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Profitability and growth are two of the most important financial metrics to SaaS companies, but two that don’t usually move in the same direction—especially for startups.
So which one is more important? Which should you focus on most? The Rule of 40 says you don’t have to choose.
According to the Rule of 40, it’s the combined sum of profitability and growth that matters most to SaaS companies when it comes to measuring their financial health—and investors agree.
In this guide, we’ll explain how the Rule of 40 works, why it matters to SaaS companies, how to calculate it and other key considerations related to its application in practice.
In the simplest terms, the Rule of 40 states that a company’s combined growth rate plus profit margin should reach or exceed 40% at all times. It was popularized when Techstars founder Brad Feld wrote about it in 2015, after he heard it from a late-stage investor at a board meeting.
Feld called it “the minimum point of happiness” for high-growth SaaS companies, and ever since, finance teams and investors alike have used the Rule of 40 as a go-to valuation metric to determine the financial health, viability, and growth potential of SaaS companies.
But what is it about the Rule of 40 that makes it so special?
Mostly, it’s the ability to measure success of the SaaS startup journey in a standard way, during which growth and profitability are both prioritized, but whose weighted importance changes depending on where a company is in its lifecycle.
The Rule of 40 measures these two key metrics in a singular way that accounts for the reality that growth rate and profitability change, but if the two stay balanced at all times, a company can still be deemed “healthy” and worth investing in.
Let’s consider the Rule of 40 in context.
SaaS Company A is a few years old, but still in the fairly early stages of growth as a startup. They’re scaling rapidly and earning huge influxes of new users every month—the company’s growth rate is at 50%. But because they are investing heavily in growth-focused product development and marketing, their profitability is in the negative at -5%.
But because their growth rate is so high, their Rule of 40 score exceeds 40% when combined with profitability (it totals 45%). That would mean Startup A is still considered healthy by the rule’s standards.
SaaS Company B is nearly a decade old now and has reached organizational maturity. As a result, their growth rate has flattened to around 10%, but they have been able to shift their focus to increasing profitability, which stands at 35%.
Just like Company A, Company B’s Rule of 40 result is 45%—they’re a healthy company. But the way they reach this metric is quite different.
It all goes back to the trajectory of the SaaS startup journey—the main reason the Rule of 40 is needed in the first place.
As you can see below, after a company finds product/market fit and hits the market, they pour on resources to drive growth and scale their business. Once they reach maturity, their growth curve flattens out and they compensate by working to maximize profit margins through improved efficiency.
It should be noted that there is a time considered too early for SaaS companies to use the Rule of 40—the very earliest days of establishment and growth.
While early-stage startups can and do use the rule, doing so before you have a reliable user base and some established demand can make the results unreliable. During that time, growth and profitability are both so volatile that any measurement of the two isn’t likely to stand the test of time—even to the next week or month.
A better plan at that stage is to focus on metrics like revenue run rate or cash runway, then use the Rule of 40 once a trajectory of growth has been demonstrated.
The simple Rule of 40 calculation is growth rate + profitability, as seen below:
But before you can calculate your Rule of 40 number, you also must calculate your growth and profitability. So what numbers should you use to determine those?
While there isn’t a singular answer, many SaaS startups choose to use year over year monthly recurring revenue (MRR) as their growth percentage number (because most SaaS revenue comes from recurring subscriptions), and earnings before interest, taxes, depreciation, and amortization (EBITDA) as the profitability indicator.
Once you know your growth rate and profitability, you can calculate your rule of 40. Input your numbers, and try our Rule of 40 calculator below.
SaaS companies care a lot about investors’ perspective—even if a company’s founders and leaders feel comfortable with their financial health, they need investors to see things the same way if they’re going to earn funding.
The Software Equity Group (SEG) reports that investors actually favor companies that reach a Weighted Rule of 40 focused more on growth than profitability. It’s calculated as follows:
SEG found that companies scoring greater than 40% on the Weighted Rule of 40—which included the likes of Zoom and Twilio—showed a median enterprise value / revenue ratio (a key valuation metric for investors, measuring a company’s overall valuation relative to its sales) of 22.4X.
This was significantly higher than low scorers, as demonstrated below:
The Weighted Rule of 40 of course benefits high-growth (and usually early-stage) SaaS companies given that it prioritizes growth above profitability, and the fact that investors pay particular attention to this version of the rule is significant for any company seeking growth funding. You can try our free weighted rule of 40 calculator below.
The Rule of 40 avoids having to use either growth or profitability as a singular measure of success. Instead, it accounts for the fact that these two metrics generally mirror each other (as one moves one way, the other moves in the opposite direction).
That means your company can focus on what it needs in the moment while also ensuring it’s positioned for long-term success. As long as you maintain the right balance between the two metrics, you can be confident in your financial stability.
But while the Rule of 40 has become a valuable industry standard, it’s not the only SaaS KPI you should be tracking. To build a complete growth strategy, you should also know your unit economics and other key SaaS metrics like customer acquisition cost, customer lifetime value, revenue retention and churn.
How can you monitor all this and do it efficiently?
Ideally, with complete planning software that simplifies revenue planning by centralizing data from all your systems such as your ERP, CRM and HRIS and Payroll. With Vena for SaaS, you can hit the ground running with proven SaaS dashboards, templates and modeling tools—all within the Excel interface your finance team knows and loves.
Did you find this article helpful? If so, you might also enjoy this related content:
3 Key Processes SaaS Finance Teams Can Focus On to Streamline Growth
51 SaaS Statistics, Trends and Benchmarks for 2023
Revenue vs. Profit: Key Differences and Which Matters More
Track ARR for existing, churned, pipeline, and future opportunities with our free SaaS Metrics Dashboard.
Melissa Howatson, Chief Financial Officer at Vena, has a wealth of experience in financial and consulting roles, ranging from EdTech, automotive and Big Four accounting firms. She was CFO and board member at D2L—a global learning technology company—and led its successful initial public offering in 2021. Prior to that, she held finance leadership positions at Bend All Automotive, Qwalify and Primal. Melissa is a CPA-CA, having obtained her designation while working in KPMG's assurance practice. With her combination of scale-up and start-up experience, Melissa has an impressive track record of building and leading successful finance teams that drive the business forward.
