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What is The Rule of 40 in Investing?
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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 roughly 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 under the guidelines of the rule.
A Metric for Benchmarking
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 capital into its operations. Some examples of companies that have passed the Rule of 40 historically include names like Atlassian, Crowdstrike, and Zoom.
How to Calculate the Rule of 40
Calculating the rule of 40 is relatively simple compared to some other financial ratios. For modeling purposes, we’ll imagine a fictional SaaS company that generated $20 million in revenue for 2020 and saw its profits increase to $24 million in 2021. This means that the year-over-year growth in revenue equals 20%.
To calculate the rule of 40, we also need to calculate the profit margin. The fictional company’s EBITDA, its primary metric for profitability, was 6 million dollars in 2021. That means that the profit margin for the company was 25%.
In the example above the company has passed the rule of 40 and then some. By adding revenue growth and profitability, we get a value of 45. This means that, according to the rule of 40 the company is a quality business. It should also be noted that the rule of 40 is bendable. For example, revenue growth can be at 35 percent while profitability is at 10 percent, and the company still passes with flying colors.
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 as an instrument in their toolbox 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, and one of the factors weighed when determining whether a company might be a good investment or not.
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