The Rule of 40 in Subscription Business

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Subscription Business
Subscription Business

Subscription Business: The SaaS industry is overgrowing. The COVID-19 pandemic streamlined SaaS growth due to the necessity of shifting to online, even for those businesses that were traditionally operating offline. While the crisis impacted many companies, specific industries like wellness, entertainment, gaming, and ed-tech are experiencing a significant increase in demand. Looking at the SaaS boom, revenue-financing firms plan to invest more funds in tech startups attracted with their low margins and exponential growth potential.

Regardless of the fact, SaaS industry has been continuously growing during the last decade, traditional investors are still cautious about startups with negative or small profits even though they show exponential sales growth.

Due to this contradiction, investors often overlook the companies that blow the world a few years later. The top-of-mind example to illustrate this phenomenon is the Salesforce CRM case. From 2011 to 2017, Salesforce had negative profit in the background of active growth puzzling investors. However, up to 2019, a company’s price per share increased x5 compared to 2011.

The SaaS companies’ specifics, including scalability and low marginality, make it possible to experience rapid growth. To facilitate new companies’ valuation for investments and find a healthy balance between growth and profitability, the SaaS rule of 40 was adopted.

Rule of 40 for SaaS businesses

The SaaS rule of 40 is a kind of rule of thumb applicable to large companies and early-stage startups. The author of this rule is Brad Feld, an angel investor who first introduced this concept in his blog post in 2015. The rule says that a healthy SaaS company’s growth rate % and profitability % should give 40% or more in total, and the proportion depends much on a company’s development stage.

Image credit: thesaascfo

Let’s say you have 20% revenue growth. Then, you should hit not less than 20% profit to be qualified as a “healthy” business according to the Rule of 40. Having a 40% growth rate, 0% profit would be okay. With 50% sales growth, you even can lose 10%. As soon as your sales + profit = 40% – you’re on track. If you’re doing better than 40% – you’re fantastic!

This simple formula’s key idea is that a fast-growing Subscription Business with sales growth of 40% and more may have from zero to negative profit and remain sustainable. If you have continuously grown sales, the profit is only a matter of time – this belief underlies the SaaS rule of 40. Brad Feld claims that this rule can be applied equally to $50 million businesses and companies with only $1 million revenue.

How to calculate the Rule of 40

To calculate the rule of 40 for SaaS some options exist. It’s recommended to take year-to-year growth based on MRR to see a business growth rate. You can take either recurring or total revenue growth. If you’re getting 80% revenue from recurring subscription payments, it would be more accurate to use recurring revenue for the growth rate calculation.

Image credit: thesaascfo

The profitability can be calculated in different ways – gross profit, net profit, free cash flow, or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) profitability. It’s more common to use EBITDA in the SaaS industry.

Image credit: thesaascfo

However, the appropriate profitability type will entirely depend on a SaaS business type.

As Brad Feld explains, if you have a cloud service, calculating profitability should be relatively straightforward. On the other hand, running an infrastructure, your EBITDA will deviate from net income and cash flow due to various associated costs as rental expenses, financial debts, etc.

As we can understand from the above, the company’s profitability can vary depending on its business structure and the development stage.

And here is the logical question comes up – when a company should start measuring a rule of 40. The experts say it’s more reasonable to measure this rule when your company overgrows a startup stage. You should reach at least $1 million of monthly recurring revenue before the rule of 40 calculation. When you have all your essential departments as sales, marketing, support, accounting, and R&D built, it’ll be more likely the time when you hit your first $1 million MRR milestone.

In case you’re an earlier stage startup, concentrate first on building your go-to-market strategy and cash flow.

Rule of 40 example

To get more understanding of how to calculate your rule of 40, see the example below.

Here the growth % is calculated using a YTD (year-to-date) revenue growth. The requirement is to use a period that shows the best your actual revenue and profit picture. For the profit calculation, the EBITDA margin is used.

Image credit: thesaascfo

Actually, the rule of 40 is a constant balance between growth and profitability. You should realize that it’s never possible to keep both metrics high. When your revenue is growing, it means that you sacrifice your margin investing in sales and marketing. On the contrary, high profit reflects your intent to please stakeholders and investors.

Image credit: thesaascfo

Many SaaS businesses combat achieving the right balance between revenue growth and profitability. They can tend to either sales or profit growth depending on business objectives. For example, Oracle, a database management company, has a slow lower than 10% growth rate focusing on high profitability. Aiming to find the right balance between profitability and growth, the businesses like Adobe having strong products moved to a subscription business model. They’re focusing on improving their core products rather than investing huge money in sales and marketing to expand their market shares.

As a conclusion

Even though the rule of 40 is an excellent tool to get a quick idea of a company’s condition, it remains a rule of thumb. To get a precise picture of your Subscription Business health, you should track various metrics regularly and take necessary steps based on a thorough analysis. Also, when following the rule of 40, you should remember that it’s always a tradeoff between growth and profitability.

 

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