Kent Collier on LinkedIn: The Rule of 40 is dead. Its evolved state, the Rule of 50 (ARR Growth… | 17 comments (2024)

Kent Collier

Founder & CEO at Reorg

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The Rule of 40 is dead.Its evolved state, the Rule of 50 (ARR Growth Rate + EBITDA Margins > 50), has taken hold across growth equity investing in 2023 as SAAS companies have rationalized costs and S&M spend and boosted EBITDA margins at the expense of eye popping higher growth rates.50% growth + a negative 10% EBITDA margin was great.Today, a 30% growth + a positive 20% EBITDA margin would result in nearly a doubling of the multiple and capital raising prospects of the company. IMO, the story will not stop there.A new more nuanced metric: Proprietary + Embeddedness will be next great way to value a SAAS business: 1) How proprietary is your data and content?2) How embedded is your technology, workflow into customer systems?Technology is inherently deflationary. Companies that raised hundreds of millions of dollars to build a tech stack in the last decade will be able to refactor their entire code base for a fraction of that by the use of tools like CoPilot or other GenAI solutions.Maybe not today, but soon. We are in what I like to call the "1996 of the internet." Imagine the velocity of change we saw in the late 90s.The change over the next 5 years will be POWERS higher than that.And if we agree that technology is deflationary, the the costs for new players to enter any market to compete will decrease precipitously.If that happens, price of services and solutions will inevitably in the long run approach zero. And if prices approach zero, businesses models will die. So how do we counter this? Start with proprietary. What do you have that is so unique to you that no one can copy it no matter how hard they try? Technology doesn't count. Neither do patents. Nor does your unique hard working workforce or badass culture. Then move to embeddedness. C Suite executives hate changing software systems. It sucks. How deeply are your customer tooling embedded into with your systems. What are the number of API calls you are receiving on a daily basis from your customers and is that number increasing. It doesn't need to be technology only. Moody's Credit Ratings are written into legal documents of securitizations. You have to use them no matter what. Fully embedded.Product-driven CEOs should be maniacally focused on these two metrics.Otherwise their companies will go the way of the Rule of 40...extinct.

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David Spitz

6mo

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Provocative post. I like it.... Proprietary is pretty tough in this day and age... Just about everything can be copied.... No? Still, I think you're right that if you have it, you're golden!As for pushing the Rule of 40/50 to higher profits... I still think high growth with some profits and demonstrable ability to flip easily to lower growth/higher profits... is best... If you can step on the gas effectively (meaning grow fast)... you should!.. Until you're Adobe or Salesforce, your company is valued as a multiple of revenues/ARR -- Better to move that needle when the getting is good.Just my 2¢

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Rick Rudman

Curbio CEO, USAF Vet, Old dog learning new tricks.

6mo

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Great post. Proprietary has been a strong driver of value forever. In my Series seed through B rounds 2018-2021, "what's your moat?" was a constant area of focus by investors. Proprietary is underpinned by technology and will become cheaper and tougher as a barrier to entry. Embeddedness will become the crucial differentiator. Not just in terms of tech but also in terms of sales and marketing processes.

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Prashant Gokhale

6mo

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Interesting points, thanks for sharing.. The problems are that like multiples (P/E, P/B and EV/EBITDA), the rule of 40 is a shortcut. Created to fit a narrative because the traditional multiples dont work. The premise is that cost increases will lag revenue growth eventually, leading to a hockey stick in profits. Twitter and Zoom show that, this is not necessarily true. How do you measure "Embeddedness" and "Propreitary" easily and in a manner that is comparable across companies? I am curious...I agree with your premise in general.

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Ziv Peled

4x Top 25 Customer Success Influencer 2020 - 2023 | Chief Customer Officer. People, value and relationships obsessed. I support people in their career, happy to help anyone. Feel free to contact me.

6mo

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Love it, I think it’s time to develop a parallel equation for B2B SaaS to coexist with the rules of 40/50 which will determine and drive how important your value is for your customers and how much it’s recurring over time, the positive trend of it should be the key for the rule of 40/50.

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David B.

UI/Full Stack Developer (TypeScript/JS, C#/.NET Core, Vue.js) at Projetech ☁

6mo

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Lol @ github coplit allowing massive refactorings in fraction of time. Copilot is a glorified code snippet generator at best. No doubt it saves some keystrokes but it's not as intelligent (yet) to be an actual productivity multiplier.

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Kevin Hixson, MBA, MS

Strategy & Planning Leader Focused On Value Transformation

6mo

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Great thoughts, your perspective mimics the old MBA logic! You will stay in business as long as what you are building is hard to replicate and the switching costs are too high. Makes complete sense and there are a lot of platforms that are going to reduce the impact of switching costs soon with the same rationale as code-AI adoption / platform replication. So, better get cracking on innovation ASAP, only way to stay ahead.

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Thomas Brown

Curious Contrarian with more questions than answers

6mo

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SaaS goalposts come with wheels.

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Richard Sosa

Merger Arbitrage and Event-Driven Sales at The Capitol Forum

6mo

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Thanks for sharing, Kent. Can you share a screenshot of an API clause from a legal docket?

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Irnest Kaplan, CFA

Top-rated technology equity analyst. Investor. Tech companies. Electrical Engineer. CFA Charterholder. Took that photo above in the Kruger Park in Jun '17. Lovely cheetah!

6mo

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Great points raised Kent Collier , interesting, thank you

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C. Earl Peek, CPA

Founder/Managing Partner-Diamond Ventures

6mo

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Deep.

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Kent Collier on LinkedIn: The Rule of 40 is dead.Its evolved state, the Rule of 50 (ARR Growth… | 17 comments (44)

Kent Collier on LinkedIn: The Rule of 40 is dead.Its evolved state, the Rule of 50 (ARR Growth… | 17 comments (45)

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Kent Collier on LinkedIn: The Rule of 40 is dead.

Its evolved state, the Rule of 50 (ARR Growth… | 17 comments (2024)

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Kent Collier on LinkedIn: The Rule of 40 is dead. Its evolved state, the Rule of 50 (ARR Growth… | 17 comments? ›

The Rule of 40 is dead. Its evolved state, the Rule of 50 (ARR Growth Rate + EBITDA Margins > 50), has taken hold across growth equity investing in 2023 as SAAS companies have rationalized costs and S&M spend and boosted EBITDA margins at the expense of eye popping higher growth rates.

What is the rule of 50 EBITDA? ›

Stated simply, the Rule of 50 is governed by the principle that if the percentage of annual revenue growth plus earnings before interest, taxes, depreciation and amortization (EBITDA) as a percentage of revenue are equal to 50 or greater, the company is performing at an elite level; if it falls below this metric, some ...

What is the rule of 40 growth? ›

The Rule of 40 is a principle that states a software company's combined revenue growth rate and profit margin should equal or exceed 40%. SaaS companies above 40% are generating profit at a rate that's sustainable, whereas companies below 40% may face cash flow or liquidity issues.

Is the rule of 40 dead? ›

The traditional Rule of 40 math is dead wrong. The world has over-rotated into a FCF margin mindset over a growth mindset, which is backwards for growing efficient businesses. Long-term models show that even in tight markets, growth should be valued at least ~2x-3x more than FCF margin.

What is the rule of 40 in private equity? ›

The Rule of 40 states that, at scale, the combined value of revenue growth rate and profit margin should exceed 40% for healthy SaaS companies. The Rule of 40 – popularized by Brad Feld – states that an SaaS company's revenue growth rate plus profit margin should be equal to or exceed 40%.

What does 50% EBITDA mean? ›

EBITDA Margin = EBITDA / Revenue

For example, if a company has an EBITDA of $50 million and a revenue of $100 million, its EBITDA margin is 50%. This means that for every dollar of revenue, the company has 50 cents left after paying for its operating expenses.

What is the rule of 40 with negative EBITDA? ›

With the Rule of Negative 40, you'd be willing to have a -140% EBITDA margin to support 100% growth, or in this case, burn $14m. That's still over a 3x return on the $14m investment ($60m gain in value for $14m of spend). There's one caveat: The rest of your P&L needs to be at the right ratios.

What is the 40 rule for sustainable growth? ›

It states that a company's combined growth rate and profit margin should equal or exceed 40%. In simpler terms, if you're running a SaaS startup or in charge of the marketing engine, this rule is your litmus test for balancing rapid growth with sustainable profitability.

What is the rule for growth rate? ›

There are some useful rules that describe the behavior of percentage changes and growth rates. x = yz. %Δx = %Δy + %Δz. In other words, the growth rate of a product of two variables equals the sum of the growth rates of the individual variables.

What is the growth rule? ›

So with the rule of 70, it gives us an approximation of how long it's going to take to double And all we have to do with the rule of 70. The number of years to double is 70 divided by the growth rate. So a lot of times this will be the average growth rate.

What are the benefits of the rule of 40? ›

The first and most immediate benefit of monitoring the Rule of 40 is its ability to spotlight the balance, or imbalance, between your company's growth and profitability. For a SaaS business, keeping an eye on this metric can offer insights into how to manage the company's resources more efficiently.

Who invented rule of 40? ›

The term “Rule of 40” was originally coined in 2015 by venture capitalists Brad Feld and Fred Wilson, referring to their view that venture-backed companies should strive to achieve 40% or greater when combining growth rate plus profitability margin.

What is the rule of 40 in Kellblog? ›

[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.

What is the rule of 40 example? ›

The rule of 40 formula requires just two inputs, growth and profit margin. To calculate this metric, you simply add your growth in percentage terms plus your profit margin. For example, if your revenue growth is 15% and your profit margin is 20%, your rule of 40 number is 35% (15 + 20) which is below the 40% target.

What companies are rule of 40? ›

Index Constituents
TickerCompanyEBITDA Margin
SPLKSplunk33.9%
ADBEAdobe40.9%
DOCNDigitalOcean41%
PAYCPaycom31.7%
43 more rows

How does rule of 40 affect valuation? ›

Valuation Discount: Companies with a Rule of 40 score below 40% might receive a valuation discount compared to companies that meet or exceed the benchmark. This discount reflects the perceived higher risk associated with the company's ability to achieve sustainable profitability and could result in a lower valuation.

Is 50% EBITDA margin good? ›

For example, a 50% EBITDA margin in most industries is considered exceptionally good. If your EBITDA margin is 10%, your SaaS startup's operations may not be sustainable.

What is the accounting rule of 50? ›

The 50% rule in accounting is critical. It makes sure companies recognize expenses that will benefit them for less than 50% of their useful life.

What is considered a good EBITDA ratio? ›

A good EBITDA margin is relative because it depends on the company's industry, but generally an EBITDA margin of 10% or more is considered good. Naturally, a higher margin implies lower operating expenses relative to total revenue, while a low or below-average margin indicates problems with cash flow and profitability.

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