The Rule of 40, first introduced to the SaaS industry by venture capitalists Brad Feld and Fred Wilson in 2015, is a financial metric that helps CFOs and other executives assess the overall health and growth potential of a company.
It’s calculated by adding a company’s annual revenue growth rate to its EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) margin. If the sum of these two numbers is equal to or greater than 40, the company is considered to be healthy and well-positioned for growth.
Chief Financial Officers (CFOs) care about the Rule of 40 because it provides a simple and effective way to evaluate a software company’s financial performance and potential. It allows CFOs to quickly assess whether a company is generating enough revenue to cover its costs and also investing in growth opportunities.
Why is the Rule of 40 particularly important to SaaS Companies?
This rule pertains mainly to software companies because it takes into account both revenue growth and profitability. In their early stages, software companies often prioritize revenue growth over profitability. However, to ensure long-term sustainability, they need to balance revenue growth with profitability as they mature.
How to calculate the Rule of 40
To apply the Rule of 40, CFOs typically take the following steps:
Calculate the company’s revenue growth rate for a given period (usually one year). This is typically done by comparing the company’s revenue from the current year to its revenue from the previous year.
Calculate the company’s profitability by measuring its EBITDA margin for the same period. This is calculated by dividing EBITDA by revenue.
Add the company’s revenue growth rate and EBITDA margin together. If the result is 40% or higher, the company is considered to be in good financial health. If the result is below 40%, the company may need to make changes to improve its profitability or growth rate.
While CFOs may use this rule as a quick way to assess the overall health of a company, it’s important to note that the rule doesn’t take into account other important factors such as cash flow, debt levels, and market share. CFOs should use the Rule of 40 in combination with other financial metrics and qualitative factors when making decisions about a company’s performance and future direction.
Overall, the rule of 40 is a useful metric when evaluating the financial health and potential of software companies. With this rule, CFOs can quickly identify companies that are well-positioned for growth and those that may need to adjust their strategy to achieve sustainable growth.