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Deconstructing the Rule of 40 SaaS Metric for Sustainable Growth

By August 4, 2023No Comments

In the dynamic software landscape, certain SaaS metrics hold significant value for investors and company stakeholders. Rule of 40 SaaS metric is one such example known to drive sustainable growth.

In the first edition of our new KPIs Hot Takes Series, Discern’s CEO, Helen Lin, recently sat down with GTM expert from Insight Partners, Jeremey Donovan, to discuss the Rule of 40. During their conversation, Helen and Jeremey revealed how a SaaS business can improve Rule of 40 performance to drive the long-term valuation of the company. In this article, we review the key takeaways from the discussion.

Understanding the Rule of 40

The Rule of 40 is a performance metric that combines a company’s growth rate and profit margin. According to The Rule of 40, SaaS companies should have a combined revenue growth rate and profit margin equal to or greater than 40%. This serves as an indicator of the software company’s  health.

Rule of 40 Formula: How to Calculate Rule of 40

Calculating the Rule of 40 requires the sum of a company’s profit margin, measured by free cash flow (FCF) margin and growth percentage, measured by ARR growth.

For example, let’s say a SaaS company has an ARR growth of 25% and a free cash flow margin of 12%. The company’s Rule of 40 is 37%. Because this is slightly below the 40% target, this company should improve the efficiency of their revenue growth and operations.

Rule of 40 Applicability for SaaS Companies

The Rule of 40 is particularly applicable to SaaS companies with an annual recurring revenue (ARR) greater than $10 million. For companies in the early stages with recurring revenues below this threshold, investors tend to prioritize strong subscription revenue growth over high profitability margins.

Importance of the Rule of 40

The Rule of 40 plays a crucial role in attracting investors and assessing a company’s financial valuation. Based on an analysis of more than 100 public SaaS companies, those meeting the Rule of 40 tend to perform significantly better than those below the threshold.

In fact, the SaaS businesses meetings the Rule of 40 saw noticeably higher market cap-to-revenue multiples. This indicates a substantial reward for being both a rapid-growth and high-efficiency company.

Deconstructing the Rule of 40 SaaS Metric for Efficient Revenue Growth

In order to improve their Rule of 40, SaaS businesses need to focus on balancing growth with efficiency. As a result, companies looking to increase their Rule of 40 should zero in on the following sub-components:

  1. Revenue Growth:

    1. New logo acquisition: Companies must focus on generating pipeline consistently by setting targets and engaging in high ROI marketing activities.

    2. Net retention: Having a robust customer success organization with health scoring and proactive customer engagement is vital to reducing churn and increasing expansion.

  2. Free Cash Flow Margin:

The free cash flow margin is influenced by gross margin, sales and marketing expenses, R&D expenses, and general administrative expenses. Historically, most software companies were in a growth-at-all-costs mode. However, focus has now shifted to a sustainable growth model, with highly efficient marketing and sales strategies.

CAC payback is an important indicator of marketing and sales efficiency. Measuring the return on ad spend,deploying budget to the most effective channels, and increasing bookings per ramped rep can lead to a shorter CAC payback period, a higher Free Cash Flow Margin, and ultimately a stronger Rule of 40 number.

Conclusion: Rule of 40 is a Key Metrics for High Growth Software Companies

The Rule of 40 acts as a beacon for the SaaS industry, guiding >$10 million annual recurring revenue companies towards sustainable growth in a highly competitive market. By striking the right balance between revenue growth and profitability, software companies can attract investors, unlock growth potential, and drive valuation success for all stakeholders.

By deconstructing the Rule of 40, SaaS companies can identify areas for improvement and implement strategies that align with market demands and customer needs.

Want to Participate in Discern’s KPI Hot Takes Series?

Contact us to learn more and discuss what other SaaS metrics and KPIs you think a healthy SaaS company should prioritize, in addition to Rule of 40.

About Discern

Discern is a Business Operations and Intelligence platform designed to help companies automatically monitor performance of KPIs and SaaS metrics (like Rule of 40) against targets. As a result, customers can proactively pinpoint which areas of the business need to be focused on in order to drive operational excellence.

By connecting data siloed in any SaaS platforms, spreadsheet, or database, Discern creates a single source of truth for cross-business performance, automating the creation of investor reports and board decks.

If you’re a high growth SaaS business looking to efficiently monitor and improve the performance of 200+ SaaS metrics such as Rule of 40, Discern could be a good fit.

Request a demo to learn more about our 1-2 week implementations.