Brad Feld wrote a great piece last month titled The Rule of 40% for a Healthy SaaS Company. The idea is that growth plus profitability should be 40% or greater once at scale (double digit millions of revenue). As an example, if a SaaS company grew 100% year-over-year, and had negative margins of 60% (burning lots of cash), then those combined percentages equal 40% (yes, they’re two different percentages, but the metric is more of a gauge rather than scientific). As for another example, if a SaaS company grew 20% year-over-year, and had EBITDA (profit) margins of 20%, then those combined percentages equal 40%, and hit the mark.
Here are a few thoughts on the rule of 40% for SaaS companies:
- For seed stage (under $1M run-rate) and early stage ($1-$5M run-rate), the percentage should be much higher
- Higher growth rates often equate to higher valuations (see the growth rate valuation multiplier)
- No growth, and profit margins of 40%, would still fit this 40% metric, but not be nearly as interesting to traditional venture and growth stage investors (unless they thought significant revenue growth was possible)
- As scale increases, maintaining high growth rates becomes much more difficult as the law of large numbers kicks in
- Mailchimp, a rare unicorn, has double digit revenue growth and greater than 50% profit margins
Thinking about growth rate in conjunction with profitability makes perfect sense as there’s always a trade off between the two. The Rule of 40% for SaaS companies provides a general metric that takes into account both growth and profitability.
What else? What are some more thoughts on the Rule of 40% for SaaS companies?