Rule of 50 Weighted 2x for Growth

With the shift from growth at all costs to a heavier emphasis on profitability, the traditional Rule of 40 has become more popular over the last two and a half years. Put simply, the Rule of 40 is a combination of growth rate and profitability (free cash flow margin) with a target score of 40 or higher. Some hypergrowth startups achieve a score of 100 or more for an extended period, while many venture-backed startups struggle to reach 40 due to a high burn rate. For example, if a startup is growing 60% per year and has negative 20% free cash flow margins, adding 60 and -20 results in a score of 40, indicating a good position. Even during pre-boom times, the Rule of 40 was used to justify aggressive spending to achieve growth (e.g., growing 200% with negative 100% free cash flow margins).

Reflexively, this is a simple metric, but there’s one element that isn’t quite right: growth and profitability can’t be equal. While the focus on growth fluctuates based on market conditions and investors, adding an extra dollar of growth for high-margin recurring revenue SaaS startups is clearly better than adding a dollar of one-time profit. Thankfully, Bessemer conducted an analysis of publicly traded SaaS companies over an extended period and showed that a multiplier on the growth rate, combined with a free cash flow profitability measure, more accurately predicted valuations compared to the traditional Rule of 40 score. Their finding: 1% more growth is roughly twice as valuable as 1% more profitability (see The Rule of X). The growth multiplier fluctuates over time and reached as high as 9x during the early COVID years.

Intuitively, growth being twice as valuable as profitability makes sense. Investing in growth and reducing profitability can potentially make the company more valuable by buying a recurring revenue stream, with the expectation that the revenue will add to the current revenue, making the business larger indefinitely.

Now, with growth being twice as valuable as profitability, the Rule of 40 target of 40 needs to be adjusted upwards to reflect a new, higher target in line with historic public company data. Bessemer did this work as well, and the resulting target is 50. Let’s look at an example: a startup growing 10% due to the downturn combined with 20% free cash flow margins. Under the Rule of 50 scoring, that’s a score of 40 (10 * 2 plus 20), which is below the 50 target. Not good. Now, for a second example: a startup growing 100% with free cash flow margins of negative 100% gets a score of 100 (100 * 2 plus -100), which is excellent. Both examples pass the gut check, assuming they have millions in revenue (e.g., not seed stage).

My recommendation is to use the naming convention Rule of 40 when discussing the traditional growth plus profitability score, and use the naming convention Rule of 50 when discussing growth plus profitability where growth is doubled to represent its greater weighting. Startups should use the Rule of 50, representing growth rate multiplied by two plus free cash flow margins when assessing their performance. Growth is more valuable than profitability.