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.

Compounding Revenue 20% Per Year

Two years ago one of the most successful software investors in the country told me he’d never sell a SaaS business that was growing 20% per year, especially if it looked like it would grow that way indefinitely. Last month, another extremely successful investor said he just wants to invest in great companies that grow 20% per year, and doesn’t like the current mentality of growth at all costs. Clearly, there’s something more experienced investors see that isn’t appreciated enough: the power of compounding.

Let’s take a look at a couple of examples:

$10 million revenue start

  • Year 1 – $12 million
  • Year 2 – $14.4 million
  • Year 3 – $17.3 million
  • Year 4 – $20.7 million
  • Year 5 – $24.9 million
  • Year 6 – $29.9 million
  • Year 7 – $35.8 million
  • Year 8 – $43 million
  • Year 9 – $51.6 million
  • Year 10 – $61.9 million

$100 million revenue start

  • Year 1 – $120 million
  • Year 2 – $144 million
  • Year 3 – $173 million
  • Year 4 – $207 million
  • Year 5 – $249 million
  • Year 6 – $299 million
  • Year 7 – $358 million
  • Year 8 – $430 million
  • Year 9 – $516 million
  • Year 10 – $619 million

Growing revenue 20% per year for 10 years results in a 5x overall growth — the compounding effect is impressive, especially in the later years. When looking at these examples, it’s clear that growing much faster in the early years is necessary to get to a larger base by the time the 20% annual growth years set in.

Now, thinking in terms of SaaS, there’s a secret weapon that can make this compounding revenue phenomenon even more attainable: positive net dollar retention. Net dollar retention is the revenue renewal amount plus upsell/cross sell minus churned revenue. Put another way, ensure that existing customers buy more product than the amount non-renewing customers stop spending so that that the business grows forever, without signing a new customer. If you can grow new customer revenue 10% per year organically, and 10% per year with net dollar retention, that’s 20% growth. Now, do that for 10 years and you’ve quintupled the business.

Compounding is hard to appreciate for most people, especially many years out in the future. Build a business that grows fast to some level of scale, and work on the underlying fundamentals to compound revenue 20% per year indefinitely.

So Many Tries, So Many Entrepreneurial Failures

Recently, a friend was asking about entrepreneurial endeavors I’d tried over the years, and I realized it’d be fun to enumerate them and reflect on lessons learned. From starting a business, talking to customers, finding solutions, and working to build a sustainable business — every part of the entrepreneurial journey is a learning experience.

Here are some of the ideas I tried, in chronological order.

  • Lawn maintenance service – Enjoyed the work, only did it passively as jobs came in
  • Shareware software – Loved programming and fascinated by the idea strangers would pay for software over the Internet without talking to anyone
  • Local classified ads – Bought a second phone line and connected an answering machine for people to call in with their ads, placed printed classified ads in two local restaurants, realized quickly there wasn’t much demand
  • Sports cards dealer – Loved tracking the players, buying cards from different markets, and helping people complete their collections
  • Web design – Enjoyed the creative process of designing a site in Photoshop, crafting all the pages by hand (HTML + Dreamweaver), and delivering a finished product to the client
  • College textbook exchange – Provided a quality solution to students and learned there’s a number of structural challenges to changing the textbook market
  • College professor rating service – Students loved leaving ratings and reviews but a number of ethical questions arose and there was a lack of interest scaling it
  • College laundry service – Clear product demand but a number of logistical and pricing/margin challenges
  • College online food ordering – Built a working prototype but couldn’t get adoption from restaurants without point of sale integration (times are different now, 20 years later)

In hindsight, each idea played on something I was personally interested in and simply translated into a service for the market.

Every idea was a failure in that I wasn’t able to make it into a sustainable, profitable business.

Every idea was a success in that I created a product or service, brought it to market, and gained more experience.

The lesson: it takes a number of failures before a success. Find a problem, create a solution, and start a business — the more you try, the more you learn.

Compounding Revenue’s Value in the Future

When talking to entrepreneurs about revenue growth, I look to emphasize the value of compounding revenue now and how it plays out over an extended period of time. It’s easy to think that it’s no big deal that we missed our sales number for the quarter or had a lower renewal rate than expected. Only, when you really dig in, a lost dollar today translates into many lost dollars of revenue and enterprise value over the long run. Similarly, an extra dollar of revenue sold today translates into much more revenue and enterprise value over time.

Let’s look at an example. Say you were able to beat the sales plan and the net dollar retention plan adding an additional $1 million in new recurring revenue in a calendar year. With an extra $1 million in recurring revenue:

  • Year 1 after exceeding goals
    • Extra ~$800,000 to grow the business (assume 80% gross margin)
    • Hire two additional sales reps and increase marketing spend (assume 50% of the extra $800,000 goes to sales and marketing)
    • Add $1M of new annual recurring revenue from the new reps (assume the two reps each have a $500,000 quota and hit it)
  • Year 2
    • Extra $1,600,000 to grow the business (year 1 gross margin plus the gross margin added by the new reps assuming 100% net dollar retention)
    • Hire four additional sales reps and increase marketing spend
    • Add $2M of new annual recurring revenue from the new reps
  • Year 3
    • Extra $3,200,000 to grow the business (it keeps layering on the previous year!)
    • Hire eight additional sales reps and increase marketing spend
    • Add $4M of new annual recurring revenue from the new reps

In this example, by the end of the third year after the year of an extra $1M in annual recurring revenue, the business has added $8M of new annual recurring revenue. $8M of annual recurring revenue pays for dozens of employees and adds $40M – $80M of enterprise value in today’s market (assumes 5-10x run rate multiples).

The next time someone questions the importance of renewing an existing customer, or signing a new customer, remind them that $10,000 of recurring revenue today is worth up to $800,000 of enterprise value after three years. Every dollar counts.

The Email Inflection Point in the Product/Market Fit Journey

When we launched the initial marketing automation product for Pardot, the feature set was quite simple. We had a minimal analytics that would track the individual lead’s movement around the site, a basic form capture to collect contact information, rudimentary CRM integration to sync data, and that was about it. Over time we added core modules like landing pages, automation rules, complex CRM integrations, and dynamic customer journeys. Only, the initial plans didn’t call for email marketing.

In fact, we actively didn’t want to do email marketing. Who wants to be an email service provider (tools like Sendgrid didn’t exist then)? Who wants to deal with deliverability? Who wants to fight spammers? The initial strategy was to have integrations to Mailchimp and Constant Contact such that modules like the forms manager could trigger an autoresponder and an automation rule could trigger a 1-to-1 email.

Quickly, we realized something was wrong.

Our approach delivered a poor, incomplete experience to our customers. Email was too important to be siloed from the marketing automation system. Email was too powerful as a marketing channel to not be a first-class module.

After endless internal debates about email, we finally decided to become an email service provider. Now, we enabled email to be a core feature throughout the platform. Now, marketers didn’t have to switch between as many different systems to run their marketing programs.

Email was a major inflection point in our product/market fit journey. Prior, customers liked the software but our product/market fit was modest. After adding email marketing, and a few rounds of refinement, our product/market fit was excellent and customers raved about the solution.

Major strategy changes often seem daunting. By focusing on the customer, and going down a much more difficult path technically, we delivered a superior experience. And, in the end, that was one of the most important product decisions we ever made.

Time and Effort are the Greatest Barriers to Entry for New Markets

Back when we were pitching Pardot to VCs in an unsuccessful attempt to raise money, one of the more common questions was, “What are the barriers to entry?” Then, a more specific variation of this question would arise, “What’s stopping Google from assigning 100 engineers to this market and crushing you?” Both are legitimate questions and we’d counter with things like having a mini-brand, 100+ paying customers, strong product/market fit, and so on. One famous investor, who writes the excellent Above the Crowd blog, told us he wasn’t interested because there weren’t enough defensible network effects or marketplace elements to be interesting. Fair enough.

In hindsight, the answer to the barriers-to-entry-question is much simpler: until there’s a meaningful market, no big company is going to care. By the time the market is large enough to matter, the winners will have been established, and the massive tech companies will merely acquire one of the leaders. When a major tech company does enter a large existing market as a laggard, most often they abandon it a few years later (see Google Hire’s recent shut down notice). Why? The market it already saturated with viable solutions and competitive dynamics are too strong. For major tech companies it’s always better to buy than build for a new product offering.

So, with small-but-fast-growing markets as the ideal target for most startups, barriers to entry are almost non-existent. After talking to thousands of people about entrepreneurship, and seeing so few people start companies, I take a different view.

Time and effort are the greatest barriers to entry for new markets.

Creating a new company is hard. Expect 5 – 10 years of difficult work to build something viable.

Most entrepreneurs don’t have the time.

Most entrepreneurs aren’t willing to put in the effort.

With new markets, there’s no guarantee it will grow into a large, meaningful market. Some do, most don’t. Quite often, people think a market will catch on and grow fast, only to have it fizzle out. That’s a big risk, and people are generally averse to risk.

The next time someone asks about barriers to entry for a new market, remember that it’s rarely an issue. It’s not that an entrepreneur couldn’t enter the market, it’s that there are so few entrepreneurs out there, and even fewer are going to commit the time and effort.

The Recurrent Competitor Worry

Back when starting Pardot, we only knew of one existing competitor: Eloqua. After getting into the marketing automation market (then called demand generation followed by lead management), we quickly found competitors that were established but subscale in Austin and Minneapolis.

Then, as with any small but fast growing market, more competitors emerged. And more emerged. And more emerged. The number of new competitors was staggering.

I was worried.

Two years in this new upstart called Genius emerged. With slick marketing, a clever edge to their product, and tons of VC money we were nervous. A couple quarters went by and we kept losing deals to them — we were losing the fight.

Then, unexpectedly, something happened. Genius essentially went away. We were no longer losing competitive deals. Customers they had signed were defecting and coming to us. While they were great at raising money and customer acquisition, their product wasn’t meeting the needs of the customer. No matter how hard they tried, and how much money they threw at the technology, they weren’t able to deliver a compelling product.

One competitor down.

But, how were we going to compete with all the players in the market?

I was asking the wrong question.

The focus must be on the customer.

The focus must be on delivering an amazing experience.

The focus must be on delivering incredible value.

Staying close to the customer is what matters most, not competitors. Yes, being cognizant of competition is prudent, but competitors are outside your control. Delighting the customer is within your control.

With hindsight, I realized I worried too much about the competition. I obsessed over them. I feared them. Only after experiencing continual success in the market, and seeing many competitors flail, did I come to understand that this was a normal part of the entrepreneurial journey. Competitors will always come and go — I needed to redirect my worrying to serving the customer.

In the end, the customer decides who wins.

Serve the customer.