What the “Rule of 40” Means at the Early Stage

Photo Credit: gust.com

Over the past few years there have been a flurry of articles about the “Rule of 40”, which describes a tradeoff between growth and profitability for software companies:

Growth rate plus profit should be greater than or equal to 40%.

CEOs and leadership teams have to steer many directions (go upmarket or downmarket; when to enter adjacent markets, etc.) but one of the fundamental questions is when to accelerate investments in growth, when to “stay the course” and when to tap the brakes. I’d argue the trope about Rule of 40 is misleading and actually harms venture-backed companies. Instead, a simple, metrics-driven analysis can provide a clearer framework for the decision.

As an investor, I wholeheartedly embrace the idea that companies should manage with discipline and put themselves on a path to profitability. Being funded by customers rather than investors lets companies control their own destiny. Profit and growth matter and the rule does explain 30%-50% of the valuation of public software companies according to several analyses. However, it doesn’t explain the other 50%-70% where growth and profitability aren’t of equal value and it is incredibly hard to achieve before companies reach significant scale (often $200m).

Source: KeyBanc Capital Markets

Almost nobody falls exactly upon that line in the chart above. The companies above the line are excellent businesses performing well, but note how most of them are much bigger dots, meaning they are much bigger businesses like Salesforce, Workday, and ServiceNow with benefits of scale, well known brand names and platform effects already long at work. Even a $50m SaaS company will find it nearly impossible to achieve “40.” As with other simplistic ideas, following the Rule of 40 could lead to bad decisions, such as systematically underinvesting in growth.

Early stage companies are better served by doing detailed analyses of their unit economics: customer acquisition cost (by customer type and/or channel), gross margin adjusted Lifetime Value (LTV), churn rate, and net renewal rate. These metrics tell you how much to invest in growth and the go-to-market strategy. Prospective investors also use these metrics to evaluate your business, so companies might as well track them. Of course, you can’t invest money you don’t have so cash on hand, monthly burn rate, payback period on investment in sales and marketing, and your confidence in your ability to raise follow on capital also inform decisions.

To be clear, eventual profitability does matter. Companies should have a strategic plan and long term financial model where the lines converge as they achieve scale. Especially in an early stage start up, it may suffice to have a well thought out theory of the business that achieves profitability as gross margins improve, as customer acquisition channels get more developed, as data accumulates and machine learning models get trained. But you can’t lose money on every customer and make it up in volume.

Both public and private markets value revenue growth and profitability, but they aren’t the whole story. Revenue growth is valued higher than EBITDA margin since it compounds in a way that profitability doesn’t. This is especially true in private companies and in bull markets. There are other factors that affect company value such as perception of Total Available Market, strategic, technical & data moats, and quality of leadership. Good investors will value your understanding of unit economics, your ability to analyze your business and explain trade offs, and your ability to be profitable in the future — even if you aren’t now.