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The rule of 40 in the SaaS industry

(Software as a service) became a major industry only in the last decade. More than 50 SaaS companies are listed on Nasdaq.

When SaaS startups started mushrooming around 10 years ago, most investors doubted their business models.
SaaS businesses are a capital-intensive.

After dozens of IPOs, investors no longer doubt the SaaS business model. They know the high investment in technology and S*M (sales and marketing) leads to exponential growth. Now they evaluate SaaS companies on .

The Rule of 40 is one common metric VCs use to analyse mid and late-stage SaaS startups. The underlying belief of the rule of 40 is simple – It's fine to be unprofitable as long as you are growing rapidly to justify losses.

Annual revenue growth rate + Profit margin > 40

Let's consider a mid-stage SaaS startup with a –40% profit margin. It is burning money. But it will continue to attract as long as its revenue in the same period grew by 80% or more.

80% (Growth) – 40% (Profit) = 40

But if the growth was just 60%, it will struggle to attract investors at a negative 40% profit margin. 60% growth is not good enough to justify this high burn.

Why do investors care about this Rule of 40?

SaaS is an attractive industry because investments pay back quickly. The payback period of CAC (customer acquisition cost) is less than a year for the best companies. So the company recovers every dollar it spends on acquiring a new customer within 12 months. Since the SaaS revenue is recurring, the customer continues paying until it discontinues the subscription which can take years.

SaaS investors prioritise growth because of this recurring nature of revenue. The results validate their hypothesis. The biggest public SaaS companies have negative profit margins. But they get a high valuation multiple because of growth.

This rule of 40 seems like an easy one to meet. But most public SaaS companies don't satisfy it. The revenue growth slows down as the company becomes huge. It's difficult to grow at 50–60% every year at $200 MN revenue. In such cases, the management tries to cut costs to increase profits. Consequently, the growth slows down further.

The best SaaS companies follow this rule of 40. Hence, their Valuation multiples are also the highest. The market gives them a premium.

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post credit - Pushkar Singh