The rule of 40 in SaaS: Why growth and profitability matter

Did you know? Capchase's SaaS Benchmark Report 2024 revealed that despite a slowdown in year-over-year growth, the rule of 40 has remained stable or even improved in some SaaS segments. This highlights the increasing importance of understanding what this rule means in the SaaS industry.

In this article, we'll explain the rule of 40 and its role in such a competitive industry as SaaS. 

You'll also learn:

• How to calculate the rule of 40
• Why this metric matters to SaaS companies and investors
• How to interpret your rule of 40 score
• Strategies for improving your score and achieving sustainable growth

Let’s get started by defining the rule of 40 in SaaS in particular. 

What is the rule of 40 in SaaS?

The rule of 40 is a key performance indicator (KPI). It’s used to assess the financial health of SaaS companies. In essence, it proposes that a healthy SaaS business should maintain a balance between its growth rate and profitability.

The rule of 40 in SaaS suggests that the sum of a company's revenue growth rate and profit margin should be at least 40%. It's a quick and easy way to gauge whether a company is prioritizing growth at the expense of profitability, or vice versa.

Typically, the rule of 40 calculation uses annual recurring revenue (ARR) to measure growth. ARR represents the predictable revenue generated from customer subscriptions. 

Profitability is most commonly assessed using the EBITDA margin. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. This margin shows how much profit a company makes from its core operations.

Why is this rule specific to SaaS?

The SaaS industry is known for its high profit margins, typically ranging from 70% to 90%. This fact makes the rule of 40 a more relevant benchmark for SaaS companies than other business models.

Remember: The rule of 40 provides valuable insights into a company's performance, but it doesn't tell the whole story. It should be used in conjunction with other metrics to get a full benchmark of a SaaS company's financial health.

Why does this metric matter?

The rule of 40 in SaaS provides valuable insights for both SaaS companies and their investors. Let's dive deeper into why this metric matters:

Balancing growth and profitability

The rule of 40 in SaaS is important because it helps companies strike a balance between growth and profitability. It's easy for SaaS companies to get caught up in the pursuit of rapid growth. However, sustainable success requires a healthy profit margin as well.

The rule of 40 serves as a reminder that both growth and profitability are crucial for long-term success. It encourages companies to make strategic decisions about how to allocate resources. The key is for them to make sure they are not sacrificing one for the other.

Attracting investors

Investors are always on the lookout for promising SaaS companies to invest in. The rule of 40 provides a quick and easy way for them to assess a company's potential.

A strong rule of 40 score indicates that a company is managing its finances well. This factor makes the company more attractive to investors, as it suggests a higher likelihood of future success and ROI.

Guiding decision-making

The rule of 40 can also be a valuable tool for internal decision-making. By tracking their rule of 40 score, companies can get a clear picture of their overall financial health.

If a company's score is below 40%, it may signal the need to re-evaluate its strategy. Perhaps it's time to focus on improving profitability, even if it means slightly slowing down growth. 

Conversely, a high score above 40% may indicate that the company has room to invest in further growth initiatives.

Note: We’ll explore what these percentages mean in more detail further down below. 

Benchmarking performance

The rule of 40 allows SaaS companies to benchmark their performance against others. It provides a common framework for comparison, even for companies at different stages of growth.

By comparing their score to industry averages and competitors, companies can find areas for improvement and set realistic goals for the future.

How to use the rule of 40 formula

As you know, the rule of 40 in SaaS states that a company's revenue growth rate plus its profit margin should equal 40% or more. Its formula is deceptively simple, but understanding its components is key to using it effectively. Here's the formula:

Revenue Growth Rate (%) + Profit Margin (%) = 40%  

Now, let's take a closer look at each component:

Calculating revenue growth rate

The revenue growth rate typically focuses on recurring revenue. This metric is considered the lifeblood of SaaS companies. It is usually measured as ARR, the predictable revenue generated from customer subscriptions over a year.  

To calculate the ARR growth rate, you can use this formula:

ARR Growth Rate (%) = (Current Year ARR - Prior Year ARR) / Prior Year ARR  

For example, Imagine a SaaS company with an ARR of $10 million in 2022 and $13 million in 2023. Their ARR growth rate would be:

(13 million - 10 million) / 10 million = 0.3 or 30%

Calculating profit margin

The most common method for the rule of 40 is using the EBITDA margin. As stated before, it reflects a company's profitability from its core operations. Here's the formula for the EBITDA margin:

EBITDA Margin (%) = EBITDA / Revenue  

Let's continue our example. If the same SaaS company had an EBITDA of $3 million in 2023, its EBITDA margin would be:

3 million / 13 million = 0.23 or 23%

Putting it all together

Now, let's plug those numbers back into the rule of 40 formula:

30% (ARR Growth Rate) + 23% (EBITDA Margin) = 53%

In this example, the company has a score of 53%. It’s comfortably exceeding the 40% benchmark. This percentage indicates that the company is doing well in balancing growth and profitability.

Remember: Exceeding 40% is generally a good sign, but it's important to consider the context. A very high growth rate with a negative profit margin might not be sustainable in the long run. Similarly, a high profit margin with minimal growth could indicate missed opportunities.

Benefits from using the rule of 40

The rule of 40 offers several advantages for SaaS companies. Here are some key benefits:

• Find a sustainable balance between growth and profit. Instead of focusing solely on new customers, the rule of 40 encourages companies to also prioritize their bottom line. This approach ensures they are building a sustainable business for the long term.
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• Uncover potential financial red flags early on. A low score can signal issues like high customer acquisition costs, inefficient operations, or pricing issues. Addressing these issues early can prevent larger problems in the future.
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• Gain clarity on where to invest your resources. A high growth rate with a low profit margin might lead you to focus on operational efficiency. Conversely, a healthy profit margin with slow growth might encourage you to invest more in sales and marketing.
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• Promote transparency and accountability within your company. When everyone understands the rule of 40, it creates a shared understanding of the company's financial goals. It can help align everyone towards achieving those goals and foster accountability.
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• Adapt your financial strategy to different stages of your company's lifecycle. Early-stage startups might prioritize growth over profitability. Mature companies may focus more on profits. The rule of 40 can be adjusted to reflect these different priorities.

What does it mean if you pass the rule of 40?

Passing the rule of 40 is a considerable achievement for any SaaS company. But what does this mean in practice, and what new opportunities does it unlock? Let’s answer those questions:

A mark of financial health

First and foremost, exceeding the 40% benchmark signals strong financial health. It shows that the company is growing its revenue while also generating profits. The goal? Long-term sustainability. 

Sustainability is particularly important in the current economic climate. Why? Because investors are increasingly prioritizing profitability alongside growth.

Increased valuation premiums

SaaS firms that pass the rule of 40 are now attracting higher valuations. Aalto’s analysis of over 500 software companies yielded some interesting findings. The valuation premium for companies meeting the rule of 40 has jumped from 23% in 2022 to a remarkable 129% in 2024. 

Fueling further growth

Passing the rule of 40 can create a positive feedback loop. The increased profitability can be reinvested back into the business, fueling growth. This growth could involve expanding into new markets or developing new products or features. 

Building competitive advantage

A healthy rule of 40 score can also provide a competitive advantage. Companies that pass the rule of 40 are often in a stronger position to weather economic downturns. They’re also more likely to invest in innovation and outmaneuver their competitors.

Greater flexibility

Passing the rule of 40 gives companies more flexibility in their strategic decision-making. They might choose to reinvest profits to accelerate growth. Maybe they might decide to prioritize profitability to build a stronger financial foundation. 

This extra flexibility allows companies to adapt to changing market conditions. It can also help them pursue the strategies that best align with their long-term goals.

What does it mean if you're below 40%?

Exceeding the rule of 40 is a desirable goal. However, falling short of this benchmark isn't necessarily a cause for panic. It's important to understand what a lower score might indicate and what steps you can take to improve. That’s exactly what we’ll discuss now:

Potential concerns

A rule of 40 score below 40% suggests that a company may face challenges related to:

• Cash flow: The company might be spending more than it's earning, leading to cash flow problems.
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• Liquidity: A low score could indicate that the company doesn't have enough liquid assets to cover its short-term obligations.
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• Sustainability: It might signal that the company's current growth trajectory isn't sustainable in the long run.

How to address a low score

If your company finds itself below the 40% threshold, here are some potential solutions to consider:

• Improve operational efficiency: Look for ways to reduce costs without sacrificing growth. Can you negotiate better deals with vendors? Are there any redundant processes that can be eliminated?
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• Increase pricing: Consider raising prices. You should do this especially if your product offers significant value and your customers are happy.
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• Focus on customer retention: Retaining existing customers is usually more cost-effective than getting new ones. Invest in customer success initiatives to reduce churn and increase customer lifetime value.
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• Re-evaluate your growth strategy: Are you spending too much on customer acquisition? Consider adjusting your marketing and sales strategies to improve efficiency.
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• Seek external funding: If cash flow is a major concern, consider raising capital from investors to provide a financial cushion.

Exceptions to the rule

A score below 40% often warrants attention. However, there are some exceptions where it might not be as concerning:

• Early-stage startups: Young companies often prioritize rapid growth. They do so even if it means sacrificing profitability in the short term. As they mature and gain market share, they can shift their focus towards profitability.
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• Companies with disruptive innovations: Investors might be willing to overlook a lower rule of 40 score in the early stages. This exception applies if a company has a truly disruptive product with the potential to dominate a large market. 
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• Strategic investments: A company might temporarily fall below 40% if it's making big investments. Think research and development, new market expansion, or acquisitions. These investments can pay off long-term with higher growth and profitability.

Get ahead of your finances with the help of Orb

We've explored the ins and outs of the rule of 40 in SaaS. We’ve also explained how crucial it is for companies to balance growth with profitability. To achieve this balance, you need accurate insights into your financial performance to adapt your pricing strategy as you scale.

That's where Orb comes in.

Orb is a done-for-you billing platform designed to help SaaS businesses like yours achieve and exceed the rule of 40. We do so by providing accurate billing, flexible pricing structures, and in-depth financial reporting. 

Here's how Orb can help you maintain a healthy rule of 40 score:

• Gain complete control over your revenue streams. Orb's usage tracking and metering infrastructure ensures accurate billing down to the very last detail. We help prevent revenue leakage and provide a clear picture of your financial performance.
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• Adapt your pricing strategy in real-time. With Orb's plan versioning, you can easily adjust your pricing models to optimize for growth or profitability. Experiment with different pricing tiers, volume discounts, and usage-based models to find the perfect balance.
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• Make data-driven decisions with in-depth reporting. Orb provides detailed financial reports that give you valuable insights. Think revenue streams, customer behavior, and key SaaS metrics. This data helps you to make decisions about your growth strategy.
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• Prevent billing errors and disputes. Orb's accurate invoicing system helps you build trust with your customers and reduce billing disputes. We help you keep customers happy while also protecting your revenue streams.
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• Simplify your billing operations. Orb integrates with popular data warehouses and accounting software. We automate your billing processes and reduce the risk of errors. This advantage helps free up your team to focus on higher-value operations.

Ready to take control of your finances and unlock the potential of your SaaS business? Try Orb and discover how it can help you achieve a healthy rule of 40 score. Check our pricing options to find a plan that aligns with your unique needs.