Rule of 40
Since its introduction in 2015, the Rule of 40 had gained widespread usage as a way to judge SaaS and internet marketplace company performance and compare it to other high-growth companies. At SGE, we view it as one of the most important indicators of whether a company has the potential to be a great company.
What is it? Mathematically
Rule of 40 = Revenue Growth Rate (typically GAAP, year over year) + EBITDA margin
There are several other iterations of the formula, such as substituting GAAP revenue for ARR or replacing EBITDA margins with net income or cash flow. However the formula is framed, fundamentally it is trying to calibrate the balance between growth and profitability to understand the overall health of the business. Particularly healthy businesses will sustain the Rule of 40%+ performance in perpetuity.
Over time, we have seen the market paying a higher premium for growth over profitability, and thus, we have moved towards a growth weighted Rule of 40. We first saw this formula promulgated by the First Analysis Group, which mathematically defined it as:
Growth Weighted Rule of 40 = (1.33 * Revenue Growth Rate) + 0.67 * (EBITDA margin)
Some points of note:
- The Rule of 40 is less applicable for very early stage companies based on very high growth rates/negative EBITDA margins. Indeed, the formula is probably not particularly relevant until a company exceeds $10M in revenue.
- As companies get larger, growth percentages almost always decrease. Simply put, it becomes harder to maintain very high growth rates off larger and larger revenue bases. In response, healthy companies will counterbalance this growth challenge by increasing profitability margins to maintain a healthy “Rule of 40.”
Below is a best-in-class growth weighted Rule of 40 progression for a top performing Susquehanna portfolio company as well as an average company in the portfolio:
As companies grow, revenue growth typically slows, ideally complemented with expanding EBITDA margins as seen with a composite analysis of the same company’s growth weighted Rule of 40:
We believe the growth weighted Rule of 40 is a good predictor of company health regardless of revenue. Breaking out our current and former portfolio companies, we have seen the following growth weighted Rule of 40 performance from top quartile and median performers:
While not every company can be a Rule of 40 company, we view it as a benchmark worthy of trying to achieve. Even if a company can’t hit or exceed the exact target, it is still an extremely useful tool for assessing the tradeoffs that need to be made between growth and profits at any point in a company’s lifecycle.
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