The Rule of 40: Balancing Growth and Profitability of SaaS Startups
Updated: Mar 29
As mentioned in other publications, one of the biggest differences between Startups and other traditional businesses is the pursuit of accelerated growth. Along the way, as the company matures, it is essential to have benchmarks that help us identify whether we are growing or achieving the expected result.
In 2015, Venture Capital companies began using the Rule of 40% to assess the operating health of technology companies, particularly SaaS. This is a rule applicable to mature companies, startups that are taking their first steps have better references than this one to assess the health of their business, such as the T2D3 model by Neeraj Agrawal, Partner at Battery Ventures.
The Rule of 40% establishes that the sum of the company's growth in revenue and profitability must be greater than 40%:
If a company grew 20% year over year in revenue, its profit should represent 20% as well. If the growth was 40%, the profit margin could be equal to 0%. If the growth was 50%, the profit margin could be -10%.
The calculation and indicators used for growth and profit may vary. For example, for revenue growth you can use the following values:
GAAP Revenue growth from one year to the next. GAAP Revenue refers to revenue calculated in accordance with the criteria established by accounting, it is the same amount that appears in the income statement of the companies;
MRR (Monthly Recurring Revenue) or ARR (Annual Recurring Revenue) growth from one year to the next. MRR is basically monthly recurring revenue, it can be calculated as the product of total bills at the end of the year and the average ticket paid by customers. The ARR is the multiplication of the MRR by 12.
MRR = Total Number of Clients x Average Price
ARR = MRR x 12
For the profitability indicator, the following metrics can be used:
Free Cash Flow and Net Revenue Ratio;
Cash Flow and Net Revenue Ratio.
The EBITDA margin is the most used, but some aspects may suggest that another indicator is more appropriate. For example, if a company makes large investments in infrastructure by not using third-party servers such as AWS, it can have very different cash flow and EBITDA values.