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The SaaS Rule of 40: What It Is and How You Can Achieve It

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How do you measure the success of a SaaS business?

Is it through the amount of profit that it generates? Or the speed of its growth rate?
As a SaaS company, you need to be able to precisely measure the success of your business.

But not just for your sake. You need to give a good impression to your respective market as a whole.

The analysts. The media. The investors.

Especially the investors.

These capitalists have ways of evaluating and projecting a company’s success. After all, they need to thoroughly assess their potential investments before making a commitment.

So let’s talk about how you can evaluate the success of your SaaS company.

 

How To Value a SaaS Company

 

Whether or not there is a standard way to value a SaaS company is still a matter of debate. There are a lot of possible aspects of a SaaS business that can indicate its health.

The most obvious one is profit. However, there are other companies out there that prioritize growth. This is especially true for SaaS startups that are deadset at climbing the ranks quickly and efficiently.

To measure a business’ current standings, there are several valuation metrics that you need to consider. Price-to-earnings ratio (P/E ratio) and free cash flow (FCF) are just some of them.

Because SaaS works differently than other forms of business, its metrics can vary depending on several factors.

Let’s discuss a couple of these factors and when they’re best used.

 

Seller Discretionary Earnings (SDE)

 

SDE is the net income left to the business owner once you deduct production cost and operational expenses from the gross revenue. If the owner receives a salary or dividend, they can also add it to the total computation for the SDE.

Here’s a simple formula:

 

SDE Formula 2

 

SDE is generally used to value small businesses that don’t have their own management teams. The worth of these companies usually falls below $5 million.

The reason why SDE is used for businesses on this scale is how owner-managers usually operate.

Small business owners tend to pay themselves a salary that does not necessarily follow the market rate.

Moreover, there can be a thin line between personal and business equipment.
Take a computer, for example.

If a small business owner buys a new computer, they would likely use it for personal and work-related activities. But they would record the purchase under business expenses for tax efficiency purposes.

Cash flow in small businesses is usually simple enough that SDE is the most accurate metric for its value.

But growing businesses don’t stay that way for too long, do they? In fact, rapidly growing SaaS businesses often get investors early on.

At some point, SDE will start falling short in accounting for all the company’s financial transactions. As your business grows, you will have more shareholders, more employees, and more company assets.

When that happens, you will need a more advanced metric to measure your financial performance.

Enter EBITDA.

 

EBITDA

 

This big chunk of an acronym stands for earnings before interest, taxes, depreciation, and amortization. It’s one of the most widely used ways to measure a company’s current operational performance regardless of any financial deductions.

It excludes the historical and circumstantial deductions from the following:

    • Interest: It is excluded because financing structures and interest rates vary from business to business.
    • Taxes: EBITDA does not include taxes because they also depend on your geographical location.
    • Depreciation and amortization: These depend on the investment your company has made.

For instance, when you buy a company server for $2000, you don’t record the full two grand as a cost for the year. You add it to your assets.

If, for example, it depreciates by $400 in one year, then that is a depreciation expense of $400 deducted from your assets. Another depreciation cost will be deducted the following year, and so on.
EBITDA does not include this depreciation expense in measuring your company’s overall financial performance.

Now, EBITDA by itself is not enough to measure your overall profitability. You still need to compute your EBITDA margin and compare it to your industry standard.

EBITDA margin is the percentage of your EBITDA compared to your total revenue.

You can calculate it using this formula:

 

EBITDA Margin Formula

 

Let’s look at one example.

Let’s say your EBITDA is around $1 million and your total revenue is $10 million. That gives you an EBITDA Margin of 10%.

Now, if you’re going to use EBITDA for growing a SaaS business, it may amount up to zero or even a negative value. These companies make a lot of investments dedicated to their scaling efforts. And sometimes, things go south.

That’s why EBITDA is more accurately used for larger companies worth more than $5 million. As bigger corporate entities, they have more complex financing structures.

There are a significant number of shareholders who have less active roles in the company. Moreover, they have management teams.

For businesses like these, any owner compensation and discretionary expense need to be reflected in the business to accurately indicate its financial capability.

 

Revenue Growth Rate

 

Revenue Growth Rate is the increase or decrease of a company’s income between two consecutive time periods. For SaaS companies, it’s usually measured in annual recurring revenue (ARR).

Unlike SDE and EBITDA, Revenue Growth Rate focuses on how much your company’s profitability has improved or regressed over time.

You can calculate Revenue Growth Rate with this formula:

 

Revenue Growth Rate Formula

 

For example, last year, you had an ARR of $10 million. This year, it went up to $13 million. That’s an improvement of $3 million, which is a 30% improvement from the previous year.

While these metrics show you how profitable you are, they don’t tell you if it’s enough to make your business successful.

Thus, there is a need for a benchmark.

And so we arrive at the Rule of 40.

 

What Is The Rule of 40?

 

The Rule of 40 is one of the most popular standards when it comes to measuring the success of a Saas business. It is often used by equity buyers and venture capitalists in evaluating a company they are interested in.

 

Profit VS Growth

 

The Rule of 40 for SaaS companies is a means to address the never-ending debate on whether to focus on profit or growth. Both are important to any company’s success.

But you can’t prioritize both at the same time.

Focusing on a high profit margin means that you are keeping funds that you could otherwise reinvest for your growth.

On the other hand, focusing on growth means aggressively investing in expansion, which can give you a slim profit margin. If there is any profit at all.

The Rule of 40 brings the two together to measure your company’s financial performance regardless of where your priorities lie.

Let’s see the calculations involved in the Rule of 40.

 

Rule of 40 SaaS Formula

 

The Rule of 40 says that a successful SaaS company should have a total growth rate and profit margin of more than 40%.
It’s calculated using this formula:

 

SaaS Rule of 40 Formula

 

The Rule of 40 formula takes two key things into account: growth rate and profit margin. Since Revenue Growth Rate and EBITDA Margin are two of the most commonly used metrics on growth and profitability, they are often used in the Rule of 40 as well.

Now, let’s take the examples we used earlier.

In our previous scenarios, you have an EBITDA margin of 10% and a Revenue Growth Rate of 30%. Add them, and you get 40%, the bare minimum to meet the Rule of 40.

In this scenario, the 40% means that you are on the right track to making your SaaS company successful.

But that’s not all there is to it.

There’s still a little something called the weighted Rule of 40.

 

The Weighted Rule of 40

 

In the struggle of choosing between profit or growth, most venture capitalists prefer growth over profit. This brought the need to have a Rule of 40 calculation that gives growth more value than profitability.
Thus, the weighted Rule of 40 was born.

 

Weighted Rule of 40 Formula

 

Let’s take our earlier scenario as an example.

With a revenue growth rate of 30% and an EBITDA Margin of 10%, you have a weighted Rule of 40 value of 46.6%.

Because you have a high growth rate compared to your profit margin, the weighted formula puts you a little bit higher than the initial formula does.

True enough in real life, investors have favored SaaS businesses that score high with the weighted Rule of 40. These include fast-growing Saas companies like Zoom, Adobe, and Twilio.

 

How To Achieve the Rule of 40

 

Whatever stage your company is in, you can work towards going past the 40% mark. After all, venture capitalists and buyers are attracted to companies that make the cut.
And who doesn’t want to attract investors?

Here are some things you can do to meet the Rule of 40:

 

Widen Your Profit Margin

 

SaaS products are generally profitable because of their subscription-based payment models. Its profits are measured in recurring revenue.

Moreover, operational expenses mainly consist of hosting, marketing, sales, and business SaaS needs.

One way you can widen your profit margin is by cutting costs. It can be switching to a more affordable SaaS provider or hiring a fractional marketing team.

Or you can improve your selling price.
Sometimes, SaaS companies don’t maximize the price range that their customers are willing to pay. That’s why you need to pick a good pricing model and strategy for your SaaS solution and maximize your potential profits.

 

Rapid Growth

 

With more and more venture capitalists looking at the weighted Rule of 40, aggressive growth is becoming a preferred strategy.

Sure, there are risks that come with limiting your profits. But you can leverage a high growth rate to attract investors. That would help you further scale your business and eventually earn more profit.

Growing your SaaS company takes a lot of expanding your market share. You need to level up your marketing and sales processes. And you need to improve your upsells and conversion rates.

Sometimes, growth even means acquiring or merging with other fast-developing companies.

 

Improve User Experience

 

One of the most common mistakes SaaS startups make is failing to improve their current system. As a result, they’ll slowly lose their customer base as they’re not evolving with their market.

Don’t be that kind of company.

Redesign your interface and make it easier for your users to navigate.

They will love you for it. They will tell others about it. And ultimately, that will lead to more sales, more growth, and more profit.

Of course, you should base the improvement on collected data and what your customer needs.

 

Lower Churn

 

The flipside of the previous point is churn, the most dreaded word in SaaS. Aside from delivering a high-quality product to your customers, you can lower churn by listening to them.

Give them top-notch customer support. Know what they like and don’t like about your product. Analyze what other features or services they want for future updates.

There are other ways you can lower your churn too. To name a few, you can improve your onboarding process, analyze customer feedback, and prioritize your most profitable subscription tier.

 

Final Thoughts

 

The Rule of 40 has been a popular metric for the health and success of SaaS businesses. Investors and venture capitalists use it to evaluate whether or not a company is worth funding.

As a SaaS business looking to secure that funding to drive more growth and profit, you need to display that you can make the cut.

But to balance it out, don’t get too caught up in trying to pass that 40% mark.

Ultimately, the end goal is the long-term success of your business. Your Rule of 40 calculation is just an indicator of your current progress.

If you made the cut, that’s good. Leverage it to attract investors and media exposure.

If not, don’t panic. Revisit your strategy and analyze aspects that need improvement.

For more strategies on making your SaaS business succeed, click here.

 

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Ken Moo
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