About Brian DeChesare
Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.
In Software as a Service (SaaS) financial models, the “Rule of 40” states that a company’s Revenue Growth + EBITDA Margin should equal or exceed 40% to be considered “healthy”; companies that exceed it by a wider margin may be valued more highly.
The “Rule of 40” in SaaS: Examples, Calculations, and Real-World Meaning
Rule of 40 Definition: In Software as a Service (SaaS) financial models, the “Rule of 40” states that a company’s Revenue Growth + EBITDA Margin should equal or exceed 40% to be considered “healthy”; companies that exceed it by a wider margin may be valued more highly.
The Rule of 40 reflects the basic trade-off between growth and profitability that all businesses face.
In other words, if the business wants to grow more quickly, it needs to spend more on sales & marketing to distribute its products and reach new customers.
On the other hand, if the company wants to become more profitable, it can reduce this sales & marketing spending and accept that it will reach fewer new customers and grow more slowly.
The Rule of 40 was popularized in a 2015 blog post by venture capitalist Brad Feld.
The startup / VC ecosystem is a bit of an echo chamber, so “everyone” started repeating this rule as if it were the same as gravity or momentum in physics.
But that’s not the case!
Not only are there disagreements about how to calculate the Rule of 40, but its meaning and implications also differ by company and vertical.
For many SaaS companies, valuation is just as highly correlated with simple Revenue Growth or Annualized Recurring Revenue Growth.
The Rule of 40 is useful for assessing a company’s forecasts and benchmarking it, but it is a rule of thumb – not a natural law.
To calculate the Rule of 40, you start by taking the company’s most recent Revenue Growth and adding its EBITDA Margin.
For example, if we look at Salesforce’s 10-K, its Revenue Growth was $34,857 / $31,352 – 1 = 11.2%:
Its EBITDA equals its Operating Income of $5,011 + Depreciation & Amortization on the Cash Flow Statement of $3,959 = $8,970:
In this case, we would not add back the Restructuring Expense since it has recurred in 2 out of 3 historical years.
This produces an EBITDA margin of 25.7%, so Salesforce’s “Rule of 40” is 36.9%, which is very close to the target.
But this simple exercise also reveals potential disagreements about how to calculate this metric. For example:
Salesforce’s Free Cash Flow, or Cash Flow from Operations minus CapEx, is close to its EBITDA (~$9.0 billion), so the second question here does not make a big difference.
This point would matter more if the company were younger, growing more quickly, or had a much bigger Change in Deferred Revenue relative to its overall Revenue.
The first question is more interesting because it potentially impacts many companies.
Salesforce does not disclose its ARR, but we can take its quarterly numbers and make our estimates by annualizing the quarterly Subscription Revenue:
In this case, though, the results are boring because ARR Growth is nearly the same as Revenue Growth, so the “Rule of 40” numbers are almost the same.
We expect this result since Salesforce is a large, mature company with modest growth rates.
If we were analyzing a $10 million revenue startup or a $100 million revenue growth-stage company, we would likely get different results, with ARR Growth potentially exceeding Revenue Growth.
In some cases, the “Rule of 40” is closely correlated with SaaS companies’ revenue multiples, but it depends heavily on the set of companies you’re looking at.
We’ll look at 3 sets taken from different periods (2022, 2023, and 2024) to illustrate the correlations:
The first 2 sets use Revenue Growth + EBITDA Margin for the Rule of 40, while the last one uses Revenue Growth + FCF Margin.
The main conclusion is that no matter how we measure revenue or profit, the “Rule of 40” is not much different than simple Revenue Growth for predicting Revenue Multiples.
It’s better for two sets and worse for the other, but it never produces a dramatic difference, such as 80% vs. 50% correlation.
The Rule of 40 is the most meaningful for the set with constraints on both Revenue Growth and EBITDA Margins (10% or higher for both).
This is unsurprising because both growth and profitability matter for these smaller companies without huge growth potential.
Since the correlation between the Rule of 40 and revenue multiples is not always strong, it is often more useful as an operation or benchmarking metric.
For example, if most of the peer SaaS companies have a Revenue Growth + EBITDA Margin of ~30%, but the company you’re analyzing claims to be at ~60%, you should be very skeptical.
At a large scale, no company can outperform this basic trade-off between growth and profitability for long.
When analyzing a SaaS company’s budgets and forecasts, we might see numbers like the following:
This is an encouraging sign because the Revenue Growth + EBITDA Margin is consistent but falls significantly when the company spends a huge amount on sales & marketing in the first projected year to boost its growth rate.
We would be more suspicious if the Revenue Growth + EBITDA Margin increased significantly over this projected period or did not reflect the effects of the higher sales & marketing spending.
Because of these issues, firms such as Bessemer have invented new variations on the Rule of 40, such as “The Rule of X,” where the growth rate in the formula gets a higher multiplier than the profit portion.
For example:
Rule of X = Revenue Growth Rate * Multiplier + EBITDA or FCF Margin
This multiplier on the Revenue Growth Rate might range from 1.5x to 3.0x, depending on the company stage and market.
The multiplier means the Revenue Growth is more valuable than the Margin, at least for many mid and late-stage SaaS companies.
They do present data indicating that R^2 is higher for the Rule of X and Revenue Multiples than it is for the Rule of 40:
The Rule of X is probably better than the Rule of 40, but remember that they’re rules of thumb, not universal laws.
The real way to value any company is with an in-depth, long-term DCF model built around the company’s unit economics.
That approach will always be more accurate than these quick rules, even if it takes more time and effort and requires more judgment calls.
Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.