With the Great Exuberance behind us and more restructuring pain ahead of us, it’s clear that we’re back to the standard Rule of 40 in startup land. For several years, it was growth at all costs. Want to raise exceptional amounts of money? Show strong growth. Now that those days are done, let’s review the Rule of 40.
The Rule of 40 is a score that combines growth rate and profit margin.
Growth rate, as we all know, is typically measured year-over-year. So, if the startup was at $10 million annual recurring revenue (ARR) 12 months ago and is at $15 million ARR today, that’s a 50% growth rate. As always, the higher the better. The big difference now is that it’s in the context of profits/losses, as a percentage of revenue.
Profit margin is talked about a few different ways from EBITDA to free cash flow. For our purposes here, we’re going to focus on free cash flow. Free cash flow is the cash left over after paying all expenses and capital expenditures. As part of the Rule of 40, we’re interested in free cash flow as a percentage of revenue — profit margin. If we receive $10 million in revenue and generate $2 million of free cash flow, that’s 20%. If we receive $10 million in revenue and lose $2 million, that’s -20%.
For our Rule of 40 score, we add growth rate and profit margin together, with a target of 40 or higher. Since we’re adding two unrelated percentages, we call the resulting value a score. Some simple examples to achieve 40:
- Grow 60% with -20% profit margins (lose money)
- Grow 40% at break even
- Grow 20% with 20% profit margins (make money)
The challenge in startup land today is that too many startups have a Rule of 40 score well below 40, with some even having a negative score. To get to a score of 40, or higher, many of these startups are laying off employees to cut expenses to reduce their losses and improve their margins. For all startups, cost cutting is the fastest way to improve the Rule of 40 score.
Beyond being an important overall metric for startups, it’s also an important score to use for educating and aligning employees. As you can see, there’s an indefinite trade-off between growth and profits. Startups, by their very definition, are growth-oriented companies. So, growth is a given, yet it’s constrained by cash — both cash from investors and cash generated/lost from operations. The more team members keep the Rule of 40 as an important driver in their decisions, the more they’ll optimize for capital efficient growth.
Entrepreneurs would do well to make the Rule of 40 score one of the key metrics of their business and ensure all stakeholders understand the importance.