Last week I was talking to an entrepreneur and he asked what valuation I thought the market would bear for his startup’s next round of funding. I asked for the business state of the union and standard financial metrics like recurring revenue, growth rate, gross margin, burn rate, cost to acquire a customer, renewal rate, and net dollar retention.
After hearing the metrics, I shared that they’re below the Rule of 40 or better. Confused, he asked what that meant. The Rule of 40 is the growth rate, as a number, plus the burn or profitability percentage, as a positive (profits!) or negative (losses) number, added together.
If the business is growing 100% year-over-year, and is burning the cash equivalent to 40% of revenue, it would be 100 + (-40) = 60, which is 40 or better.
If the business is growing 50% year-over-year, and is burning the cash equivalent to 30% of revenue, it would be 50 + (-30) = 20, which is below 40, and not as good.
Let’s look at a more specific example:
- $10 million of revenue
- 50% year-over-year growth rate
- $1 million in trailing twelve months burn (burn is 10% of revenue)
Here, the Rule of 40 calculation would be 50 + (-10) = 40. So, they’re in good shape and are right at the Rule of 40.
Another way to think about the Rule of 40 is that if the startup has a high burn rate relative to revenue, it needs to have a high growth rate. If the startup has a low growth rate, it needs to be profitable.
If some extreme cases like dramatic user growth (e.g. Facebook in the early days) and amazing net dollar retention (existing customers buy significantly more product every year and outweigh the customers that leave), the Rule of 40 is less applicable. For most startups, it’s very relevant.
The Rule of 40 is a great way to assess how a startup is performing in an objective manner and should be a regular topic of conversation for entrepreneurs.