How SaaS founders can beat the Rule of 40 🧮

What is the Rule of 40? 🤔

The Rule of 40 is an investing principle which adds a Software as a Service (SaaS) company’s revenue growth rate with its profit margin. If the sum exceeds 40%, the company is assumed to be a worthwhile investment opportunity. Specifically, the formula is:

Revenue Growth (%) + EBITDA margin (%) = Rule of 40

The rule has its origin in the venture capital space when startup investors began using the formula in 2015 as a litmus test for SaaS business investing. The formula is meant as a quick check of a venture’s vitals and captures the firm’s efforts of investing in growth and short-term profitability.

For which founders is it relevant? 🔮

The Rule of 40 is relevant at all stages of a SaaS business’ life cycle, but should be viewed through different lenses.

Early stage: Beating the rule should not be seen as an exceptional achievement, but more of an indicator if product market fit can be delivered.

Late stage: Becomes increasingly more difficult as a business matures. Growth rates naturally taper off as “low-hanging fruits” are picked off and market share increases. At this stage, the Rule of 40 serves as a benchmark to compare SaaS businesses in the same cohort to each other to assess which are closest to outperforming the principle.

Strategies for beating it 💡

Focus on:

Outperforming through growth
Balancing profitable growth
Boosting profitability

Tactics for beating it ⚡️

Focus on:

Leveraging exiting customers (e.g. raising prices, counteract churn)
Increasing productivity (e.g. reduce costs of external services)
Employing operational excellence (e.g. build a remote organization)