The Rule of 40 for SaaS Businesses and What to Learn From It?

A business will always need money to operate; revenue differentiates successful ones from failures. You want revenue, investors want profits, and your company needs fuel to function. Only a few startups generate enough profits to sustain themselves and provide good returns to shareholders. Running out of funds is one of the biggest reasons for startups leading to failure.

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If you don’t focus on the right things when you should, you are headed for shutdown.  In a SaaS business, especially, you need a recurring revenue stream because there is a gap between booking and payments.

So, customer retention is crucial for earnings. And the startup journey becomes quite painful if your team is not aligned to serve top-level business goals. Fundraising can sustain you for a while, but without any decent revenue coming in, even investors will not put in much money.

What is the Rule of 40?

Rule of 40 has become a go-to number for the SaaS industry investors, shareholders, and founders to gauge its success in the present and future. But it does not decide the fate of your business.

It tells you about the overall business performance of the startup quickly. A startup needs to keep a balance between expenses and revenues. Rule of 40 tells you how good you are at maintaining this balance.

Rule of 40 = GR + FCF (Company Growth Rate + Free Cash Flow Rate)

Few startups reach this benchmark, and fewer stay there for a long time. A Mckinsey survey found that organizations exceeded the Rule of 40 only 16% of the time.

How to calculate it?

• GR (Growth Rate)

The percentage of annual change in a given variable.

GR = (EV-BV)/BV*100

where: EV = End Value and BV = Beginning Value

For example, the revenue growth rate for a business that generated revenue of, $50000 in 2021 and $70000 in 2022 is (70000-50000)/50000*100 = 40%. Find more about GR here.

• FCF (Free Cash Flow Rate)

It’s the cash left after the company’s operating expenses and capital expenditures. It is another useful metric for investors. They look for organizations with high FCF. It tells funders how good the company is with its capital management and that it can sustain its operations.

One can simply look at the financial statements and find out the free cash flow rate as follows:

Free cash flow = Operating Cash Flow – Capital Expenditures

There are other methods also to calculate this. Find out more here.

What Should You Learn from the Rule of 40?

So now you know that the Rule of 40 is a big deal for investors and stakeholders. It is a simple metric that tells them that your business is highly profitable. But it is not common; many businesses can’t even reach the 40% mark.

SaaS startups that achieve the Rule of 40 attract big investments. Mckinsey data shows that the SaaS companies in the top quartile of Rule of 40 performance are valued 3 times more than those in the bottom quartile.

You are bound to shut the shop if you cannot bring in customers and make a lovely SaaS product. You don’t have to think about the Rule of 40; if you’re new, you have got other major things to care about, such as market traction and aligning your team.

But you should definitely learn from the companies that achieved the Rule of 40 mark. Here is what they did right:

1. Set the Right Goals

You must have heard this countless times, but it is a fact that there is not enough room for new SaaS businesses in the market if you don’t make it yourself. Only a few SaaS companies can sustain steep growth rates. 

These small number of companies clearly understand the company vision; their teams are aligned with the top-level organizational goals. They set realistic growth objectives and never work without numbers (KPIs and OKRs).

Huge SaaS companies such as Salesforce and Adobe also use revenue growth objectives, OKR (Objectives and Key Results) framework, or some sort of goals-setting framework.

See how a company adjusts its business operations and the team around growth objectives.

For example, a $600m SaaS business stagnated at a 15% revenue growth rate once it dominated its business domain, and its FCF (Free cash flow rate) also dropped. This company then optimized their cost structure by setting an objective to achieve a 20% improvement in FCF in next two years. 

Now, this is what only a few SaaS businesses can do, but this is definitely something you should aspire to.

2. Customer Retention

For SaaS businesses, it’s a delicate balance between onboarding new customers and retaining existing ones. You have to invest your team efforts and capital in such a way that you maintain this balance.

Smaller SaaS companies prioritize acquiring new customers because existing ones don’t contribute much to the revenue. They don’t realize that ignoring existing customers can add more costs in the long term. It can make present customers go away, and even demotivate the sales team.

A nice NRR (Net Retention Rate) tells many positive things about a SaaS business. A study of 40 B2B SaaS businesses by Mckinsey showed that companies with NRR of 120% or more have median revenue of 21-fold as compared to 9-fold for the ones with NRR below 120%.

It tells investors that your business has strong growth potential and efficient marketing and sales team.

3. Doing More with Less

Money saved in operations gives you more cash to invest in revenue-building activities or teams. For example, sales and marketing eat up a major chunk of capital for SaaS organizations. This expenditure can go up to 50% or more in fast-growing businesses.

You should optimize sales and marketing team performance by aligning them well with company goals and tracking their progress with data. Help them remove any barriers to effective communication and collaborate in real time.

More practices used by top revenue-making companies are resources allocation based on future growth opportunities. For example, preferring a segment of business with higher customer retention value than the CAC (Customer acquisition cost). 

Overall, put the money where there are opportunities to grow fast.

4. Grow Fast

Only a few make it to the top when it comes to growing at the rate of Rule of 40. This tells you that you don’t just keep making money year-on-year but also spend it on things that can make you more bucks (more FCF).

Mckinsey observed in their research that top revenue-making SaaS businesses slow down near the peak of their S-shaped growth curve. Their FCF becomes the deciding growth factor at that stage because the money should go where the growth possibilities are. For example, putting more money into retaining customers.

Another way these big companies pick up growth after the initial dip is by starting a new venture. For example, a Rule of 40 SaaS business with a $400m revenue built another business with a $50m ARR within 1.5 years. But that’s for the later stage, you must make it profitable first.

Focus on growth-oriented strategic planning for the initial years. Put your cash where you can generate more of it. Align your organization with revenue goals and invest in customer-facing teams. Allocate resources carefully, and recognize and reward your teams’ efforts with good performance management. 

The rule of 40 is more of a concern or metric for mid-sized SaaS businesses. As an early-stage SaaS startup founder, you should only focus on a few areas. Leverage the strongest growth opportunities present for your company’s position and stage. Set growth-oriented priorities and objectives, such as increasing your customer base, and retention rate, aligning team members and optimizing expenses. 

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