rate of prosperous new products tends to be constantly rising.
CultureIQ, a startup that allows employers to receive feedback from their employees, showed unbelievable results. Founded in 2013, this company reached a 165% growth ratio during the first half of 2019. Thus, despite no revenue, their economic indicators still satisfied the rule of 40 SaaS.
Now, let’s talk about the very formula of the rule of 40 SaaS, which is quite simple.
The best thing about this financial framework is balancing the percentage of both growth and profit. For instance, the growth ratio can be 10% while the net margin 30%. It can even happen that the profit makes up 50%, which allows you to have -10% in growth.
In the picture below, we can see the graph showing the profit and growth ratios of SaaS businesses as of 2019. Additionally, there is a line separating the projects that “hacked” the rule of 40 (marked with green) from the ones that didn’t manage to do it (red).
It is evident that in the formula of the rule of 40, both components are interconnected variables. Even with minus profit, your SaaS application can have a huge growth percentage and vice versa.
A clear advantage of this rule is more space for creativity and a variety of strategies for your SaaS product development. For instance, you can choose the time to focus on leveling up the growth ratio, while the net margin will remain stable enough to stick to this principle.
When to start counting and what time periods to count
This is the question that remains quite complicated for many software companies. Right after launching your project, it may be unnecessary to apply the rule of 40 because things may turn either splendid or terrible at any minute. So, you better take it easy and start getting into this financial framework a few years after you’ve launched your product.
An additional formula to be applied here is known as the T2D3 approach. Within this framework, the annual recurring revenue (ARR) should be tripled for two years and then doubled for the next three years. Most software companies use this formula, and only after the first 5-6 years, they start applying the rule of 40 for SaaS.
During all this time, your product will likely be passing the first stage of the product life cycle — the introduction stage with no profit and moving to the next phase — the growth stage. Even though it can be a challenging and unstable period, you will finally be making some revenue, so that you can evaluate the prospects of your software business properly by applying the rule of 40 for SaaS.
Why do we need the rule of 40?
At first sight, this principle for SaaS aims at comparing the service to the other ones in the market. By such observation, you can double-check if your business is profitable or whether it needs improvements. However, this rule of thumb goes much deeper than just a brief analysis and, in fact, each SaaS company should use it to maintain steady development.
Despite getting deeper into financial risks and prospects, the rule of 40 aids with preparing a plan for future development. By analyzing growth rate and net margin, you can map the strategies for the next years or even come up with new methods for your business development.
Why does the rule of 40 apply mostly to SaaS products?
The answer is simple: it best describes and fits the dynamics of SaaS product development. Unlike many subscription services, the software is probably the only product that can both grow and decline incredibly fast. That is, both the net margin and growth ratio can surpass even 100%.
Of course, you can analyze even non-digital products using the same formula, but the eventual figures will probably be irrelevant as these projects grow slower. Even if they fail to reach 40% as per the rule, it does not necessarily mean that they are loss-making or will have to be closed soon.
Two main components of the rule of 40 are the company’s net margin and growth. With many popular software products skyrocketing within the first few years, 40, as the sum of these indicators, is a totally achievable figure to strive for.
Is the rule of 40 for SaaS enough?
Without a doubt, there are many ways and opinions on how to evaluate and measure your SaaS solution. The software’s rule of 40 has become the ultimate most common framework for this. By applying this formula, you do not only compare and contrast the service to the other ones but also check if your business is in perfect condition.
Similarly, it is quite difficult to move forward without any plan or directions. The rule of 40 for SaaS also makes a certain guideline on how to run your SaaS company and make both short and long-term growth plans.
When it comes to economics and financial success, the rule of 40 is the main indicator of a robust developing company. Still, if you want to get a full picture of your SaaS application’s position on the market, its prospects, and earnings, you can also take notice of other metrics and the tools to keep track of them in our blog-post about SaaS dashboard.
What is SaaS? Explanation, Benefits, and Examples
At the beginning of 2021, we can definitely state that SaaS is literally everywhere. From large organizations like Google, Microsoft, or Adobe Systems, to small apps that offer data cleanup or financial calculations, almost every type of software we use daily is SaaS.
So, what is SaaS and why is the SaaS business market growing so rapidly?
SaaS is Software as a Service. The emphasis is on "service" — is not a one-and-done transaction, it’s an ongoing experience that gives the clients continual value. User experience is how the value is delivered in SaaS applications. When you look at UX design this way, it becomes clear why UX is one of the most important elements of SaaS.
When SaaS emerged on the market, they quickly started replacing old-school software on a disk. This is because they offered a much better experience by providing both a better value and more convenient user interfaces. The software companies that are still building desktop-oriented applications, typically offer a poor user experience, especially on mobile devices. In 2021, when best-in-class user experiences can be downloaded in the App Store for free, people don’t just want the software they use at work to have great UX, they’ve come to expect and demand it.
It's not that SaaS, in comparison to desktop-oriented applications, offers better UX by definition. For example, most SaaS companies in the space of sales and marketing usually start small and grow very complex as they add up new features and additional products.
When we were working on designing TextMagic, a SaaS product in the sales and marketing space, complexity was the main problem we wanted to avoid. To reduce the complexity we combined marketing campaigns, CRM, and help desk functionality on one platform (check out our case study).
This way with the help of design we made the product simple and pleasant to use and as we already know a great user experience is a key to SaaS success.
With so many SaaS applications that surround us, this business model has become the most popular and profitable for software entrepreneurs.
In this article, we are going to figure out what software as a service is, why this business model has become so popular, and how it manages to provide a better user experience in comparison with stand-alone desktop software. As well, we will go through some popular examples of SaaS products to explain to you everything about this type of product.
Basic information about SaaS
SaaS (Software as a Service) is a method of software delivery with the help of which people can access the data over the internet. Cloud applications run on the server of the SaaS provider, and users can access them with their browser from any place and any device.
The user does not buy an application, but rents it - customers pay for a subscription on the regular basis as long as they need it.
The SaaS vendor takes care of the application's performance, provides technical support, and independently installs updates. Thus, the customer doesn't have to worry about technical issues and can focus more on their business goals.
How does it work?
Installing the traditional, desktop-oriented software requires a physical disk and a tedious installation process. Software as a service is hosted in the cloud and in most cases does not require installation.
Instead, a person visits the software's website and register for an account using only their email address, create a password, and here we go! After registration, they can log in and have access to all the tools and features the software offers anytime and anywhere only via the Internet.
Benefits of SaaS
Software as a service model is beneficial both for those who develop the software and those who use it.
The software as a service is beneficial due to the fact that it:
- generates recurring revenue for businesses (provides relatively stable income because of a subscription-based model)
- is affordable for users
- is cost-effective for businesses (no need to spend on hardware maintenance)
- gives a possibility to scale easily (when the business grows and the requirements increase the client can quickly and easily upgrade the subscription. And vice versa, they can downgrade the plan when needed.
- makes it easier to attract new customers (again because of the low initial cost and the possibility to have a trial period)
- let users receive updates and new features without buying a new product
- provides great user experience (SaaS applications offer simple and hassle-free experiences across all devices).
To better understand what the software as a service is, let's take a look at some popular SaaS companies and their products. We are sure you've used at least one of them.
Examples of popular SaaS products that you've definitely heard about
Even if you don't know much about the software as a service industry, it doesn't mean you've never used SaaS products before. There is no need to be an expert in SaaS to understand how tightly it is connected with people’s everyday routine. Just check these examples of well-known cloud-based software to get a better understanding of this business model.
Dropbox is a leader in cloud storage services. It allows us to store the information, share data, and in general collaborate easily.
Dropbox gained its popularity because of the ease of use and availability across different platforms and devices. Its UX is equally coherent on desktops and smartphones, Windows or IOS.
Google workspace (former G Suit) offers a range of tools to optimize the working process. It includes custom business email (Gmail), cloud storage (Drive), word processing (Docs), spreadsheets (Sheets), survey builder (Forms), and much more.
Delivering this software using the SaaS model allows few people to work with the same document simultaneously, see all changes, comment on everything, and not be afraid of forgetting to save the changes. Organizing video meetings with the use of Google Drive has made the working process easier as well. Of course, it is worth mentioning Gmail here. Its clean UI and intuitive navigation have made Gmail the main way of sharing mail in most modern companies.
Even large corporations move to SaaS. One such example is Office 365 by Microsoft. Well-known services like Word, Excel, PowerPoint, etc. without which any enterprise couldn't imagine its work ten years ago are now available on a SaaS subscription basis and can be accessed from everywhere via the Internet. You don't need to buy a license and spend time installing a number of applications on your desktop.
Shopify is an e-commerce software as a service platform that allows users to start their business online and offer tools for marketing and SEO optimization. And again this cloud-based software has gained popularity because of the clear UI and intuitive user experience.
Slack is a cloud solution for business communication. This messenger allows you to create channels on different topics, have direct private conversations, share files, and comment on them.
Slack's design is one of the main reasons it became so successful. From the onboarding process to presenting updates, everything in this app is extremely easy-to-understand. This messenger provides the best possible user experience and customers value it.
With the beginning of the COVID-19 pandemic in 2019, there is hardly any person that has never heard about Zoom. This service for video communication gives an opportunity to conduct video meetings, conferences, hold webinars, and chat only having a browser and an Internet connection.
Many people wonder, how Zoom managed to become so popular in such a short period. Previously Skype was the number one software for video communication, but because of its clunky and hard to use UX, it is no more a competitor for cloud-based Zoom with an intuitive and user-friendly design.
Read more about popular SaaS companies and their products in Best SaaS Companies and Secrets of Their Success.
All of the above companies that choose the SaaS model to deliver their software have become popular among customers as they provide the best user experience on the market and their products are known for their simplicity and ease of use. But why SaaS products manage to provide a better experience to their customers than on-premises software?
SaaS vs stand-alone desktop software
The main objective of providing service with a SaaS business model is to make the interaction with the product more efficient, user experience better and as a result the customer happier. Usually, the client is not interested if the data is stored locally or on the cloud, all they want is to receive an outstanding user experience and get their problem solved.
But why are SaaS applications better at delivering a great customer experience than standalone desktop software?
While on-premise software is installed locally (on the company's computer) the SaaS is hosted on the vendor’s server and enterprises don't have to worry about maintenance and managing everything themselves. This fact allows organizations that use SaaS to decrease spendings on software updates, support, and implementation and lets them focus more on and improving their services and UX.
Size and functionality
In the past, most software products used to be large, complex, expensive and offered a wide range of functions in one app. When software includes so many features in one product, it becomes extremely difficult to keep the design clean and clear. As the result the customer experience becomes poor.
In their turn, SaaS products are usually simpler as they solve some specific user problems (they are more focused on a particular niche). It allows them to have a better design with intuitive and user-friendly interfaces.
Unlike the on-premises software SaaS doesn't have a "final version" - the product is constantly evolving and tested, companies regularly add new features and improve the design of their apps. SaaS business model makes it possible for users not to constantly pay for new versions, download separate products, or new additions on the desktop. With cloud-based applications, customers get all the updates on the go, unlike with the stand-alone desktop software.
More than 90 percent of the overall Internet users access the web with their mobile devices at least once in a while. That's why it's natural that in our mobile-driven world an application should give real-time access to platforms and data from different devices regardless of the location.
Unlike traditional desktop-oriented software that is available on computers only, SaaS technology allows connecting from any gadget that has an internet connection. It promotes providing a coherent user experience both on desktops, smartphones, or tablets, different operating systems, and browsers.
So, because of cost-effectiveness, narrow focus, and constant development SaaS companies can pay more attention to the customer-centered design of their applications.
What waits for SaaS in the future?
Software as a service has merged into our lives and has no intention to leave the market. Companies and ordinary people use SaaS applications daily as they offer continual value and user-friendly interfaces. Its accessibility, affordability, and ease of use explain the rising popularity of SaaS. Anyone who has a computer and a browser can try it out and see the difference a SaaS has made.
SaaS is constantly developing and today it has become the most profitable business model that offers its customers an outstanding user experience.
With the development of new technologies, the SaaS will evolve as well. Some people say that mobile-optimization will be the number one priority of cloud-based software applications, others think that SaaS will focus on developing software for artificial intelligence.
No matter, what future is waiting for software as a service model, as more companies are moving to the cloud the list of unique SaaS solutions continues to rise. Businesses continue to search for specialists able to analyze and design practical and effective cloud-based software that meet both the needs of the market and their business needs.
Great design is more important than ever in SaaS success. But what makes a good SaaS product? Find out in our next blog post!
3 Aha Moment Examples That Can Redouble Your Retention
In 1924 George Mallory was preparing to summit Everest. A dozen people have previously perished along the way, so the New York Times reporter rightly asked the climber why he wanted to risk his life on this formidable mountain. Mallory replied, "Because it is there."
In August of that year, Mallory and his partner Andrew Irvine disappeared on the way to the peak.
We retell this iconic story for the last hundred years because it’s an unprecedented case of man’s desire to conquer the universe. We’re not like Mr. Mallory. Your clients are not like Mr. Mallory either.
If you compare any SaaS app with Everest, you’d be amazed by the number of people who signed up and started their user journey just to leave in the very first days. The picture below shows that about 80% of people who signed up finally abandon an app.
Part of your contract with app users is that there's something worthwhile at the top of the mountain. Something valuable. But to reach that value, users have to learn how the app works, which is a tough task, because…
- How do I find out more about this?
- Where is that feature I’m looking for?
- What should I do next?
As a UI/UX design studio representative, I’d say there’s always something confusing for users in their user experience. And as they get trapped, people rarely show stoic persistence to continue the user journey just "because your app is there." They’ll go check Twitter, they’ll poke around for a smaller mountain nearby. And maybe the current solution to their problem is not bad at all?
Is there a way to reduce the number of churned users?
The picture from above says that the retention is almost the same for SaaS, eCommerce, finance and media apps. No industry has a recipe to stop the churn.
Best-of-breed companies in each category, however, seem to know something that most entrepreneurs never figure out. Just compare the retention dynamic for the top 10% apps in each category (the chart on the left) with the retention dynamic for median companies (the chart on the right).
Elite SaaS companies somehow manage to understand users better and retain them almost twice as good (38%) as median apps (20%).
If we match the two curves, we’ll notice that the tails of the charts are roughly the same, all the difference happens within week one. Best-of-breed apps make initial contacts with users in some specific way that retains even impatient ones.
“Aha” moments is the secret they don’t tell you
We can define “aha” moment as a user's emotional reaction to the discovery of how they can truly benefit from your app.
The most famous “aha” moments story belongs to Chamath Palihapitiya, ex-Facebook executive. In the darkest times when Facebook had 45 million users and MySpace had 115 million, the Facebook team coined their formula of 7 friends for 10 days. The rest was history.
After all the testing, all the iterating, all of this stuff, you know what the single biggest thing we realized? Get any individual to seven friends in 10 days. That was it. You want a keystone? That was our keystone. There's not much more complexity than that.
Facebook is a social network, and until users connect with a certain number of friends, they can’t feel any of its wonderful network effects. I still remember when I first signed up for my Facebook account, without a big friends list, I quickly lost interest.
But as soon as the number of friends rose, I started getting new posts every time I smacked the update button. Here came the “aha! now it makes sense” moment. That first insight was a turning point that kept me from bailing on my account.
Like any other social media, Facebook doesn’t leave your “aha” moment to chance. The company builds its onboarding path so that newcomers have no opportunity to feel lonely in their brand-new accounts.
- Facebook pulls in a list of suggested friends from your Gmail account.
- It recommends friends from your school, college, and the company you work for.
- It puts a big square blue “Add friend” button everywhere so that you don’t forget to add your friends.
Best product “aha” moment examples under the microscope
Any unsuccessful app is unsuccessful in its own way, but any successful app is good in hooking users with “aha” moments. So let’s reveal what is an “aha” moment for some best-of-breed SaaS apps and what exactly they are doing to make people stick.
Calendly and their step by step “aha” moment strategy
Why would anyone need a paid scheduling service when we all have Google Calendar, this free-of-charge perfection? And still, Calendly became an inherently viral meeting scheduler. After getting through its onboarding process, I see how it happened.
After the signup, Calendly offers you to schedule your first event. And as you go, you meet some little gems:
- “aha, I can specify the location where both parties will connect at the scheduled time”
- “aha, I can add some buffer time before or after events”
- “aha, I can collect payments inside the app”
- “aha, I can build automatic workflows around events”
These little features that Calendly strategically put on my road to the main value of the app made the road engaging.
But the kill shot was Calendly’s invitation to try booking my newly created event. What a smooth booking it was! In front of my eyes was a recent back-and-forth scheduling dance I had with my hairdresser, and in a moment of sudden, I realized the unique value that Calendly offers.
Monday’s road to “aha” when there’s no shortcut
Monday.com is a universal team management tool that works equally well for running a real estate CRM or an editorial calendar. When you see a tool so universal, it means that its customers not only stay in front of a mountain that pierces the clouds, the mountain also has numerous peaks. It’s a mountain range with multiple “aha” moments for multiple types of users.
For Monday, the road to “aha” starts not from showing you its finest features as it was for Calendly. It starts by cutting off all irrelevant branches of the road.
Monday asks users to self-select their roles, goals, and use cases to steer them toward features and templates that make them say “I’m glad I am using this tool.” I’ve selected a marketing branch at the very beginning of my trial and since then, through contextual tips, Monday was guiding me to my marketing success.
Monday allows a single-player mode but knows that in most cases the user reaches their “aha” moment after they invite their colleagues. So next the app pushes you (a bit aggressively) from solo productivity towards team productivity.
Another reason for pushing users hard is competition.
Monday.com is a relative newcomer to the team productivity space, which is pretty cluttered, full of large funded competitors.
For the product design team, it means plenty of testers, and it also means that if they nail fast, accurate and relentless onboarding experiences for each tester they win.
That leads us to a stream of reminders, emails, and push notifications that works pretty well. Monday didn’t become a meme as the most annoying app (check the Duolingo meme craze). Instead, it became the fourth fastest growing app in 2020, with 149% growth year over year.
Canva: I came, I saw, I said “aha”
The article comes to a close and I feel we know each other well enough for personal stories. Nobody knows, but when I was a child, I wanted to be a designer. Not for long, though, because I was traumatized by Photoshop and Illustrator, principal (and very complicated) design tools of the old times. That's how I became a writer — text editors were pretty intuitive even 10 years ago.
With all that background, it took me five minutes to fall in love with Canva, the easiest design tool on the planet Earth. The user onboarding is also the easiest — an engaged user doesn’t even have to sign up for the product to start designing.
Canva removes all the obstacles in the way of your “ah-ha, it can be that simple to make pictures” moment. The product itself is so straightforward that users rocket to the top of this not-so-steep mountain before even noticing it.
Yes, this app has a lot of limitations that you discover afterward. But it’s too late, you’re already hooked. And for non-designers, it’s still better than Photoshop.
“Aha” moment notice and note
Canva has taught us to pave the way in front of a user rushing to their “aha” moment so that no one tripped on an unclear feature or confusing form.
Monday showed us that personalization can help to point users toward the “aha” moment meaning that is relevant to them. And sometimes it wouldn't hurt to push them in the right direction with some reminders.
Calendly proves that you can engage users climbing big mountains by showing them little fancy features all the way up.
And Eleken design agency examins best practices from all over the world, so if you’ll need someone to create onboarding flow that will leave your customers forever hooked… you know where to find us.