The rule of 40

Investors and executives alike are often faced with a fundamental question: should a company prioritize growth, or should it focus on profitability? The Rule of 40 offers a simple yet powerful framework to evaluate a company's performance in this trade-off.

The Rule of 40 states that the sum of a company’s growth rate and profit margin should equal or exceed 40%. This metric is particularly relevant for SaaS companies but has been applied more broadly in the tech sector.

• Growth Rate: Typically measured as year-over-year (YoY) revenue growth. This indicates how quickly the company is expanding its top line.

• Profit Margin: Commonly calculated using operating margin or EBITDA margin (Earnings Before Interest, Taxes, Depreciation, and Amortization). This reflects the efficiency and profitability of the company’s operations.

For example, if a SaaS company has a 25% YoY growth rate and a 15% profit margin, the Rule of 40 is satisfied because 25% + 15% = 40%.

The Rule of 40 is a helpful benchmark for evaluating the health of a SaaS business. Here’s why:

1. Balancing Growth and Profitability: • High growth often comes at the expense of profitability, as companies invest heavily in customer acquisition, product development, and scaling operations. • Conversely, high profitability with low growth may indicate a lack of innovation or competitive positioning.

   The Rule of 40 provides a way to balance these two critical dimensions.

2. Investor Confidence: Investors use this rule to gauge whether a company is effectively managing its resources to drive sustainable value creation. Falling below the 40% threshold may signal inefficiency or stagnation.

3. Simple and Scalable: The metric is easy to calculate and can be applied consistently across companies, making it a popular tool for benchmarking within the SaaS industry.