Rule of 40 Performance

The Rule of 40 is a Company Health Metric that measures the trade-off between profit and growth. It suggests that Investors will only invest in companies with a combined Revenue Growth Percentage + EBITDA margin percentage above 40%.

Example of Rule of 40 for a SaaS-based Business:

“One metric for investing in any growth stage company”

• Year on Year Revenue Growth Rate= ($30 million- $25 million)/ $25 million= 20%
• March 2022 EBITDA= $7 million
• 2022 EBITDA Margin %= EBITDA/ Total Revenue= $7m / $30m= 23%

Rule of 40 = Revenue Growth %+ EBITDA Margin%= 20%+23%= 43%> 40%

If the number is:

Below 40% – if the company is in the early start-up stage, nothing to worry about. But if the company is in the growth stage, the Founder needs to take the matter more seriously

Exact 40% – Hitting the 40% mark means the company is eligible to be attractive as a business

Above 40% – Anything above 40%- 45% means the company is a profitable and growing company. However, they need to make sure that there is a proper balance between profit and growth otherwise this might be a fluke or short-term success.

A good time to start measuring Rule of 40 is:

• When the company reaches $1 million MRR.
• They have clearly separated and functioning departments like customer care, resources, CSM, R&D, distribution, and marketing.
• The main focus should be on Gross Margins, Operational Productivity, Sales Growth, EBITDA, etc.

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Credits: Fazlur Shah