Every company has its own definition of achievement and success. It is not a consistent criterion or a standardized system for success. The Rule of 40 has recently become famous and essential for analyzing the operating performance of any company for revenue growth.
The Rule of 40 is a simple rule for analyzing the health of a SaaS business or SaaS software to see the revenue growth rate, focusing on two company aspects – Growth and profit.
- Defining the Rule of 40
- Calculating the Rule of 40
- When to Use the Rule of 40
- Why Is Rule of 40 Important (and Effective)?
- When do SaaS Companies Utilize the Rule of 40?
Defining the Rule of 40
Investors and buyers use this Rule of 40 to measure any company’s growth and profit under SaaS. For measuring the trade-off between growth and profit, the Rule of 40 maintains that SaaS software companies target their growth and profit margin by adding up to 40% or even more.
Calculating the Rule of 40
The Rule of 40 is considered a rule of thumb to analyze the health of any business related to SaaS to assure rapid growth. It is a simple rule that looks at two aspects of any company: growth and profit. A simple formula can calculate it:
GP RATIO = GROWTH RATE + PROFIT
This formula means that your growth rate and profit should add up to 40%. The total sum should be equal to or more than 40%. If you are doing 40%, you have good growth and are running a healthy and stable business. And if you are getting more than 40%, your company is moving in the right direction.
When to Use the Rule of 40
It is feasible to use the Rule of 40 when comparing different SaaS companies as per the business model. With this Rule, the health of a SaaS company can easily be measured. Individual health can be measured along with the proper comparison with different companies.
This Rule helps business owners (investors and buyers) to analyze the important factors (growth and profit) before getting into any business. A company can use different strategies to reach 40% easily.
Why Is Rule 40 Important (and Effective)?
People are still confused about whether they should rely entirely on the Rule of 40 or not. Whether the Rule of 40 can decide the financial health. There are some reasons why the Rule of 40 is quite effective:
- Speaks the Investor’s Language
When you are talking to investors, you know how to get them attracted to you. You can present the calculations using the Rule of 40 to show your company’s growth, operating income, professional services, sustainable rate, financial metrics, sustainable growth, growth percentage, and overall performance. The company’s health can easily be calculated and measured using the Rule of 40.
- Creates a Healthy Balance between Growth and Profit
By using the Rule of 40, companies are more focused on creating a healthy balance between company growth potential and profit. They understand that these aspects should go hand in hand, and one cannot get priority over the other. The future growth of the company is taken into consideration too.
- Helps in Running the Business
The company knows its growth and profit rate with a proper focus on the Rule of 40, and it helps carve a basis for comparing profit and growth. This focus doesn’t let them fail and close their business altogether the company considers the factors involved in the Rule of 40 to keep moving forward with a growth rate percentage.
- Makes you Serious in a Competitive Market
Any business cannot stay healthy and successful without proper diagnosis. The best way to move forward and stay successful is to recognize the problem becoming a hindrance to your success. Potential investors get attracted to your business if you work on your growth and profit margin.
When do SaaS Companies Utilize the Rule of 40?
Initially, the Rule of 40 was applied only if the company exceeded $50 million in annual revenue. The pioneer of the Rule then recommended applying this Rule if your company has reached $1 million in annual revenue. Many SaaS companies use this Rule when their revenue reaches $1 million in ARR.
A rule of 40 is one way to measure the health of any business. The Rule of 40 is quite simple and easy and helps in knowing the growth over profitability ratio and helps in the annual growth rate. The only thing to consider is whether your business needs to use this Rule or not. It helps you determine the standings of your business and growth rate too.