Rule of 40 and Startups

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.

4 thoughts on “Rule of 40 and Startups

  1. David, could you talk a little bit about the stage when Rule of 40 becomes a useful metric to track? When did you start using as guidance at Pardot?

    I rarely hear from sub $30m ARR SaaS CEO’s where they believe that the Rule of 40 is both tracked and valuable as an indicator. Most of the time its pre IPO (or maybe as low as $60m ARR) CEO’s and exec teams that start tracking Ro40 religiously.

    1. You talk to high profile, high growth CEOs, which isn’t normal :). Most startup CEOs should be paying attention to the Rule of 40.

  2. Hey David. We are at 135 currently. 153% YoY + (18 burn) = 135

    Two questions:

    1. In the article it doesn’t explain “why” this matters. Why is 40 the rule? What’s magic about that?

    2. Is the goal to have the number as high as possible? So, go from 135 to 1,000? Etc.

    Thanks for the help in advance.

    1. The “why” is that too much attention is paid to fast growth without enough attention paid to the cost of the growth. The Rule of 40 captures growth and burn/profits, which is the right way to think about the pair.

      The goal is to have the number be as high as possible assuming the other core metrics like renewal rates are inline with industry best practices as well.

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