Stop with the Rule of 40

‘The Rule of 40’ is an old maxim that sounds convenient and is easy to understand, but it’s a dangerous oversimplification of value.  In summary, Rule of 40 says the profit margin and revenue growth of SaaS company summed together needs to be at least 40% in order to attract a strong revenue multiple.  By way of example, a SaaS company with 20% growth and 20% profit margin achieves the Rule of 40 (20+20 = 40).  However, having 0% profit margin but 40% YOY growth is cheating; the Rule of 40 says buyers want a blend of profitability and growth.  Here's why the Rule of 40 is wrong:

It assumes all buyers want the same thing.  A small private equity group that doesn’t have significant capital for growth probably cares about profitability a lot.  A large strategic like Salesforce does not.  They’re not the same buyer, they don’t pay the same multiple, so the Rule of 40 is wrong when evaluating the attractiveness of your company to large strategics or large private equity that weight growth versus profitability far differently. 

It undervalues size and compounding.  Suppose a business has $10mm of ARR today, has a 20% margin, and 20% YOY growth.  In 10 years, that business will have $62mm in ARR.  That’s great, but let’s suppose instead they had a 0% margin and 40% YOY growth.  The power of compounding means in 10 years, that 40% growth would result in a business with $289mm of ARR.  Which one do you think is more attractive to a big strategic and commands a higher multiple? The latter.  The power of compounding and size is grossly undervalued by Rule of 40. 

Big buyers aren’t as sensitive to burn.  Let’s suppose you’re a $100mm ARR business with 30% YOY growth burning $50mm a year.  Rule of 40 says its far less valuable because of that burn.  However, strategics and big private equity are very adept at getting burn down over time.  Part of their plan is to realize synergies.  So, if a strategic pays 10x ARR which is $1bln, but can get burn down by $10mm a year, that means they need another $150mm to get to profitability over 5 years, on top of their $1bln purchase price.  That’s only 15% of the purchase price.  It’s not nothing, but it’s also not nearly as impactful as the Rule of 40 implies. 

The Rule of 40 is an interesting concept, but it could quickly fall apart depending on the ideal buyer and what that buyer really cares about.  

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