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rule of 40

The software sector has many exciting prospects for investors. However, what’s the best way to determine if a company is a good investment? The Rule of 40 is one of the most widely used metrics for evaluating software companies. However, the Rule’s dominance in analysis has been questioned in recent years. The Rule looks at the company’s earnings and growth rate. We’ll dive deeper into the Rule, how it’s used, and whether it should continue to be used.

What is the Rule of 40?

The Rule of 40 is one of the most used metrics for evaluating the growth and profitability of firms in the software industry. 

The Rule of 40 is considered a rule of thumb for analyzing a company’s operating performance. Brad Feld and Fred Wilson originally coined the term in 2015. The Rule quickly gained wide acceptance by venture capitalists and private equity firms.

Rule of 40 Definition

The Rule of 40 states that a software company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) margin plus the company’s growth rate should be at least 40%. For example, a company with an EBITDA margin of 30% and a growth rate of 12% would meet the criteria, while a company with a 38% EBITDA margin and a 1% growth rate would not. A company may meet the requirements while losing money but experiencing significant growth.

How to Calculate Rule of 40

rule of 40 formula

The Rule of 40 takes into account two key financial metrics: growth rate and profitability margin.

The growth rate of a software as a service (SaaS) business is measured by comparing year-over-year results. You can calculate it using annual recurring revenue (ARR) or monthly recurring revenue (MRR) at any point in time.

You usually calculate the company’s profitability using EBITDA. Although some investors may use other profit calculations. The key is to be consistent when comparing different firms. To calculate the percentage of profit, you divide the EBITDA by the company’s revenue to yield a profit percentage.

You then add together the profit percentage and growth rate. If the sum of these two figures is at least 40%, you can consider the company a good investment. 

How Can Software Firms Use the 40 Rule?

Software firms can use the Rule of 40 internally to evaluate operational performance, profitability, and growth. Once the company calculates its own figure, it can evaluate where they stand in the industry and how attractive they look to potential investors. 

The Rule of 40 can help a company set goals for either profitability or growth to improve its score. However, note that the Rule will not be applicable in all circumstances. For example, a company moving from one to two clients would have a growth rate of 100%, but the rate is not credible. You should not use it in this case. Additionally, if the company has one-time expenses that affect profitability, it does not necessarily mean that the company is a bad investment. 

What if My Company Doesn’t Pass?

If your company fails to pass the Rule of 40, you should evaluate areas of potential improvement. The improvement can come from either increased profitability or increased growth rate. However, it’s important to note that an improvement in growth may lead to additional expenses. This could lower the company’s profitability margin. Therefore, you should notice the interplay between the two metrics when setting goals.

To increase profitability, you should evaluate areas of potential revenue growth. This would be: untapped markets, changing fees, or additional services. You should also identify areas to cut back on expenses. When cutting back expenses, you should ensure that the cuts will not affect the company’s growth rate.

You can also improve the score by increasing the growth rate, which you can accomplish by investing in marketing, changing salesperson incentives, upselling existing clients, or expanding into new markets.

Is the Rule of 40 Still Relevant?

A study completed in 2021 by McKinsey found that less than a third of existing software companies met the Rule of 40. The growth and profitability rates which were achievable 5-10 years ago may no longer be relevant to today’s competitive environment. Though many firms still calculate the rule, they will use it along with other metrics.

Software firms should aim to pass the Rule of 40 before exploring sales, investment from venture capital and private equity, or public listings since it may increase their valuation. In addition, passing the Rule of 40 can indicate to investors and potential acquirers that the company is growing rapidly and is profitable, which can positively impact its valuation.

However, others argue that software firms should not rely solely on the Rule of 40 and should consider other metrics and factors when evaluating their financial performance and growth potential. Additionally, passing the Rule of 40 may not necessarily have a substantial impact on a company’s valuation if investors and acquirers are also considering other factors such as the company’s market position, technology, and management team.

While the Rule of 40 may still be a relevant metric for evaluating software firms in certain situations, it’s important for companies to consider other metrics and factors and not rely solely on this one benchmark. Ultimately, the most crucial factor for investors and acquirers is the company’s growth potential. Furthermore, it is important to note the company’s ability to create value over the long term.

Closing Thoughts

While the Rule of 40 has been a widely used metric for evaluating software firms’ financial performance, its relevance in today’s rapidly changing industry is a topic of debate. Some investors and executives still consider the Rule of 40 when evaluating software companies. Others argue that it may not be the most relevant or effective metric in today’s market. 

Passing the rule can still indicate a company’s financial strength and growth potential. This can be beneficial for attracting investors and potential acquirers. But, ultimately, while the Rule of 40 can be a helpful tool, companies need to consider other metrics and factors when evaluating their financial performance and growth potential in order to create value over the long term. 

That’s where TaxHack comes in – we can help you evaluate your performance and growth potential with other important metrics. Contact us to learn more.

 

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