SaaS Valuations Using The Rule of 40
In today’s highly competitive M&A environment, SaaS companies face enormous pressure to reach certain metrics. The metrics and tools for evaluating your own business are seemingly endless, but potential investors and buyers often decide whether or not they’d like to learn more about your company based on just a few numbers. That’s where the Rule of 40 (“RO40”) comes in. Investors and buyers use the RO40 to quickly evaluate a company’s balance between growth and profitability. Read on to learn more about this rule, how it’s used, and how you can improve your score.
What is the Rule of 40?
The Rule of 40 states that a company’s rate of revenue growth plus profitability margin should be equal to or greater than 40%. It has become a construct for framing the balance of these two factors in SaaS businesses, which are always striving for either accelerated growth or improved profitability.
Rate of revenue growth is most commonly calculated using year-over-year growth percentage based on GAAP revenue, since it is the most consistent basis for comparison.
Profitability margin is most commonly the EBITDA margin, because it removes disparities in interest cost and tax treatment, making it the most accurate measure of profitability. However, some companies may use net income or cash flow as additional profitability indicators.
The Rule of 40 equation simply sums two numbers:
1. Revenue growth rate %
2. EBITDA or Profitability margin %
Note that the RO40 is not an all-encompassing calculation and can’t be used alone to measure the performance of a company. There are many important metrics that should be measured on an ongoing basis internally to gauge growth and catch concerns quickly. Rather, the RO40 is a useful calculation that levels the playing field for comparing sustainability between multiple SaaS companies.
How Do Investors and Buyers use the Rule of 40?
Investors and buyers use the Rule of 40 to compare SaaS companies and quickly assess potential stability based on the harmony between growth and profitability. While a company’s priorities may shift depending on its stage of growth, the Rule of 40 indicates a positive overall trend. A newer SaaS startup may be growing quite rapidly, but not yet achieving great profitability margins. A more mature company, on the other hand, may be more focused on scaling than growth. The Rule of 40 is a helpful comparison because it allows companies to compete more fairly against one another in these two areas.
Software companies that can surpass the Rule of 40 have valuations that are twice as high as those that do not, and they generate returns that are up to 15% higher than the S&P 500*. Industry experts generally agree that the RO40 isn’t relevant for all companies. For example, a very early-stage startup might exceed 100% due to rapid growth and investment, which won’t be sustainable long-term. A good starting point to use the RO40 is after reaching $15-$20 million in revenue. Others advise waiting until the company has developed all of the appropriate departments for expansion, like research and development, sales and marketing, customer service, and so on.
Understanding the Rule of 40 is important in order to understand how to leverage it for your company. You may need to use a certain variation of the calculation to show it in the best light, or perhaps avoid the discussion entirely, depending on your specific scenario.
How to Improve your Rule of 40 Score
It’s important to note that pushing to pass a certain threshold of any metric is not always the right choice for your business. SaaS company leaders need to place the sustainability and long-term wellbeing of the business, employees, and customers above all else. That said, there are some ways to nudge your Rule of 40 score a bit higher to help catch the eye of potential investors and boost valuations.
Of course, the most straightforward way to improve your RO40 standing is to increase one or both of the numbers in the equation. The best approach for your business will depend on your stage of growth and future plans.
1. Accelerate Growth
Early and growth-stage SaaS companies are often focused on growth. Investing in research and marketing, developing new business branches, expanding your target audience, and expanding the areas you serve are all ways to accelerate growth.
2. Improve Profitability
More mature companies may not find significant change to growth rate feasible, so targeting higher profitability may be a more realistic strategy. This may mean focusing on increasing income from existing customers, improving user experience, or increasing efficiency, just to name a few options.
3. Try Different Calculations
While GAAP revenue and EBITDA are most commonly used, they aren’t the only acceptable metrics to use in the calculation. Some companies use ARR or MRR for revenue and Unlevered Free Cash Flow, Cash from Operations, Net Change in Cash, or Operating Income for profitability.
If you haven’t yet surpassed the 40% mark, don’t worry. It’s a number few companies will ever see. It is, however, a worthwhile goal to pursue. Since it became a popular metric 10+ years ago, the data has consistently shown that the public SaaS companies do maintain this benchmark.
If you would like a brief evaluation of your business to determine your SaaS or IT services companies valuation range, please contact us: [email protected]
About Solganick & Co.
Solganick & Co. is a data-driven investment bank and M&A advisory firm focused exclusively on software and tech-enabled services companies.