Rule of 40 for SaaS Companies

Sally Sherman

Published March 12, 2024

The Rule of 40 Calculation: What it Really Means for Your SaaS Startup

In the world of SaaS, there is a key metric that many companies use to measure their overall health and performance: the Rule of 40. This "rule" is a simple formula that helps SaaS companies understand the balance between growth and profitability.

The Rule of 40 helps SaaS companies because it gives them a success metric that balances both growth and profit. Companies that focus solely on growth at the expense of profitability may struggle in the long run. In contrast, companies that prioritize profitability without investing in growth may miss out on expansion opportunities.

In this guide, we’ll run you through what exactly the Rule of 40 is, how to calculate it, and some possible alternatives you may want to consider so that you can properly gauge the strength of your SaaS startup.

What is the Rule of 40 formula?

While you can calculate the Rule of 40 in different ways, the most common method is adding the company's growth rate to its profit margin.

Growth Rate + Profit Margin = X

If X exceeds 40, the company is likely healthy, with a good balance for long-term success. Financial experts and business leaders often apply the Rule of 40 calculation to SaaS companies because it's simple to calculate and apply broadly across many businesses in the same sphere.

Here's an example:

Company A has a 20% profit margin and a 30% growth rate, which would leave it with a Rule of 40 score of 50 (20+30=50) — a strong indicator the company is performing well.

On the other hand, Company B has a 10% profit margin and a 35% growth rate, giving it a score of 45 (10+35=45), which is also a good indicator but not as strong as Company A.

Why use the Rule of 40 in your SaaS startup?

The Rule of 40 is attractive to startup leaders because it's incredibly simple. It doesn't require a rich financial background to calculate, and it means the same thing to everyone — no matter how it's applied.

For SaaS companies, it can be a guiding metric for all business decisions about driving long-term success. It demonstrates how well a company pursues growth without sacrificing profits (or vice versa).

While the metric is standard for startups, you can use it in various situations. Here's how stakeholders might use this metric today:

1. Measure ongoing performance

The Rule of 40 is a fairly straightforward metric that plays a vital role in nurturing a fledgling startup. By regularly calculating this metric, companies can track their progress over time, identify trends, and adjust their strategies.

With this information, they can also recalculate and pivot their business or even double down on the things that work while those actions still have influence.

2. Justify unprofitability

The Rule of 40 also gives founders cover for the stages where they aren't profitable since they can still demonstrate significant growth and margins. This matters during the initial seed phases when there's dramatic growth or investment in R&D, but the company isn't quite making money yet.

3. Cultivate investor confidence

The financials on your SaaS may not all be sunshine and roses, but investors still want to know what's going on with their projects. Investors and other stakeholders often use the Rule of 40 to assess the health and stability of a SaaS company, and it's a metric that you should easily be able to provide on demand.

Since a strong Rule of 40 can signal to investors that the company is well-positioned for growth and profitability, there's no need to hold back this info. Calculate it often throughout the partnership to signal your SaaS startup's position and even solicit increased investment and support for future initiatives.

4. Inform strategy

The Rule of 40 is a concrete and valuable tool for guiding strategic decision-making within a SaaS company.

By setting a target Rule of 40 and regularly monitoring progress towards that goal, companies can make informed decisions about resource allocation, pricing strategies, and other key aspects of their business.

For example, suppose subscriber growth is high but profit margins are low. In this case, a company might look for ways to cut infrastructure costs, like reducing bloated tech stacks or focusing on only the most effective marketing platforms.

How to calculate whether your startup fulfills the Rule of 40

Calculating the Rule of 40 is as easy as adding your growth rate to your profit margins. Easy enough, but there is some nuance in how you calculate these two metrics, which we get into in the sections below.

How to calculate your growth rate

To calculate your growth rate, you must have been in operation for over a year. You can look at annual recurring revenue (ARR) or multiply your monthly recurring revenue (MRR) by 12 months. Then, calculate the year-over-year change in revenue.

So, if the revenue for the current year is $825,000 and the revenue for the previous year was $712,000, you would calculate it this way:

$825,000 - $712,000 = $113,000

Then, divide the difference of these numbers by the previous year's revenue:

$113,000 / $712,000 = 0.1587

And multiply it by 100 to get the growth rate as a percentage:

0.1587 x 100 = 15.87%

How to calculate your profit margin

Profit margin is profit divided by revenue. For "profit" itself, use EBITDA (earnings before interest, taxes, depreciation, and amortization). An alternative method is to use free cash flow (the amount of money a company generates minus operating expenses and capital expenditures).

For example, if a company generated $875,000 in revenue but had $682,000 in expenses, the profit would be $193,000.

Now, divide the profit by revenue (and multiply it by 100) to find the profit margin as a percentage:

$193,000 / $875,000 x 100 = 22.05%

Ultimately, the key is to be consistent and use relevant metrics when calculating the Rule of 40. By using the metrics most appropriate for your business (for example, choosing between EBITDA and cash flow), you can understand overall performance and make better growth decisions.

Example calculations of the Rule of 40

Using the growth and profit numbers used above, we can find out if they meet the Rule of 40.

15.87% growth rate + 22.05% profit margin = 37.92%

In this case, the number is slightly less than 40, so it doesn't. Depending on what the company leaders deem is the issue (growth, profit, or both), they can take actions to improve both and hopefully meet the 40% goal before the next reporting period.

What are some Rule of 40 alternatives?

The Rule of 40 is popular and widely used, but it's not the only respected metric for startups. Depending on the highlights you want investors to see, one of the following calculations might be more revealing and representative of your SaaS startup's success.

Bessemer's Efficiency Score

The Bessemer's Efficiency Score or Bessemer Venture Partners Efficiency Score (BVPES) helps demonstrate a SaaS company's capital efficiency. Investors and business leaders use it to measure how well a company generates revenue compared to spending, with a score of 0.5 or more being satisfactory. A score of 1.5 or more is ideal.

To calculate this capital efficiency, divide the net new Annual Recurring Revenue (ARR) by the net burn, or how much a company spends.

These two metrics can be calculated in the following way:

Net New ARR = New ARR + Expansion ARR – Churned ARR

Net Burn = Revenue – Operating Expenses

An example of the score in action could look like this:

$5 million (Net New ARR) / $2 million (Net Burn) = 2.5 BVPES

Investors who want a clear idea of how many dollars a company generates for every dollar it spends can see the answer with this simple metric.

The Rule of X

To showcase a SaaS company's potential for future growth, Bessemer Venture Partners developed the Rule of X.

This modified version of the Rule of 40 seeks to weigh factors more appropriately using the market's current growth rate for private vs. public companies. It's recommended for startup leaders who want to know not just their company's value today but also its potential.

The thinking behind the Rule of X is that, if given the choice between receiving $1 today or $1 every year starting next year, investors would prefer the latter because of the potential for steady, recurring revenue. With SaaS pricing models offering just that, these cloud companies need a more accurate way to showcase their potential value, not just current profit margins, growth rates, and free cash flow.

The formula for Rule of X is:

(Growth Rate x Multiplier) + free cash flow (FCF) margin

Use the multiplier of 2x for private companies and 2-3x for public companies.

For the same company we showed above (with a growth rate of 15.87 and an FCF margin of 22.05), we would calculate the Rule of X by:

(15.87 x 2) + 22.05 = 53.79 for private companies

(15.87 x 3) + 22.05 = 69.66 for some public companies

These numbers are much higher than the 37.92% offered by the Rule of 40. For investors, the Rule of X can show more promise and even force higher valuations for the company.

But the two differ in more than just the numbers — the growth number gets doubled or even tripled. With all things equal, a company with a 15.87% growth rate and 22.05% FCF margin will not be valued as highly as a company with a 22.05% growth rate and 15.87% FCF margin using the Rule of X. The Rule of 40, however, makes no distinction between them.

For investors interested in exponential growth potential and not just how much profit they can make on a widget, the Rule of X brings more to the table.

SaaS Magic Number

The SaaS Magic number is another metric that measures operational efficiency and sustainability. It calculates how much annual recurring revenue each marketing and sales dollar creates for a company.

Because it tries to figure out how influential and effective the marketing spend is for a company, it takes more reporting and numerical inputs than some of the other calculations on our list.

Here's how it works:

Take the current quarter's Generally Accepted Accounting Principles (GAAP) revenue and subtract the previous quarter's GAAP revenue. Then, multiply it by four.

Divide that number by the previous quarter's sales and marketing expenses.

For a company with recurring revenue of $500,000 in Q3 and $400,000 in Q2 that also spent $450,000 in sales and marketing in Q3, you would do the following:

($500,000 - $400,000) x 4 / $450,000 = 0.88 Magic Number

What does the number mean? While it depends on the company, here are some general estimations.

If your company has recently expanded, launched a new product, or spent a lot more on marketing than normal, this number may be skewed. Therefore, look at it over time to get a true feel for its significance.

T2D3

While not so much a metric as a business tactic, the term "T2D3" has gotten a lot of attention in the SaaS startup world. Neeraj Agrawal of Battery Ventures coined the phrase, and it stands for "triple, triple, double, double, double."

A company that has achieved T2D3 experiences exponential growth by tripling revenue two years in a row, then doubling revenue for the next three years.

It could look like this:

Year 1 – Triple from $1M to $3M ARR

Year 2 - Triple from $3M to $9M ARR

Year 3 - Double from $9M to $18M ARR

Year 4 - Double from $18M to $36M ARR

Year 5 - Double from $36M to 72M ARR

This metric may show investors that your company knows how to generate revenue, is steadily growing, and has momentum in the marketplace — all qualities many "unicorn" ventures have shown.

However, it's not the only indicator of a company's success; revenue size can greatly affect how practical this model is. (Tripling $20,000 is not the same as tripling $800,000.) It also lacks insights like burn rate, profit, and other metrics that may be important to investors.

Get more accurate SaaS KPIs with Digits

Each of these calculations, including the Rule of 40, offers unique benefits and can demonstrate to investors why your startup is one to watch. While they all use different KPIs, they only work with accurate data. Whether using net profit margin or annual recurring revenue (ARR), you'll need assurance your numbers demonstrate the truth about your company.

This is much easier with reliable and up-to-the-minute bookkeeping. Digits live dashboards show you exactly what you need for today's business calculations and are fully customizable, interactive, and designed to put your most important metrics at your fingertips.

Book a call with Digits today to see how AI-powered accounting can help you better understand the state of your SaaS business so you can wow your investors and stakeholders with less work.