SaaS Rule of 40

 
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How to use it

  • Utilize Rule of 40 metric to facilitate trade-off decisions between investing in growth and short-term / yearly profitability

  • For Profit Margin, most use EBITDA, but others have proposed free cash flow, EBIT or net income. We use EBITDA for simplicity of reporting, as well as access to public comparables

  • Utilize public information to identify companies that have similar profiles and use as a template for Management decisions

Pro’s & con’s

Pro’s

Large software companies are, increasingly, measured against the Rule of 40, using the metric to guide resource allocations and command higher valuations.

Con’s

The metric has been glamorized a bit and may benefit from sector-specific context (e.g., healthcare Rule of 40 may be closer to ~35 given a higher reliance on services)

 

ARDAN TAKEAWAY

Focus on growth. Create a qualified pipeline that drives revenue expansion from existing customers. As growth slows, realize operational efficiency by shifting from a “hunting” to “farming” mindset.