‘The Rule of 40’ is an old maxim that sounds convenient and is easy tounderstand, but it’s a dangerous oversimplification of value. In summary, Rule of 40 says the profit marginand revenue growth of SaaS company summed together needs to be at least 40% inorder to attract a strong revenue multiple. By way of example, a SaaS company with 20% growth and 20% profit marginachieves the Rule of 40 (20+20 = 40). However,having 0% profit margin but 40% YOY growth is cheating; the Rule of 40 says buyerswant a blend of profitability and growth. Here's why the Rule of 40 is wrong:
Itassumes all buyers want the same thing. A smallprivate equity group that doesn’t have significant capital for growth probably caresabout profitability a lot. A largestrategic like Salesforce does not. They’renot the same buyer, they don’t pay the same multiple, so the Rule of 40 iswrong when evaluating the attractiveness of your company to large strategics orlarge private equity that weight growth versus profitability far differently.
Itundervalues size and compounding. Supposea business has $10mm of ARR today, has a 20% margin, and 20% YOY growth. In 10 years, that business will have $62mm inARR. That’s great, but let’s supposeinstead they had a 0% margin and 40% YOY growth. The power of compounding means in 10 years,that 40% growth would result in a business with $289mm of ARR. Which one do you think is more attractive toa big strategic and commands a higher multiple? The latter. The power of compounding and size is grosslyundervalued by Rule of 40.
Bigbuyers aren’t as sensitive to burn. Let’ssuppose you’re a $100mm ARR business with 30% YOY growth burning $50mm ayear. Rule of 40 says its far lessvaluable because of that burn. However, strategicsand big private equity are very adept at getting burn down over time. Part of their plan is to realize synergies. So, if a strategic pays 10x ARR which is$1bln, but can get burn down by $10mm a year, that means they need another$150mm to get to profitability over 5 years, on top of their $1bln purchaseprice. That’s only 15% of the purchaseprice. It’s not nothing, but it’s alsonot nearly as impactful as the Rule of 40 implies.
The Rule of 40 is an interesting concept, but it could quickly fall apartdepending on the ideal buyer and what that buyer really cares about.
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