The Rule of 40

The Rule of 40

Morning folks, 

If you’re interested in the world of Software as a Service (and clearly we are), you’ve probably come across “The Rule of 40”. If you haven’t, here’s a quick explainer. 

If a software company’s revenue growth rate plus its profitability margin is equal to or greater than 40%, they’ve passed The Rule of 40. Some take this to mean that the business is healthy. 

As far as I can tell, the term was first popularised by Brad Feld in his 2015 blog post, “The Rule of 40% For a Healthy SaaS Company”: 

The 40% rule is that your growth rate + your profit should add up to 40%. So, if you are growing at 20%, you should be generating a profit of 20%. If you are growing at 40%, you should be generating a 0% profit. If you are growing at 50%, you can lose 10%. If you are doing better than the 40% rule, that’s awesome.”

You can understand the thinking here. Software companies are a balancing act between growth and profit. Revenue growth is something that companies can easily achieve. If, for example, I were to set up a business that sold $10 bills for $8, I would achieve pretty miraculous revenue growth. Achieving profitability would be tricky.

Similarly, plenty of businesses that have recurring revenue, could easily achieve outstanding profitability if they simply cut all marketing spend. They could achieve even higher profits if they cut down on research and development also. However, revenue growth would drop rapidly, even go into negative figures. As the Red Queen said to Alice, “here we must run as fast as we can, just to stay in place.” 

So the trick is to find a nice balance between the two. One of the most attractive elements of software businesses is that they have zero (or practically zero) marginal costs. Let’s say a company spends $100 million to build a piece of software and deploy it. Once deployed, from a cost perspective, it doesn’t really matter whether 10 people buy it or 10 million people buy it — the cost of each additional user is practically zero. They’ll probably have to buy more server space or hire additional service representatives, but it’s not like selling cars, where every single sale entails building an actual car. 

This is why software companies are able to achieve very high gross margins (80%+), while manufacturers struggle to achieve 30%. With the advent of cloud computing, software became even more attractive because companies could now convert one-time licensing revenue to recurring subscription revenue — you don’t buy software anymore, you rent it. It also enabled better upselling and cross-selling, meaning customers can always become more profitable down the line. So, the software path to profitability seems pretty straightforward — build the product, invest in acquiring customers, and at some point, the needle will tilt to profitability as operational leverage kicks in. 

Here’s where The Rule of 40 comes into play. You can be unprofitable as long as you’re growing rapidly, but at some point, your growth is going to slow, so you need to start showing profits. 

However, like most rules, it has its problems. Firstly, it’s built on two factors (growth and profitability), so defining those factors is crucial.

What are we calling growth? Is it GAAP revenue growth? That seems the most simple way to do it. However, it doesn’t account for a lot of businesses with dual revenue streams with widely differentiated margins. Roku, for example, makes hardware revenue and platform revenue. The hardware revenue is essentially a loss leader for them, while the platform revenue is very profitable. Peloton is another good example, even though they generate very healthy hardware margins. Even businesses with no hardware element may have low-margin services revenue. Feld suggests using year-over-year monthly recurring revenue as the driver. That works, but it’s not how a lot of people measure it. 

Profit is even trickier to define. Net Income is a dirty metric at the best of times. Using it as one of two factors in a stress test would be a nightmare. We could use Operating Income, or Free Cash Flow, or Unlevered Free Cash Flow. Feld suggests EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization), which, again, seems like the best all-around option. However, do we include or exclude stock-based compensation, which is typically a big expense for high-growth technology companies? 

Not to spoil the party here, but I actually don’t know the answer to these questions. There is, in my opinion, no one correct answer. Like pretty much every rule or ratio in the world of investing, you have to adjust for multiple other factors.

Finally, The Rule of 40 doesn’t account for valuation in any way. Twitter user @qcapital2020 broke down a few businesses using the rule (he uses revenue and EBIDTA margin as the factors). For DocuSign, he gave the Rule of 40 score a 53. This is good, but does it give us any insights into DocuSign’s current valuation? Not really. For Snowflake, he scored it 68, but again, that doesn’t provide any information on whether or not Snowflake should be trading at 80-times sales? In an attempt to square this circle, Jim Cramer has suggested The Rule of 40 score should be at least five times the size of a company’s price-to-sales multiple. 

And sure, why not? Since we’re all just assigning random round numbers to things, what does it matter?

RoryRory

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