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?
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.
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 project 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 slowlier. 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 for measuring your project’s success in our blog-post Key SaaS Metrics.