{"id":29525,"date":"2024-06-26T10:40:47","date_gmt":"2024-06-26T15:40:47","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/?post_type=biws_kb&#038;p=29525"},"modified":"2024-11-19T22:56:23","modified_gmt":"2024-11-20T03:56:23","slug":"rule-of-40","status":"publish","type":"biws_kb","link":"https:\/\/breakingintowallstreet.com\/kb\/venture-capital\/rule-of-40\/","title":{"rendered":"The \u201cRule of 40\u201d in SaaS: Examples, Calculations, and Real-World Meaning"},"content":{"rendered":"<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_81 counter-flat ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">The \u201cRule of 40\u201d in SaaS: Examples, Calculations, and Real-World Meaning<\/p>\n<span class=\"ez-toc-title-toggle\"><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/breakingintowallstreet.com\/kb\/venture-capital\/rule-of-40\/#How_to_Calculate_the_Rule_of_40\">How to Calculate the Rule of 40<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/breakingintowallstreet.com\/kb\/venture-capital\/rule-of-40\/#Does_the_Rule_of_40_Mean_Anything_in_Terms_of_Valuation\">Does the Rule of 40 Mean Anything in Terms of Valuation?<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/breakingintowallstreet.com\/kb\/venture-capital\/rule-of-40\/#The_Rule_of_40_as_an_Operational_Metric_and_KPI\">The Rule of 40 as an Operational Metric and KPI<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-4\" href=\"https:\/\/breakingintowallstreet.com\/kb\/venture-capital\/rule-of-40\/#The_%E2%80%9CRule_of_X%E2%80%9D_and_Other_Variations_and_Improvements_to_the_Rule_of_40\">The \u201cRule of X\u201d and Other Variations and Improvements to the Rule of 40<\/a><\/li><\/ul><\/nav><\/div>\n\n<blockquote><p><strong>Rule of 40 Definition:<\/strong> In Software as a Service (SaaS) financial models, the \u201cRule of 40\u201d states that a company\u2019s Revenue Growth + EBITDA Margin should equal or exceed 40% to be considered \u201chealthy\u201d; companies that exceed it by a wider margin may be valued more highly.<\/p><\/blockquote>\n<p>The Rule of 40 reflects the <strong>basic trade-off<\/strong> between growth and profitability that all businesses face.<\/p>\n<p>In other words, if the business wants to grow more quickly, it needs to <strong>spend more<\/strong> on sales &amp; marketing to distribute its products and reach new customers.<\/p>\n<p>On the other hand, if the company wants to become more profitable, it can <strong>reduce<\/strong> this sales &amp; marketing spending and accept that it will reach fewer new customers and grow more slowly.<\/p>\n<p>The Rule of 40 was popularized in a <a href=\"https:\/\/feld.com\/archives\/2015\/02\/rule-40-healthy-saas-company\/\" target=\"_blank\" rel=\"noopener\">2015 blog post by venture capitalist Brad Feld<\/a>.<\/p>\n<p>The startup \/ VC ecosystem is a bit of an <strong>echo chamber<\/strong>, so \u201ceveryone\u201d started repeating this rule as if it were the same as gravity or momentum in physics.<\/p>\n<p>But that\u2019s not the case!<\/p>\n<p>Not only are there disagreements about how to calculate the Rule of 40, but its <strong>meaning and implications<\/strong> also differ by company and vertical.<\/p>\n<p>For many SaaS companies, valuation is <strong>just as highly correlated <\/strong>with simple Revenue Growth or <a href=\"https:\/\/breakingintowallstreet.com\/kb\/venture-capital\/annual-recurring-revenue-arr\/\" target=\"_blank\" rel=\"noopener\">Annualized Recurring Revenue<\/a> Growth.<\/p>\n<p>The Rule of 40 is useful for assessing a company\u2019s forecasts and benchmarking it, but it is a <em>rule of thumb<\/em> \u2013 not a natural law.<\/p>\n<h3><strong>Files &amp; Resources:<\/strong><\/h3>\n<ul>\n<li><a href=\"https:\/\/youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com\/Startups-VC\/Rule-of-40\/Rule-of-40.xlsx\" target=\"_blank\" rel=\"noopener\">Rule of 40 &#8211; Excel Examples (XL)<\/a><\/li>\n<li><a href=\"https:\/\/youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com\/Startups-VC\/Rule-of-40\/Rule-of-40-Slides.pdf\" target=\"_blank\" rel=\"noopener\">Rule of 40 &#8211; Presentation Slides (PDF)<\/a><\/li>\n<li><a href=\"https:\/\/youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com\/Startups-VC\/Rule-of-40\/Salesforce-10-K.pdf\" target=\"_blank\" rel=\"noopener\">Salesforce 10-K with Highlights (PDF)<\/a><\/li>\n<\/ul>\n<h3><strong>Video Table of Contents:<\/strong><\/h3>\n<ul>\n<li><strong>1:14: <\/strong>The Rule of 40 in a Nutshell<\/li>\n<li><strong>3:58:<\/strong> Part 1: How to Calculate the Rule of 40<\/li>\n<li><strong>7:27:<\/strong> Part 2: Valuation Implications<\/li>\n<li><strong>9:09:<\/strong> Part 3: The Rule of 40 as an Operational Metric<\/li>\n<li><strong>10:25:<\/strong> Part 4: The Rule of X and Other Variations\/Improvements<\/li>\n<li><strong>11:42:<\/strong> Recap and Summary<\/li>\n<\/ul>\n<h2><span class=\"ez-toc-section\" id=\"How_to_Calculate_the_Rule_of_40\"><\/span><strong>How to Calculate the Rule of 40<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>To calculate the Rule of 40, you start by taking the company\u2019s most recent Revenue Growth and adding its EBITDA Margin.<\/p>\n<p>For example, if we look at Salesforce\u2019s 10-K, its Revenue Growth was $34,857 \/ $31,352 \u2013 1 = 11.2%:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29526 size-full\" title=\"Revenue Growth in the Rule of 40\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103423\/01-Revenue-Growth.jpg\" alt=\"Revenue Growth in the Rule of 40\" width=\"1513\" height=\"355\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103423\/01-Revenue-Growth.jpg 1513w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103423\/01-Revenue-Growth-300x70.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103423\/01-Revenue-Growth-1024x240.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103423\/01-Revenue-Growth-768x180.jpg 768w\" sizes=\"(max-width: 1513px) 100vw, 1513px\" \/><\/p>\n<p>Its <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/ebitda\/\" target=\"_blank\" rel=\"noopener\">EBITDA<\/a> equals its Operating Income of $5,011 + Depreciation &amp; Amortization on the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/cash-flow-statement\/\" target=\"_blank\" rel=\"noopener\">Cash Flow Statement<\/a> of $3,959 = $8,970:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29527 size-full\" title=\"Operating Income in the EBITDA Calculation\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103449\/02-Operating-Income.jpg\" alt=\"Operating Income in the EBITDA Calculation\" width=\"1428\" height=\"777\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103449\/02-Operating-Income.jpg 1428w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103449\/02-Operating-Income-300x163.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103449\/02-Operating-Income-1024x557.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103449\/02-Operating-Income-768x418.jpg 768w\" sizes=\"(max-width: 1428px) 100vw, 1428px\" \/><\/p>\n<p>In this case, we would <strong>not<\/strong> add back the Restructuring Expense since it has recurred in 2 out of 3 historical years.<\/p>\n<p>This produces an EBITDA margin of 25.7%, so Salesforce\u2019s \u201cRule of 40\u201d is 36.9%, which is very close to the target.<\/p>\n<p>But this simple exercise also reveals potential <strong>disagreements<\/strong> about how to calculate this metric. For example:<\/p>\n<ol>\n<li>Do you use Subscription Revenue or Total Revenue? What about Annualized Recurring Revenue or Monthly Recurring Revenue instead?<\/li>\n<li>Should you use EBITDA for the \u201cprofit component\u201d here? Would it make more sense to use <a href=\"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/how-to-calculate-free-cash-flow\/\" target=\"_blank\" rel=\"noopener\">Free Cash Flow<\/a> since it\u2019s often higher than EBITDA due to <a href=\"https:\/\/breakingintowallstreet.com\/kb\/venture-capital\/saas-accounting\/\" target=\"_blank\" rel=\"noopener\">SaaS accounting<\/a> and high changes in Deferred Revenue? Or should you use <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/ebit-operating-income\/\" target=\"_blank\" rel=\"noopener\">Operating Income (EBIT)<\/a> instead?<\/li>\n<\/ol>\n<p>Salesforce\u2019s Free Cash Flow, or Cash Flow from Operations minus CapEx, is close to its EBITDA (~$9.0 billion), so the second question here <strong>does not make a big difference.<\/strong><\/p>\n<p>This point would matter more if the company were younger, growing more quickly, or had a much bigger Change in Deferred Revenue relative to its overall Revenue.<\/p>\n<p>The <strong>first question<\/strong> is more interesting because it potentially impacts many companies.<\/p>\n<p>Salesforce does not disclose its ARR, but we can take its quarterly numbers and make our estimates by annualizing the quarterly Subscription Revenue:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29528 size-full\" title=\"ARR Growth in the Rule of 40\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103518\/03-ARR-Rule-of-40.jpg\" alt=\"ARR Growth in the Rule of 40\" width=\"2394\" height=\"1008\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103518\/03-ARR-Rule-of-40.jpg 2394w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103518\/03-ARR-Rule-of-40-300x126.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103518\/03-ARR-Rule-of-40-1024x431.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103518\/03-ARR-Rule-of-40-768x323.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103518\/03-ARR-Rule-of-40-1536x647.jpg 1536w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103518\/03-ARR-Rule-of-40-2048x862.jpg 2048w\" sizes=\"(max-width: 2394px) 100vw, 2394px\" \/><\/p>\n<p>In this case, though, the results are boring because ARR Growth is nearly the same as Revenue Growth, so the \u201cRule of 40\u201d numbers are almost the same.<\/p>\n<p>We expect this result since Salesforce is a large, mature company with modest growth rates.<\/p>\n<p>If we were analyzing a $10 million revenue startup or a $100 million revenue growth-stage company, we would likely get different results, with ARR Growth potentially exceeding Revenue Growth.<\/p>\n<div class='code-block code-block-9' style='margin: 8px 0; clear: both;'>\n<div class=\"kb-adinsert-modal\">\n    <div class=\"kb-adinsert-top\">\n      <div class=\"media\">\n          <img decoding=\"async\" class=\"alignnone size-full wp-image-28448\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/05\/22172829\/vc-tile.png\" alt=\"Venture Capital & Growth Equity Modeling\" width=\"128\" height=\"128\" \/>\n      <\/div>\n      <div class=\"content\">\n          <h3>Model and Value Startups, Understand Cap Tables, and Prepare for VC Interviews<\/h3>\n      <\/div>\n    <\/div>\n    \n    <div class=\"full_text\">\n    \t<ul>\n        \t<li>\n            \t<h4>Evaluate companies and deals like a pro<\/h4>\n              <p>You\u2019ll understand cap tables, startup\/growth valuations, and exits<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Master financial modeling<\/h4>\n            <p>You\u2019ll build forecasts and analyze metrics for tech and biotech startups<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Complete 9 case studies<\/h4>\n            <p>You\u2019ll learn the numbers and how to make investment recommendations\n\n<\/p>\n\t\t\t  <\/li>\n      <\/ul>\n        \n      <a class=\"cta-link orange-button-medium\" href=\"https:\/\/breakingintowallstreet.com\/venture-capital-modeling\/\" target=\"_blank\">Full Details<\/a>\n      \n      <a class=\"cta-link orange-button-medium bg-blue\" href=\"https:\/\/biws-support.s3.us-east-1.amazonaws.com\/Course-Outlines\/Venture-Capital-Modeling-Course-Outline.pdf\" target=\"_blank\" rel=\"noopener\">Short Outline<\/a>\n    <\/div>\n<\/div>\n<\/div>\n\n<h2><span class=\"ez-toc-section\" id=\"Does_the_Rule_of_40_Mean_Anything_in_Terms_of_Valuation\"><\/span><strong>Does the Rule of 40 Mean Anything in Terms of Valuation?<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>In some cases, the \u201cRule of 40\u201d is closely correlated with SaaS companies\u2019 revenue multiples, but it depends heavily on the set of companies you\u2019re looking at.<\/p>\n<p>We\u2019ll look at 3 sets taken from different periods (2022, 2023, and 2024) to illustrate the correlations:<\/p>\n<ul>\n<li><strong>\u201cModerate\u201d Growth and Margin SaaS Companies:<\/strong> $100 million to $1 billion in revenue with Revenue Growth and EBITDA Margins of 10% or higher.<\/li>\n<li><strong>Small, Growth-Limited SaaS Companies:<\/strong> $100 million to $500 million in revenue with Revenue Growth between 10% and 30%.<\/li>\n<li><strong>Large \u201cCloud\u201d Companies:<\/strong> This is based on the <a href=\"https:\/\/cloudindex.bvp.com\/\" target=\"_blank\" rel=\"noopener\">Bessemer Cloud Index<\/a> and includes companies with over $1 billion in revenue.<\/li>\n<\/ul>\n<p>The first 2 sets use Revenue Growth + EBITDA Margin for the Rule of 40, while the last one uses Revenue Growth + FCF Margin.<\/p>\n<h3><strong>&#8220;Moderate&#8221; Growth and Margin SaaS Companies<\/strong><\/h3>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29529 size-full\" title=\"Moderate Growth and Margin SaaS Comps\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103609\/04-Moderate-Growth-Margin-SaaS-Comps.jpg\" alt=\"Moderate Growth and Margin SaaS Comps\" width=\"2560\" height=\"714\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103609\/04-Moderate-Growth-Margin-SaaS-Comps.jpg 2560w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103609\/04-Moderate-Growth-Margin-SaaS-Comps-300x84.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103609\/04-Moderate-Growth-Margin-SaaS-Comps-1024x286.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103609\/04-Moderate-Growth-Margin-SaaS-Comps-768x214.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103609\/04-Moderate-Growth-Margin-SaaS-Comps-1536x428.jpg 1536w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103609\/04-Moderate-Growth-Margin-SaaS-Comps-2048x571.jpg 2048w\" sizes=\"(max-width: 2560px) 100vw, 2560px\" \/><\/p>\n<h3><strong>Small SaaS Companies with Growth Between 10% and 30%<\/strong><\/h3>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29530 size-full\" title=\"Growth-Constrained SaaS Comps\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103638\/05-Growth-Constrained-SaaS-Comps.jpg\" alt=\"Growth-Constrained SaaS Comps\" width=\"2557\" height=\"709\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103638\/05-Growth-Constrained-SaaS-Comps.jpg 2557w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103638\/05-Growth-Constrained-SaaS-Comps-300x83.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103638\/05-Growth-Constrained-SaaS-Comps-1024x284.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103638\/05-Growth-Constrained-SaaS-Comps-768x213.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103638\/05-Growth-Constrained-SaaS-Comps-1536x426.jpg 1536w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103638\/05-Growth-Constrained-SaaS-Comps-2048x568.jpg 2048w\" sizes=\"(max-width: 2557px) 100vw, 2557px\" \/><\/p>\n<h3><strong>Large Cloud Companies with &gt; $1 Billion in Revenue<\/strong><\/h3>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29531 size-full\" title=\"Large Cloud Companies\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103651\/06-Large-Cloud-Companies.jpg\" alt=\"Large Cloud Companies\" width=\"2560\" height=\"697\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103651\/06-Large-Cloud-Companies.jpg 2560w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103651\/06-Large-Cloud-Companies-300x82.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103651\/06-Large-Cloud-Companies-1024x279.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103651\/06-Large-Cloud-Companies-768x209.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103651\/06-Large-Cloud-Companies-1536x418.jpg 1536w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103651\/06-Large-Cloud-Companies-2048x558.jpg 2048w\" sizes=\"(max-width: 2560px) 100vw, 2560px\" \/><\/p>\n<p>The <strong>main conclusion <\/strong>is that no matter how we measure revenue or profit, the \u201cRule of 40\u201d is not much different than simple Revenue Growth for predicting Revenue Multiples.<\/p>\n<p>It\u2019s better for two sets and worse for the other, but it never produces a dramatic difference, such as 80% vs. 50% correlation.<\/p>\n<p>The Rule of 40 is the <strong>most meaningful<\/strong> for the set with constraints on both Revenue Growth and EBITDA Margins (10% or higher for both).<\/p>\n<p>This is unsurprising because <strong>both<\/strong> growth and profitability matter for these smaller companies <em>without<\/em> huge growth potential.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"The_Rule_of_40_as_an_Operational_Metric_and_KPI\"><\/span><strong>The Rule of 40 as an Operational Metric and KPI<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>Since the correlation between the Rule of 40 and revenue multiples is not always strong, it is often more useful as an <strong>operation or benchmarking metric.<\/strong><\/p>\n<p>For example, if most of the peer SaaS companies have a Revenue Growth + EBITDA Margin of ~30%, but the company you\u2019re analyzing claims to be at ~60%, you should be very skeptical.<\/p>\n<p>At a large scale, <strong>no company<\/strong> can outperform this basic trade-off between growth and profitability for long.<\/p>\n<p>When analyzing a SaaS company\u2019s budgets and forecasts, we might see numbers like the following:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29532 size-full\" title=\"SaaS Startup - The Rule of 40\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103909\/07-SaaS-Startup-Rule-of-40.jpg\" alt=\"SaaS Startup - The Rule of 40\" width=\"2251\" height=\"387\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103909\/07-SaaS-Startup-Rule-of-40.jpg 2251w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103909\/07-SaaS-Startup-Rule-of-40-300x52.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103909\/07-SaaS-Startup-Rule-of-40-1024x176.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103909\/07-SaaS-Startup-Rule-of-40-768x132.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103909\/07-SaaS-Startup-Rule-of-40-1536x264.jpg 1536w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103909\/07-SaaS-Startup-Rule-of-40-2048x352.jpg 2048w\" sizes=\"(max-width: 2251px) 100vw, 2251px\" \/><\/p>\n<p>This is an encouraging sign because the Revenue Growth + EBITDA Margin is consistent but falls significantly when the company <strong>spends a huge amount<\/strong> on sales &amp; marketing in the first projected year to boost its growth rate.<\/p>\n<p>We would be more suspicious if the Revenue Growth + EBITDA Margin <em>increased<\/em> significantly over this projected period or did not reflect the effects of the higher sales &amp; marketing spending.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"The_%E2%80%9CRule_of_X%E2%80%9D_and_Other_Variations_and_Improvements_to_the_Rule_of_40\"><\/span><strong>The \u201cRule of X\u201d and Other Variations and Improvements to the Rule of 40<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>Because of these issues, firms such as Bessemer have invented new variations on the Rule of 40, such as \u201c<a href=\"https:\/\/www.bvp.com\/atlas\/the-rule-of-x\" target=\"_blank\" rel=\"noopener\">The Rule of X<\/a>,\u201d where <strong>the growth rate in the formula gets a higher multiplier than the profit portion<\/strong>.<\/p>\n<p>For example:<\/p>\n<p><strong>Rule of X<\/strong> = Revenue Growth Rate * Multiplier + EBITDA or FCF Margin<\/p>\n<p>This multiplier on the Revenue Growth Rate might range from 1.5x to 3.0x, depending on the company stage and market.<\/p>\n<p>The multiplier means the <strong>Revenue Growth is more valuable than the Margin<\/strong>, at least for many mid and late-stage SaaS companies.<\/p>\n<p>They do present data indicating that R^2 is higher for the Rule of X and Revenue Multiples than it is for the Rule of 40:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-29533 size-full\" title=\"The Rule of 40 vs. the Rule of X\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103936\/08-Rule-of-40-vs-Rule-of-X.jpg\" alt=\"The Rule of 40 vs. the Rule of X\" width=\"1758\" height=\"584\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103936\/08-Rule-of-40-vs-Rule-of-X.jpg 1758w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103936\/08-Rule-of-40-vs-Rule-of-X-300x100.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103936\/08-Rule-of-40-vs-Rule-of-X-1024x340.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103936\/08-Rule-of-40-vs-Rule-of-X-768x255.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/06\/26103936\/08-Rule-of-40-vs-Rule-of-X-1536x510.jpg 1536w\" sizes=\"(max-width: 1758px) 100vw, 1758px\" \/><\/p>\n<p>The Rule of X is probably better than the Rule of 40, but remember that they\u2019re <strong>rules of thumb<\/strong>, not universal laws.<\/p>\n<p>The <em>real way<\/em> to value any company is with an in-depth, long-term <a href=\"https:\/\/mergersandinquisitions.com\/dcf-model\/\" target=\"_blank\" rel=\"noopener\">DCF model<\/a> built around the company\u2019s unit economics.<\/p>\n<p>That approach will always be more accurate than these quick rules, even if it takes more time and effort and requires more judgment calls.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>In Software as a Service (SaaS) financial models, the \u201cRule of 40\u201d states that a company\u2019s Revenue Growth + EBITDA Margin should equal or exceed 40% to be considered \u201chealthy\u201d; companies that exceed it by a wider margin may be valued more highly.<\/p>\n","protected":false},"featured_media":0,"template":"","class_list":["post-29525","biws_kb","type-biws_kb","status-publish","hentry","kb_category-venture-capital"],"acf":[],"_links":{"self":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb\/29525","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb"}],"about":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/types\/biws_kb"}],"wp:attachment":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media?parent=29525"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}