How well does your software company balance short-term profitability with investing in growth in revenue and new products/services?
Investors and venture capitalists love companies that grow customers and revenue profitably.
The Rule of 40 is a popular metric that measures a software company’s combined revenue growth rate and profit margin, aiming for it to equal or exceed 40%. Hitting the 40%+ mark in one year is excellent! Hitting it again and again as a company grows bigger requires different strategies over time.
SaaS companies that measure above 40% are generating profit at a rate that’s sustainable. Companies below 40% may face cash flow or liquidity issues or even die, especially in slow funding periods like in 2023.
The Rule of 40 Formula:
To calculate CAC Payback period, use the following formula:
RULE OF 40 DEFINED
Rule of 40 = Revenue Growth Rate + Gross Profit Margin
When you calculate Rule of 40, you’ll need to understand the following numbers:
- Revenue Growth Rate: Revenue growth rate measures the percentage increase in total revenue over a specific period, as compared to revenue in a previous period. With this rate in hand, you have good insight into the company’s ability to expand its top line, by showing the pace at which your sales and revenue are increasing. High and sustained revenue growth is a great sign to venture capitalists and employees too, signaling market demand, an effective strategy, great products, strong leadership and a high potential for increased profits.
- Gross Profit Margin: How much profitable revenue does your company generate, once all costs to service the customer have been removed? The gross margin represents the percentage of revenue that exceeds your cost of goods sold (COGS). It measures the profitability of core operations, excluding other operating expenses such as marketing, administration, and research and development. To calculate, find the difference between your revenue generated and the host of costs associated with delivering the product or service over the same period. Hopefully this is a positive number!
How Do I Calculate Rule of 40?
Here’s an example of how to calculate the Rule of 40 using a fictional company in Seattle called GoodCompany. GoodCompany is a successful software company with an AI software product that uses generative AI to create custom business tools for B2B businesses.
Here’s the facts:
- GoodCompany grew revenue from $2,000,000 ARR to $2,500,000 ARR in the last year
- GoodCompany had $2,100,000 in costs of goods sold (COGS) in the last year
Let’s add up these results and see what we get:
$2,500,000 – $2,000,000 = 500,000
Revenue Growth Rate
$500,000 / $2,000,000 = 25%
$2,500,000 – $2,100,000 = $400,000
Gross Profit Margin
$400,000 / $2,500,000 = 16%
Rule of 40 Calculation
25% + 16% = 41%
GoodCompany’s investors and leadership have plenty to be proud of.
By combining strong revenue growth with strong efficient delivery, they’ve exceeded the Rule of 40 with a result of 41.
What Is A Good Rule of 40?
To understand if your software (SaaS) company is generating profit at a rate that’s sustainable, see where it sits in the following ranges:
- Below 40%: Your company is not generating sustainable profit and may soon face cash flow and/or liquidity issues
- At 40%: Your SaaS company is hitting a healthy threshold of sustainable profit
- Over 40%: Your combined revenue growth rate and profit margin is above average and overall your company is generating profit at a more than sustainable rate
According to Bain & Company, a sampling of 86 companies from 2013 to 2017 revealed the following success metrics over time for hitting the Rule of 40:
- 33 (38%) did not outperform the Rule of 40 for a single year
- 53 (62%) outperformed the Rule of 40 for a single year
- 36 (42%) outperformed the Rule of 40 for two years
- 22 (26%) outperformed the Rule of 40 for 3 or 4 years
- 15 (17%) outperformed the Rule of 40 for 5 years or more
Statistics show that less than 1 in 5 software companies are able to exceed the Rule of 40 for more than 5 years. That’s a brutal rate! It shows how excellent stewardship of attracting and keeping customers who pay and stay profitably is mandatory to attract the next round of funding.
In November 2023, Sutton Capital Partners’ Recurring Revenue Conference noted that difficult capital funding conditions like those seen in 2023 to 2024 called for strict attention to Rule of 40. In those environments, companies still need to grow rapidly, but the growth needs to be breakeven at least.
As an example, Peter Cowan of Sutton Capital gave two examples. As recently as 2022, a company growing quickly, regardless of profitability, would have been an attractive funding recipient. Slow growth, profitable companies might have been overlooked.
Now, however, the metrics read differently:
|60 – 10 = 50
|120 – 100 = 20
|Not attractive today
Of course, remember that the Rule of 40 is a guideline rather than a strict rule.
A fractional CMO can help your leadership team decide what the implications of different strategies for growth, depending on your company’s stage of growth, market conditions, business models and resources at hand.
In times when funding is plentiful, many high-growth companies prioritize rapid expansion and market domination over short-term profitability. Freezing out other competitors and then serving the customers well is a great strategy. However, this can be risky if leadership is unable to bring the company back to profitability when funding becomes more difficult to secure.
Achieving a balance between growth and profitability is always a great rule of thumb.
How Can I Improve My Company’s Rule of 40?
Improving your SaaS company’s Rule of 40 involves finding a balance between revenue growth and profitability. Each area has endless opportunities to examine and improve.
A fractional CMO can impact your Rule of 40 with these and other strategies, found below, to enhance both components of the Rule of 40.
Six Strategies to Improve Revenue Growth Rate for Rule of 40
To keep succeeding at Rule of 40 outperformance, every SaaS company has to think first about growing revenue. What is the best go to market for our brand new product? Where is the next best channel for our existing product?
Here are some ways to get more revenue growth for your software company and improve Rule of 40:
- Expand Your Market Reach: Identify new target markets or customer segments to broaden your customer base. If you have a great product, consider entering it in new markets. If you’ve saturated the market for your product, develop new products for your best existing market.
- Make Your Products Even Better: Continuously improve and innovate your products to attract new customers and retain existing ones. Ask your customers how you could help them more!
- Boost ARPU with Customer-Friendly Up-selling and Cross-selling: Implement strategies to increase the average revenue per user (ARPU) through up-selling and cross-selling.
- Form Productive Partnerships and Alliances: Form strategic partnerships and alliances to tap into new distribution channels and reach a wider audience. Are there VCs that cater to your market niche? Are there communities that serve your best customers?
- Optimize Marketing Strategies and Execution: Optimize your marketing efforts to increase lead generation and conversion rates. Are your landing experiences truly welcoming and conversion oriented? Could there be more market awareness, credibility and/or reviews? Have you maximized results in all the channels that are available?
- Reduce Churn and Retain More Customers: Focus on customer satisfaction and retention to minimize churn and maximize the lifetime value of customers. Customer lifetime value is a highly relevant indicator of how great and important your business might be in the future.
Five Strategies to Improve Profit Margin for Rule of 40
To improve your software company’s Rule of 40 result, next you need to focus on increasing profit margins. How can your costs be lowered in every area?
Considering fractional executives rather than full-time hires is a sure-fire way to reduce costs and get better results.
- Hire a Fractional CMO for Maximum Efficiency: Fractional CMOs give your company the ability to enter new markets at maximum speed, optimize your approach in existing markets, hire and train your team better, utilize data dashboards and well-integrated marketing systems, and get the best of today’s automation and generative AI tools.
- Reconsider Your Pricing Strategies: Evaluate your pricing model to ensure it reflects the value your product provides. Adjust pricing tiers or introduce new plans if necessary.
- Seek Out New Automation, AI and Efficiency: Invest in automation tools and technologies to streamline workflows and reduce manual labor costs.
- Get Efficient and Scale Faster: Ensure that your business scales efficiently by aligning resources with growth. Avoid unnecessary overhead costs. Analyze and optimize operational costs to increase overall efficiency and reduce expenses.
- Examine and Optimize Your Subscription Model: Evaluate your subscription models to encourage longer-term commitments. Avoiding the need to “re-up” customers into new contracts can greatly reduce customer acquisition costs over time.
5 Combined Strategies to Improve Rule of 40:
When you put together strategies that boost revenue growth with strategies that improve profit margin, you are bound to see a positive impact to your Rule of 40 calculation.
Overall, here are some great items to consider to get more traction with Rule of 40:
- Rely on Real-Time Data to Drive the Best Decision-Making: Utilize data analytics to make informed decisions about product development, marketing strategies, and operational efficiency.
- Invest in the Customer with New Success Programs: Implement robust customer success programs to ensure that customers derive value from your product, reducing churn and supporting long-term growth.
- Invest in Cutting-Edge Research and Development: Allocate resources to research and development to maintain a competitive edge and offer innovative solutions that attract new customers.
- Try Out Some Scenario Planning: Conduct scenario planning to assess the impact of different growth and profitability strategies. Evaluate the trade-offs between short-term gains and long-term sustainability.
- Maintain Steady Financial Discipline: Maintain financial discipline by closely monitoring key financial metrics and ensuring that investments align with strategic objectives.
Achieving the Rule of 40 is not a one-size-fits-all approach.
Find the approach that is best for you!
Do What is Best for the Customer, Profitability and Growth to Win at the Rule of 40
The optimal balance between growth and profitability may vary depending on the stage of your SaaS company, the prevailing market conditions, and your strategic goals.
Becoming one of the lucky 20% who deliver year after year of Rule of 40 outperformance is more than an exciting goal. It might be necessary to stay in business over the long term in the brutal software business.
Regularly reassess your strategy, analyze performance metrics, and make data-driven adjustments to ensure sustained success with Rule of 40.
• SaaS and the Rule of 40: Keys to the critical value creation metric by McKinsey & Company
• Rule of 40: The Guide to Understanding the Rule of 40 in SaaS Valuation by Wall Street Prep
• Hacking Software’s Rule of 40 by Bain & Company