The “Rule of 40” is one of the most commonly cited valuation benchmarks in SaaS for both public and private companies.
The SaaS “Rule of 40” has gained popularity due to its simplicity, requiring only two common financial metrics to be added together.
While SaaS is an amazingly transparent community with abundant benchmarking resources, there are much fewer publicly available studies that allow an analysis of the underlying drivers of “Rule of 40.”
Fortunately, the always excellent KeyBanc Capital Markets (KBCM) 2021 SaaS Survey – which covers over 350 private SaaS companies across various stages and categories – provides a very rich data set to work from.
What Is The SaaS “Rule of 40”?
In simple terms, the “Rule of 40” states a healthy SaaS company’s a) revenue growth rate plus b) profit margin should exceed 40%.
In equation form, Revenue Growth % + Profit Margin % > 40%.
Given widely accepted “Rule of 40” standards and our use of the KBCM 2021 SaaS Survey database, our analysis uses “Organic ARR Growth” and “Free Cash Flow (FCF) Margin” as the specific inputs in the “growth plus margin” calculation.
How Many SaaS Companies Meet The “Rule of 40”?
29% – Within the KBCM sample size of 173 SaaS companies with over $5 million of ARR, 50 were “Rule of 40” Qualifiers.
What Drives The SaaS “Rule of 40”?
KBCM helpfully presents a very detailed comparison of “Rule of 40” Qualifiers (i.e. Growth + Margin = Above 40%) versus Non-Qualifiers (Below 40%):
Given the wealth of information presented by KBCM, we examined the material differences.
2 drivers stood out as notable: Customer Acquisition Cost (CAC) and Churn.
In terms of Customer Acquisition Costs, “Rule of 40” Qualifiers spent 31% less to acquire a new customer.
In terms of Churn, “Rule of 40″ Qualifiers” had 29% lower Gross Dollar Churn.
The impact of this CAC and Churn outperformance shows up in 83% better capital efficiency for “Rule of 40” Qualifiers.
At a quick glance, you might expect a 31% CAC advantage and 29% Churn advantage to equate to a 60% difference in capital consumed. After all, 31% + 29% = 60%.
This 83% difference in capital efficiency is yet another reinforcement of Jason Lemkin’s common refrain that “SaaS Compounds.”
Year after year of lower sales and marketing costs and better customer retention really adds up.
Is The “Rule of 40” Still Relevant?
As our 2021 KBCM analysis showed, capital-efficient SaaS platforms stand out most in the “Rule of 40” framework.
Capital efficiency is especially important when capital is scarce.
My first exposure to the “Rule of 40” was through Brad Feld in 2015.
Relative to today’s frothy SaaS fundraising environment, capital was comparatively scarce in 2015 when Brad Feld popularized the “Rule of 40.”
Simultaneously, valuations for the highest growth SaaS platforms have grown disproportionately.
When investors place an extra premium on revenue growth, the capital allocation calculus for SaaS CEOs and CFOs changes.
The “Rule of 40” treats 1% of revenue growth as exactly equivalent to 1% of profit margin.
As a result, maintaining the same “Rule of 40” score requires 1% of extra revenue growth for 1% of profit margin investment. All within the same financial measurement period.
To achieve that 1%:1% growth/margin ratio would require incredibly short investment payback periods.
As context, the KBCM 2021 survey data showed customer acquisition cost (CAC) payback periods of 18 to 26 months on a gross margin basis.
To keep this simple, we will focus on new customer CACs since this is the most likely area where discretionary marginal investment would take place. The back of the napkin math works out:
- Multiply the 26-month median gross profit payback by 80% (typical gross margin) to convert to a “revenue payback” of 20.8 months.
- To compare the year 1 (meaning 12 months) investment in sales & marketing, we take 12 “cost” months divided by 20.8 “revenue” months, which yields a revenue growth:cost ratio of 0.57%
- As a result, the “Rule of 40” calculus for a median SaaS company is whether to invest 1% of revenue to generate Year 1 revenue growth of 0.57%.
- Using my rough estimate of the KBCM new customer payback histogram above, perhaps ~25% of SaaS companies have short enough payback periods to achieve the required 1:1 revenue growth:cost ratio.
Combining these 2 market trends – 1) rising revenue multiples and 2) easier access to capital – is the “Rule of 40” still as relevant compared to 2015?
More practically, should SaaS leaders optimize their budgets and capital allocation to achieve the maximum “Rule of 40” score?
The right answer depends on your exact situation.
For example, if you operate in a “winner take all” market where the platform with the most capital will win, abandoning the “Rule of 40” to drive faster revenue growth (and therefore a higher absolute valuation and dollars raised) might be the right strategic decision.
An argument can also be made that rigidly adhering to the “Rule of 40” might cause underinvestment.
Using the 26-month median payback for new customer CAC in the example above, making decisions solely to maximize your “Rule of 40” score would tell you to skip a 46%* return investment!
In my experience, any competent board would view a CEO or CFO that passes on 46% ROI projects as far too conservative. And that cautious SaaS platform would fall behind their more aggressive competitors.
Ultimately, the “Rule of 40” is ONLY a metric. You can’t pay your Azure bill or office lease in “Rule of 40” points.
Like LTV/CAC, the “Rule of 40” should be used as one of many analytical frameworks for SaaS leaders to balance growth against profitability.
* 46% Return Calculation: 12 months / 26 month payback = 0.46
Going Even Deeper – What Were We Surpised By?
Rule of 40 Drivers: Field Sales vs Inside Sales
It is commonly perceived that Field Sales are more expensive than Inside Sales.
The KBCM 2021 dataset provides good evidence here: Field Sales CACs ($1.72) are 38% higher than Inside Sale CACs ($1.25).
As a result, we expected the “Rule of 40” Qualifiers to be much more Inside Sales oriented.
Surprisingly, Qualifiers had a lower portion of Inside Sales GTM (22%) than Non-Qualifiers (32%).
However, the average Field Sales Oriented SaaS company had a lower average “Rule of 40” score (+1%) than an average Inside Sales Oriented SaaS company’s “Rule of 40” score (+16%).
Rule of 40: Average Contract Value (ACV)
- ACV – Qualifier: $53k
- ACV – Below: $37k
While in percentage terms the difference is large (43%), a $14,000 absolute dollar difference is not THAT significant.
Rule of 40 Drivers: Customer Segments + Categories
- Enterprise % – Qualifier: 50%
- Enterprise % – Below: 46%
- Vertical % – Qualifier: 24%
- Vertical % – Below: 24%
These small differences were somewhat surprising. Before diving into the KBCM data, we thought vertical + enterprise SaaS companies with dominant market positions would disproportionately be the “Rule of 40” winners.
Rule of 40 Drivers: Cost Structure
- Gross Margin % – Qualifier: 80%
- Gross Margin % – Below: 80%
Equivalent gross margins were largely expected – 80% is a very common gross margin in SaaS.
- Sales & Marketing % – Qualifier: 31%
- Sales & Marketing % – Below: 39%
Given the differences in Customer Acquisition Costs highlighted earlier, Rule of 40 Qualifier outperformance was practically inevitable.
- Research & Development (R&D) % – Qualifier: 18%
- Research & Development (R&D) % – Below: 29%
This R&D delta was a surprise. Before getting into the data, we thought the “Rule of 40” Qualifiers might have lower CACs due to a superior product (with that superiority a product of R&D investment).
Perhaps the “Rule of 40” Qualifiers just have better product management and more “10x” engineers?
- General & Administrative (G&A) % – Qualifier: 14%
- General & Administrative (G&A) % – Below: 19%
Rule of 40 Qualifiers having lower G&A costs was expected.
Going back to its publication by Pacific Crest (the predecessor to KBCM’s Technology franchise) and with special thanks to the hard work of David Skok at Matrix Partners to drive survey responses, the KBCM SaaS Survey is the benchmark report I share most frequently, whether with Founders or Investors.
Whether the “Rule of 40” framework makes sense for your company requires a case-specific analysis of your situation.
I encourage you to download the KBCM SaaS report (email required) to help frame that analysis.