The Rule of 40
This blog post was written by DougL. Edits provided by friends. AI was not used to write or edit it. Browser-based technology with generative AI and ChatGPT was used to fact check.
This past weekend I returned to Boston from San Francisco where I attended the RSA Conference – the big cybersecurity conference and exposition.
I was planning on publishing the 3rd installment of a 3-part series on generative AI and ChatGPT focusing on investments. However, in several of my conversations with people, the topic of the “Rule of 40” kept coming up. It’s clearly a timely and important topic.
So, instead of the final post in the AI series, I decided to address the Rule of 40 in this week’s missive. I’ll return to the AI investment blog series and close it out with the final post in the second week of May.
The Rule of 40 is a financial metric used in the tech industry, and especially among VCs, PE players, and investment bankers. They use it as a key performance indicator (KPI) of the financial health and growth status of startups. For the tech money crowd, the Rule of 40 gives them one way to assess a startup’s potential in the software industry.
In sum, the Rule of 40 holds that a company's combined growth rate and profit margin should be at least 40%.
The formula for calculating the Rule of 40 is as follows:
Rule of 40 = Growth Rate + Profit Margin
The details:
Growth rate = (Current year's revenue minus last year's revenue) divided by last year's revenue.
Profit margin = Net income divided by revenue.
For example, if a company's revenue in 2022 was $10 million and this year's revenue is $14 million, its growth rate calculation would be as follows:
($14 million - $10 million) / $10 million = 40%
If the company's net income for the same period was $2 million, the profit margin would be:
$2 million / $14 million = 14.3%
The Rule of 40 number for this company would therefore be:
Rule of 40 percentage = 40% + 14.3%
That’s a 54.3% Rule of 40 result, which suggests that the company is in a healthy financial position. Its combined growth rate and profit margin is well north of the 40% threshold.
A couple of observations:
Growth is still more valuable than profit alone. The growth variable in the Rule of 40 is about revenue growth rate (most often quantified by ARR). There are, of course, other metrics and KPIs that measure growth.
In recent years, the 40% rule has gained widespread acceptance among SaaS investors as a way to assess growth. This year it has become more generalized to other types of software companies.
The “path to profitability” (P2P) delineation is no longer enough. If you are financing a company or examining exit options, today your company will be assessed more pointedly on the basis of bothgrowth and profitability.
The Rule of 40 does not provide a comprehensive picture of a company’s valuation. It omits, for example, assessments of personnel, market share, intellectual property, and more.
The emergence of the Rule of 40 at this time is clearly related to the correction currently underway in public and private company valuations. In other words, this may be directly related to the “haircuts” given to or pending for dozens of the 1000+ unicorns and 1000+ “soonacorns” in the startup and venture ecosystem.
Almost certainly, VC, PE, I-bankers, startup CEOs and others will be tossing around the Rule of 40 a lot in their conversations and business dealings in the coming months. It will pay to be prepared and know how your company lines up against this increasingly important KPI.