The Data Behind The Rule Of 40%

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by: Tomasz Tunguz

In “The Rule of 40% for a Healthy SaaS Company” Brad Feld shared the rule of thumb growth investors often apply to judge the attractiveness of a business. “The 40% rule is that your growth rate + your profit should add up to 40%.”

I was curious if this theory were broadly true, applicable for both early stage and growth stage companies, so I calculated this ratio, which I’ll call the GP metric in this post, for all the publicly traded SaaS companies over their lifetimes using annual revenue growth rate and net income as a percent of revenue.

The chart above plots the median GP metric by years since founding. I’ve also added a horizontal line at 40%. The GP metric trends from 100%+ to about 30% over about 15 years. As Brad wrote, growth investors apply the 40% rule to companies with $50M+ in revenue, which is right around year five or six of most of these businesses. And the median figures in years six and later seem to support the case that the rule of 40% might be a good filter for investors in later stage companies to identify outliers.

In the early days of a company’s life though, the median GP metric is substantially greater, often exceeding 100%. In fact, it ought to be as high as possible. Larger ratios imply the business is growing quickly and/or generating lots of profit. Workday (NASDAQ:WDAY) charted the biggest GP figure in this data set of 189% in 2010 when the business grew from revenue by 252% and recorded net income of -57%.

As they age, many public SaaS companies haven’t been able to sustain a 40% GP metric. This chart shows the median score for each company across the number of years which they have provided data to public market investors. All of these companies are worth several hundred million to many billions of dollars. Yet, their median growth-profitability metric varies enormously from greater than 100% in the case of MobileIron (NASDAQ:MOBL) to 27% for Hubspot (NYSE:HUBS) and 20% for Netsuite (NYSE:N).

I also examined whether the growth-profitability metric was correlated to enterprise-value-to-trailing-revenue multiples. In other words, do higher GP ratios imply more valuable businesses? The R^2 or correlation coefficient is 0.04, meaning they are uncorrelated. For example, MobileIron, which is at the top of the median GP metric scale, trades at 4.6x trailing-twelve months while Hubspot in the bottom third of the GP metric trades at 8.3x trailing revenues. I suspect market attractiveness, gross margin, customer retention, competitive dynamics, management team and many other factors play a bigger role in determining a SaaS company’s multiple.

The GP ratio may be a solid first pass filter for a growth equity investor to determine whether a business might be a good investment. And the spirit of the Rule of 40% is a good one. It’s trying to create a relationship between growth rate and burn rate of a business and offer a floor to create a healthy business. Businesses that grow faster while burning little money are more efficient and should be more valuable

But the Rule of 40 isn’t a necessarily the best metric by which to benchmark an early SaaS startups’ performance. In the end, the unit economics (average revenue per customer, cost of customer acquisition, churn rates, contribution margin) drive the business’s top line and bottom line. Early stage founders should focus on those numbers when building their companies and the Rule of 40% will take care of itself.

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