Category Archives: Rule of 40

The Rule of 40 — Down, But Not Out!

Neeraj Agrawal and Logan Bartlett of Battery Ventures recently published the 2019 version of its outstanding annual software round-up report.  I highly recommend this report — it’s 78-pages chock full of great data about topics like:

  • Why Battery is long software overall
  • The four eras of software evolution
  • The five forces driving software’s accelerating growth
  • Key trends in 2018, including setting records in three areas:  (1) public company revenue multiples, (2) IPO volume (by over 2x), and (3) M&A volume (by over 2x).
  • Key trends from their 2017 report that are still alive, well, and driving software businesses.

But, most of all, it has some great charts on the Rule of 40 [1] that I want to present and discuss here.  Before doing that, I must note that I drank today’s morning coffee reading Alex Clayton’s CloudStrike IPO breakdown, a great post about a cloud security company with absolutely stunning growth at scale — 121% growth to $312M in Ending ARR in FY19.  And, despite my headline, well in compliance with the Rule of 40.  110% revenue growth + -26% free cashflow margin = 84%, one of the highest Rule of 40 scores that I’ve ever seen [2].  Keep an eye on this company, I expect it should have a strong IPO [3].

However, finding one superstar neither proves nor disproves the rule.  Let’s turn to the Battery data to do that.

When discussing the Rule of 40, most financial analysts make one of two plots.

  • They do a scatter plot with revenue growth on the X-axis and FCF margin on the Y-axis.  The Rule of 40 then becomes a line that separates the chart into two zones (compliant and non-compliant).  Note that a minority of public companies actually comply suggesting the rule of 40 is a pretty high bar [4].
  • Or, more interestingly, they do a linear regression of Rule of 40 score vs. enterprise-value/revenue (EV) multiple.  This puts focus on the question:  what’s the relationship between Rule of 40 score and company value? [5]

But that thing has always bugged me is that nobody does the linear regression against both the Rule of 40 score and revenue growth.  Nobody, until Battery.  Here’s what it shows.

First, let’s look at the classic Rule of 40 regression.  Recall that R-squared is a statistical measure that explains the dependence of the dependent variable (in this case, EV multiple) on the independent variable (Rule of 40 score).  Here you can see that about 58% of the variation in enterprise value multiple is explained by Rule of 40 score.  You can intuit that by looking at the dots relative to the line — while there is clearly some linear correlation between the data, it’s a long way from perfect (i.e., lots of dots are pretty far from the line).  [6]

rule of 40-4

Now, the fun part.  Let’s see the same regression against revenue growth alone.  R-squared here is 51%.  So the explanatory power of the Rule of 40 is only 7% higher than revenue growth alone.  Probably still worth looking at, but it sure gets a lot of PR for explaining only an incremental 7%.  It could be worse, I suppose.  Rule of 40 could have a lower R-squared than revenue growth alone — in fact, it did back in 2008 and in 2012.

rule of 40-3

In the vein, for some real fun let’s look at how this relationship has changed over time.  The first thing you’ll notice is that pre-2012 both last twelve month (LTM) revenue growth and the Rule of 40 had far weaker explanatory power, I suspect because profitability played a more important role in the equation.  In 2012, the explanatory power of both metrics doubled.  In 2015 and 2016 the Rule of 40 explained nearly 20% more than revenue growth alone.  In 2017 and 2018, however, that’s dropped to 7 to 8%.

rule of 40-2

I still think the Rule of 40 is a nice way to think about balancing growth vs. profit and Rule of 40 compliant companies still command a disproportionate share of market value.  But remember, its explanatory power has dropped in recent years and, if you’re running an early or mid-stage startup, there is very little comparative data available on the Rule of 40 scores of today’s giants when they were at early- or mid-stage scale.  That’s why I think early- and mid-stage startups need to think about the Rule of 40 in terms of glideslope planning.

Thanks to the folks at Battery for producing and sharing this great report. [7]

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Notes
[1] Rule of 40 score = typically calculated as revenue growth + free cashflow (FCF) margin.  When FCF margin is not available, I typically use operating margin.   Using GAAP operating margin here would result in 110% + -55% = 55%, much lower, but still in rule of 40 compliance.

[2] If calculated using subscription revenue growth, it’s 137% + -26% = 111%, even more amazing.  One thing I don’t like about the fluidity of Rule of 40 calculations, as you can see here, is that depending what might seem small nuances in calculations, you can produce a very broad range of scores.   Here, from 55% to 137%.

[3] To me, this means ending day 1 with a strong valuation.  The degree to which that is up or down from the opening price is really about how the bankers priced the offer.  I am not a financial analyst and do not make buy or sell recommendations.  See my disclaimers, here.

[4] In fact, it’s actually a double bar — first you need to have been successful enough to go public, and second you need to clear the Rule of 40.  Despite a minority of public companies actually clearing this bar, financial analysts are quick to point out the minority who do command a disproportionate share of market cap.

[5] And via the resultant R-squared score, to what extent does the Rule of 40 score explain (or drive) the EV/R multiple?

[6] If R-squared were 1.0 all the dots would fall on the least-squares fit line.

[7] Which continues with further analysis, breaking the Rule of 40 into 4 zones.

Rule of 40 Glideslope Planning

Enterprise SaaS companies need a lot of money to grow. The median company spends $1.32 to acquire $1.00 in annual recurring revenue (ARR) [1].  They need to make that investment for 14 years before getting to an IPO.  It all adds up to a median of $300M in capital raised prior to an IPO.

With such vast amounts of money in play, some say “it’s a growth at all costs” game.  But others hold to the Rule of 40 which attempts to balance growth and profitability with a simple rule:  grow as fast as you want as long as your revenue growth rate + your free cashflow margin >= 40%.

The Rule of 40 gets a lot of attention, but I think that companies are not asking the right question about it.  The right question is not “when should my growing startup be Rule of 40 compliant?” [2]

For more than half of all public SaaS companies, the answer to that question, by the way, is “not yet.”  Per multiple studies I’ve read the median Rule of 40 score for public SaaS companies is ~31%, meaning that more than half of public SaaS companies are not Rule of 40 compliant [3].

So, unless you’re an absolutely amazing company like Elastic (which had a Rule of 40 score of 87% at its IPO), you probably shouldn’t be unrealistically planning to become Rule of 40 compliant three years before your IPO [4].  If you do, especially if you’re well funded and don’t need additional expense constraints, you might well compromise growth with a premature focus on the Rule of 40, which could shoot off your corporate foot in terms of your eventual valuation.

If “when should we be Rule of 40 compliant” is the wrong question, then what’s the right one?

What should my company’s Rule of 40 glideslope be?

That is, over the next several years what is your eventual Rule of 40 score target and how do you want to evolve to it?  The big advantage of this question is that the answer isn’t “a year” and it doesn’t assume Rule of 40 compliance.  But it does get you to start thinking about and tracking your Rule of 40 score.

I built a little model to help do some what-if analysis around this question.  You can download it here.

r40-1

In our example, we’ve got a 5 year-old, $30M ARR SaaS company planning the next five years of its evolution, hopefully with an IPO in year 8 or 9.  The driver cells (orange) define how fast you want to grow and what you want your Rule of 40 glideslope to be.  Everything else is calculated.  At the bottom we have an overall efficiency analysis:  in each year how much more are we spending than the previous year, how much more revenue do we expect to get, and what’s the ratio between the two (i.e., which works like kind of an incremental revenue CAC).  As we improve the Rule of 40 score you can see that we need to improve efficiency by spending less for each incremental dollar of revenue.  You can use this as a sanity check on your results as we’ll see in a minute.

Let me demonstrate why I predict that 9 out 10 ten CFOs will love this modeling approach.  Let’s look at every CFO’s nightmare scenario.  Think:  “we can’t really control revenues but we can control expenses so my wake up in the middle of the night sweating outcome is that we build expenses per the plan and miss the revenues.”

r40-2

In the above (CFO nightmare) scenario, we hold expenses constant with the original plan and come in considerably lighter on revenue.  The drives us miles off our desired Rule of 40 glideslope (see red cells).  We end up needing to fund $42.4M more in operating losses than the original plan, all to generate a company that’s $30.5M smaller in revenue and generating much larger losses.  It’s no wonder why CFOs worry about this.  They should.

What would the CFO really like?  A Rule-of-40-driven autopilot.

As in, let’s agree to a Rule of 40 glideslope and then if revenues come up short, we have all pre-agreed to adjust expenses to fall in line with the new, reduced revenues and the desired Rule of 40 score.

r40-3

That’s what the third block shows above.  We hold to the reduced revenues of the middle scenario but reduce expenses to hold to the planned Rule of 40 glideslope.  Here’s the bad news:  in this scenario (and probably most real-life ones resembling it) you can’t actually do it — the required revenue-gathering efficiency more than doubles (see red cells).  You were spending $1.38 to get an incremental $1 of revenue and, to hold to the glideslope, you need to instantly jump to spending only $0.49.  That’s not going to happen.  While it’s probably impossible to hold to the original {-10%, 0%, 5%} glideslope, if you at least try (and, e.g., don’t build expenses fully to plan when other indicators don’t support it), then you will certainly do a lot better than the {-10%, -32%, -42%} glideslope in the second scenario.

In this post, we’ve talked about the Rule of 40 and why startups should think about it as a glideslope rather than a short- or mid-term destination.  We’ve provided you with a downloadable model where you can play with your Rule of 40 glideslope.  And we’ve shown why CFOs will inherently be drawn to the Rule of 40 as a long-term planning constraint, because in many ways it will help your company act like a self-righting ship.

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Notes

[1] The 75th percentile spends $1.92.  And 25% spend more than that.  Per KeyBanc.

[2] Rule of 40 compliant means a company has an rule of 40 score >= 40%.  See next note.

[3] Rule of 40 score is generally defined as revenue growth rate + free cashflow (FCF) margin.  Sometimes operating margin or EBITDA margin is used instead because FCF margin can be somewhat harder to find.

[4] I’m trying to find data a good data set of Rule of 40 scores at IPO time but thus far haven’t found one.  Anecdotally, I can say that lots of successful high-growth SaaS IPOs (e.g., MongoDB, Anaplan, and Blackline) were not Rule of 40 compliant at IPO time — nor were they well after, e.g., as of Oct 2018 per JMP’s quarterly software review.  It seems that if growth is sufficiently there, that the profitability constraint can be somewhat deferred in the mind of the market.