SaaS stands for Software-as-a-service. A SaaS company hosts an application on the internet and enables customers to access it. The SaaS company holds the servers, database and software which allow the customers to access the application through the internet.
SaaS companies generate revenues by charging subscription fees from the customers to access the applications they host on the internet. The subscription fees are usually charged every month. There are many common types of applications hosted by SaaS companies, such as e-commerce, web hosting, content resource management, enterprise resource planning, accounting and invoicing, etc.
SaaS companies require a proper benchmark to determine whether or not they are in the correct direction concerning revenue growth, profit margins, cash flow, business growth and other factors. Benchmarking enables SaaS companies to make internal changes and helps investors and clients make comparisons between multiple SaaS companies.
The two most important factors for benchmarking in the SaaS sector are revenue growth and profit margins. To this end, the rule of 40 is highly useful for a SaaS company to determine whether or not it is growing at a good rate and generating acceptable profit margins.
According to the rule of 40, a SaaS industry’s sales growth rate and profit margin should add up to at least 40%. Companies at 40% or more generate profit or increase revenues at a sustainable rate. Companies below 40% are likely to face a liquidity crisis.
How to calculate the rule of 40?
Revenue growth rate and profitability margin are the two inputs required to calculate the rule of 40.
The Generally Accepted Accounting Principles define what constitutes revenue. The revenue growth can be calculated based on the year-on-year growth of monthly recurring revenue.
There are many metrics for calculating profitability, such as operating income, net income, cash flow and free cash flow. However, most SaaS companies use EBIDTA for determining profits. EBIDTA stands for Earnings before interest, taxes, debt and appreciation. EBIDTA needs to be measured as a percentage of total operating revenue.
For example, a company generated a revenue of USD 10 million in 2020, which increased to USD 12 million in the year 2021. The year-on-year growth rate is 2 million/10 million × 100= 20%. The EBITDA of the company is USD 3 million for the year 2021. Thus, the profitability margin of the company is 3 million/10 million × 100= 30%. The company’s growth rate % + profitability margin % is 20% + 30% which equals to 50%. 50% is more than 40% which means the company is growing at a sustainable rate as per the rule of 40.
Why use the rule of 40?
Rule of 40 acts as a guide to the health of the SaaS business. As per the rule of 40, 20% profit margin and 20% growth rate are healthy metrics for a SaaS business; 10% loss is acceptable if the SaaS business is growing at 50% and even if the SaaS business has a 0% growth rate/profitability but 40% growth rate/profitability, it is doing fine. If the growth rate and profitability margin add up to less than 40%, the SaaS needs to review its operations, revenue model, customer base, and other aspects of detecting issues.
Investors take the rule of 40 into account for assessing the potential of SaaS companies to create value for them with growth. Rule of 40 focuses on sustained value creation instead of valuation, which helps evaluate investment potentials.
Rule 40 enables a SaaS company to assess its potential to invest without letting go of profits. A growth rate and profitability going above 40% mean the company can invest more to gain and retain more customers.
Rule of 40 helps in determining the stage when either profit margin or growth rate needs to be maximised. Small SaaS companies can use the rule of 40 to ensure that marketing and sales campaigns attract new and retain customers while the profit margins remain enough to attract investors to fund their growth. Well-established companies with high market shares can use the rule of 40 to focus on increasing profit margins instead of expansion.
Valuations of SaaS companies that beat the rule of 40 increased leaps and bounds. SaaS companies such as Zoom, Datadog and Twilio exceeded 40% in the rule of 40, and their valuations skyrocketed.
When to use the rule of 40?
Earlier, the rule of 40 was used by a SaaS company when its annual revenue exceeded $ 50 million. However, as per experts in this field, including the pioneers, the rule of 40 can be used by a SaaS company once its annual recurring revenue reaches $ 1 million. Many SaaS companies reach an ARR of $ 1 million in 5 years, as per a survey.
Another approach that can be used to determine the correct time to use the rule of 40 is T2D3. As per the T2D3 approach, a SaaS company should seek to triple its revenues for two years in a row and then double them for three years before using the rule of 40.
A SaaS company can also wait to apply the rule of 40 till the departments are set up, cash flow issues are resolved, and the product-market fit is determined.
What is a good SaaS growth rate?
The growth rate of a company shows its increase in revenue over some time. The growth rate of a company is an important indication of its sustainability and profitability.
The growth rate of SaaS companies depends upon their stages of development. On average, the growth rate of SaaS companies falls in the range of 15% to 45% on a year-on-year growth basis. SaaS companies have annual revenues of less than $ 2 million and exhibit higher growth rates compared to SaaS companies that have surpassed the $ 2 million annual revenue mark.
The growth rate of a SaaS company is inversely proportional to its age till it is 12 years old. SaaS companies that are 13 years or older usually have a year-on-year growth rate of 20%.
How can companies outperform just by following the rule of 40?
Revenue-generating activities can cut the profit margins while implementing ways to improve profit margins can disrupt revenue growth. The rule of 40 helps SaaS companies relate the profit margins and revenue growth to strike a balance between the two metrics in the long-term financial plan.
Start-ups wanting to acquire more customers rapidly can follow the rule of 40 to good effect. The most appropriate approach is to maintain revenue growth above 30%. As per the rule of 40, the profit margins can be kept at 10% or lower. This ensures sacrificing immediate profits to capture a large share of the market.
Keeping both the revenue growth and profit margin at 10%-30% as long as the sum of these metrics is 40% or more is appropriate for large and well-established companies exhibiting high adaptability.
Maintaining the revenue growth at 10% or less is favourable for well-established companies having a consistently high-profit margin of 30% or more.