5 reasons I hate the Rule of 40
This article was originally published on SaaSNordics.com
So, if you’ve been fundraising lately, or just talking to investors in general, you’ll very likely have heard it’s a different world out there. Gone are the days of growth at all costs that were in vogue only 9-12 months ago and capital-efficient growth is the flavor of the day.
It seems the pendulum has swung 180 degrees and these days everyone, even traditional VC investors, have transformed into value investors. And while I’ll definitely argue it’s good we’ve gotten rid of some of the exuberance and indiscriminate spending that went on for the last few years, and that it’s fundamentally sound to grow companies in a sustainable and capital-efficient way, I’m really troubled by how a lot of investors are indiscriminately applying capital efficiency metrics when they review a venture-stage SaaS company for a possible investment. Ultimately, this creates a risk of entrepreneurs and companies optimizing for the wrong thing at the wrong time and therefore not building for long-term value maximization. And when it comes to capital efficiency metrics, no metric is more troubling than the widely popular Rule of 40 (R40).
In its most commonly used form, R40 says that a company’s %-age revenue growth rate plus its %-age profitability margin (usually at EBITDA-level) should be equal to, or ideally greater than, 40. So if a company grows 30% and can do so with a 10% profit margin then its R40 = 40 (30+10). Same thing if the company only grows 10%, but has a profit margin of 30%, or grows 20% with a 20% profit margin, R40 still = 40. While not necessarily completely useless, I would strongly argue that R40 is a metric applicable to the world of PE and public markets investing and is not a good metric for assessing the quality of venture-stage companies. Below are my top five reasons why:
1. It’s not aligned with long-term value creation
It is widely accepted among SaaS practitioners – be they operators, advisors or investors – that the king of SaaS metrics is LTV/CAC. That’s a metric that’s not entirely unproblematic in itself and which should not be used without consideration and discrimination, but that’s a topic for another time. For now, let’s just consider a company growing 40% annually at EBITDA breakeven, i.e., R40 = 40. If this company has an LTV/CAC of 3-4x, would you increase the CAC to grow ARR faster? Most people in SaaS would say yes since you know that you are making a 3-4x return on investment in doing so, but what if the first-year revenue increase doesn’t compensate for the additional CAC so that your R40 drops below 40? What if the LTV/CAC was 6x, or even 9x, but the R40 was even more badly hurt? You get the point…
The LTV / CAC ratio is considered the king of SaaS metrics because it looks at the total value generated (hence lifetime value) in relation to the required investment, regardless of what an accounting P&L or cash flow statement says. R40 completely misses this point and resorts to a snapshot in time that says next to nothing about long-term value creation. A company with otherwise terrible SaaS metrics related to churn and LTV can show a strong R40 (at least for a while), whereas a company with great SaaS metrics related to long-term value creation can display a poor R40. I know which company I would rather invest in …
2. It’s arbitrary
Why is it 40% and not 50%? Or 30% or pick your number…. The best possible explanation I’ve heard is that it was invented by PE folks investing in mature, slower growing, and cash flow generating companies growing at 20% with 20% EBITDA margins = RULE OF 40.
3. It’s applied indiscriminately
Coming back to the point above, the R40 metric was not meant to be applied to small, fast-growing companies that are investing heavily in product and go-to-market foundations. It’s simply not applicable until you’ve hit real scale – i.e., several 10s of $m ARR if not 100s $m. Despite this people frequently apply it indiscriminately to companies that are way too young and small and are still making foundational investments in product and go-to-market. Just think about the extreme – how much operating cost could a zero-revenue company carry per the R40?
You can argue where the zone of relevance kicks in, but I’d say you need an ARR of $50m or more before the R40 is relevant, at least if you’re building a great product with a large market opportunity and you have the ambition to go after it.
4. It’s lazy and (most of the time) wrong
The rule of 40 tries to estimate capital efficiency, but is usually used with the EBITDA-margin drawn from the P&L. However, EBITDA is rarely equal to operating cash flow because of prepayments and other items impacting cash vs cost. If you’re getting paid in advance for 12-month contracts that will have a massive positive impact on your working capital and therefore capital efficiency, but in its common form, the rule of 40 doesn’t account for that. The polar opposite is a company that supplies a lot of its service before actually getting paid for it (as could be the case with long implementation projects for example) but will still accrue that revenue in the P&L and therefore overstate its true capital efficiency. Using operating cash flow instead of EBITDA as the input solves part of the problem, but you’ll still miss the capitalization of development costs which will be treated as an investment and often is a significant item for fast-growing SaaS companies. Again, this imperfection would lead to overstating your R 40. If you actually make the effort to calculate R40 from operating cash flow and then make the necessary cost vs cash-related adjustments you will get a relevant metric for capital efficiency, but who does that, or let alone knows how to do that correctly?
5. It’s a distraction that leads to mediocrity
More than anything, the R40 steers focus away from building great products and the proper go-to-market foundations. Prior to achieving real scale, i.e at least several $10m of ARR, investments in product and GTM foundations will kill the R 40 metric which means that companies with fabulous opportunities optimizing for the R40 will only produce mediocre long-term results.
Phew, rant over….
So, does this mean that R40 is never a good metric to use? No, as I’ve tried to illustrate, it’s mainly off for small and fast-growing companies making early and foundational investments in product and GTM. For mature companies, it can absolutely provide some insight and be a good complement to other SaaS metrics. But used indiscriminately and without other metrics focused on value creation, it will lead you astray.
But again, what if investors are telling you that capital efficiency is really important in this current market, what should you be focused on if it’s not R40? First and foremost, even if capital efficiency is now high on the agenda, don’t forget about long-term value creation, i.e. LTV/CAC and its precursors – net revenue retention, growing ACV and strong gross margins. If you want to complement that with a capital efficiency metric then CAC-payback goes a long way to understanding go-to-market efficiency. Somewhere between 9-18 months CAC-payback is a decent rule of thumb to target, with the faster payback for lower ACV / lower LTV products and vice versa for the longer payback periods. If you want a more holistic metric addressing the efficiency of your entire operations, the net cash burn / net new ARR / (a.k.a. the burn multiple ) is my personal favorite and a decent target is a burn multiple between 1x-2x, the lower the better.
In summary: the days of growth-at-all-costs are long gone and growing your SaaS company in a capital-efficient manner is a top priority for any entrepreneur and leadership team. However, in the early stages, before you’ve reached several $10ms of ARR, don’t optimize for capital efficiency at the expense of long-term value creation and if you want to track capital efficiency use a metric(-s) that is more suitable to your stage of development.