The Rule of 40 is perhaps the most popular SaaS KPI behind organic growth in annual recurring revenue (ARR). However, with recent shifts in the market, could the Rule of 40 for SaaS companies be considered an outdated metric? Short answer: no, it is not – but we believe there should be a slight adjustment to the calculation.
Written By: Martin Senning Eriksen, Investment Manager at Viking Venture
The minimum point of happiness for a mature company is considered to be a 40% growth rate. Building on this statement, Techstars introduced the idea that for a software company to be successful the sum of its growth rate and profitability should equal, or be greater than, 40% – enter the Rule of 40. If you are growing 25% yearly, then you need to generate 15% profit. If you are growing at just 10% yearly, you need to generate 30% profit. If you are growing at 60% a year, then you can allow yourself a loss of 20%. We measure the trade-off between growth and profitability, and if you achieve a Rule of 40 of 40% or better – you have found a healthy balance.
Calculating the Rule of 40 is simple for a SaaS company; however, the definition varies greatly. Growth is measured by comparing MRR or ARR closing balances over a certain time frame. It is important here to exclude any effects of inorganic growth like M&A, as this is not valued as highly as organic growth. Check out our article Valuation of Software Companies to read more about this.
Profitability is often a point of contention. The most common input for profitability in SaaS is EBITDA margin, an easily accessible, standardized metric. Other inputs include net income, free cash flow and in the Nordics, EBITDAC (EBITDA minus capitalized R&D costs). So, what should we use? To answer this, we need to take a step back and consider what we are actually trying to measure. We want our company to achieve a healthy balance between the money that we invest and the growth that we receive from said investment. Cash is King, right? So, let’s find a way to incorporate this into our calculation of the Rule of 40.
In the Nordics, it is common practice to use “EBITDAC”, which is EBITDA minus capitalized R&D costs, as a proxy for cash. However, this doesn’t capture one of the main benefits of the SaaS business model, which is the effects of upfront payments. A fast growing SaaS company with 12 month upfront payments can essentially fund their growth with the money they receive from new customers. To include this benefit, we can use “EBITDAC”, but we need to include the change in deferred revenue to capture the effects of upfront payments.
Viking Venture’s proposed calculation of the Rule of 40 is, therefore:
Rule of 40 = ARR organic growth rate + (EBITDA – capitalized R&D costs + change in deferred revenue)
There has been a shift in recent months where investors are no longer looking for companies with a growth at all costs mentality. This shift can be seen quite clearly in public markets where high growth, low profitability SaaS companies have seen sharp decreases in valuations. Investors interested in our portfolio companies have now started asking about profitability and EBITDA margins before growth rates. As investors, we need to respond to this change in the market and have communicated to our portfolio companies that capital efficient growth is now of the highest priority. If we can’t achieve profitability now, we need a clear path to profitability in place.
Unsurprisingly, companies with high growth rates coupled with high profitability are valued the highest. However, there has been a shift in 2022 that we have not seen previously. Before 2022 high growth, low profitability companies were valued higher than low growth, high profitability companies. So far in 2022, it now appears as though these two types of companies are valued relatively similarly.
So what does this mean? Profitability has become more and more important for B2B SaaS companies. To achieve the highest valuations companies need to combine healthy growth and profitability. It has also become apparent that if you are not able to achieve this, it is important to choose a clear profile, high growth or high profitability. Just ensure you are not caught in between with neither high growth, nor high profitability.
Sign up for our newsletter to get valuable insights and the latest perspectives on how Nordic software companies can scale faster. Learn how to improve sales processes, develop your management team, optimize pricing and accelerate through acquisitions.