May 24, 2022

SaaS metrics 101: rule of 40

Many investors use the rule of 40 (r40) to benchmark whether a SaaS company is growing sustainably. This article explains why — along with tips for calculating the metric.

When founders, VCs, and the general startup community use the phrase “unicorn potential,” what exactly does the term mean? It’s important to have an objective way to answer that question. Enter the rule of 40 (R40). 

R40 is a quick way to benchmark whether a company is growing sustainably. Here’s a look into the metric, the math, and other must-knows for founders who want to learn more about it. 

R40 overview

R40 is a high-level metric for evaluating the growth trajectory of a SaaS company. It quantifies the idea that the highest performance startups have profit margins and growth rates (profit + growth) that sum to more than 40%. Venture capitalists created this metric as a way to calculate thresholds for investing. The earlier-stage the company, the easier it is to hit or exceed the R40 metric. 

As a startup grows, it becomes a challenge to continually beat the number. That’s because startup growth tends to level out over time. While growth will level out, ideally profit margins will eventually improve and potentially make up for any reduction in top line growth. It’s well-known that the consistent overperformance of R40 is uncommon, for this reason.

When software companies balance growth and profitability, they outperform the Rule of 40 to have valuations (the ratio of enterprise value to revenue) double that of companies that fall under the R40 threshold. Companies can raise their R40 score by increasing either their revenues or profits.

How realistic is r40?

Only a small fraction of companies maintain growth rates above 30 to 40%, with the median being 22%. Higher scores are a signal of a well-balanced approach to growth. The metric accounts for the following:

  • Alignment between spending and realistic performance forecasts
  • Growth from existing customers driven by customer retention
  • R&D spend required to keep features and products current
  • Customer acquisition costs relative to the time it takes to get profitable

R40, as a number, tells the story of whether a company is succeeding in balancing these demands while showing aggressive growth- it’s an operating performance metric. For this reason, it’s normal that some companies are at the top of the curve, some are at the bottom, and some will be in the middle.

What it takes to score r40 or higher

Here’s what leaders of the pack do differently:

  • Set realistic growth targets over a three year period and manage expectations based on what’s organically achievable.
  • Rebalance cost and profitability thresholds to reflect the performance of the market.
  • Prioritize exceptional customer service to maximize retention metrics.
  • Approach go-to-market spend aggressively — approximately 50% or more in revenue for high-growth businesses

Top-quartile companies generate revenue growth 3.5 times faster than the bottom quartile. That’s because they’re allocating sales and marketing resources based on future customer opportunity instead of revenue. These high performers build their  operations on a solid data foundation by pulling together various dashboards into a shared, integrated view for employees to easily reference.

These milestones require experienced leadership, which is why first-time founders and CEOs especially will benefit from building an advisory board that can offer direction. 

Why r40 matters

R40 helps boards, investors, and VCs communicate more effectively. The metric establishes a common basis of understanding to support the due diligence process. 

One simple way to conceptualize r40 is as a discussion starter rather than a be-all-end-all metric. It’s important to remember that there are many ways to measure whether a business is successful or not. Having a low r40 doesn’t mean that your startup isn’t viable — it simply means that this measurement system may not be a good fit for your unique business model. That’s perfectly fine.

However, the metric is important if you’re looking to work with an alternative financing solution like Capchase. Because our financing is specifically designed for high-growth SaaS companies, it makes sense for us to evaluate r40 as part of our underwriting process.

At the same time, we understand that high-performing SaaS companies are diverse — and that r40 isn’t always the best fit evaluation criteria. In some cases, we’re able to underwrite companies that are under the r40 threshold. Our decision depends on a combination of underwriting variables, as our goal is to assess each application on an individual basis.

Final thoughts

The best way to understand where your company stands on the r40 scale is to simply calculate the metric (%profit + %growth). With this metric established, you can work backwards to identify strategies and tactics for increasing your score.

If your company doesn’t hit r40, don’t be discouraged. R40 is just one way of looking at startup performance. There are plenty of financing options available for SaaS companies that don’t fit into this exact mold.

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Disclosure

This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal, or tax advice.

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