Revenue, growth rate, and profit margin combined
The author and blogger Brad Feld came up with the Rule of 40 in 2015. Not long after, Venture Capitalists started to use the metric to be able to evaluate the quality of a SaaS company quickly. The key figure combines revenue, growth rate, and profit margin. If the sum of these is higher than 40, the company is considered to be of high quality.
Benchmarking SaaS companies
Aside from getting a quick overview of the quality of a SaaS company, the Rule of 40 makes it easier for investors to benchmark SaaS businesses against each other. Additionally, it helps investors assess a company's ability to reinvest; if the profit margin and revenue growth rate accumulate over 40 percent- it suggests that a company has room to pursue higher growth by reinvesting more.
A tool for investors
Sustaining profit margin and revenue growth at 20 percent each is challenging, and strong competitive advantages are required to endure this over time. Consequently, investors use the Rule of 40 to draw conclusions about a company’s moat.
As applies to any other financial metric, it would be unwise to solely use the Rule of 40 to evaluate the quality of a company. It should rather be used as an easy-to-use benchmark indicator.