Rule of 40 Index by Volition Capital (2024)

FAQs

Rule of 40 Index by Volition Capital? ›

The Rule of 40 is a popular “back of the envelope” calculation used to assess the value of public SaaS companies based on the trade-off between growth and profitability. Companies will meet the Rule of 40 if year-over-year revenue growth rate plus profitability margin equals 40%.

The Rule of 40 states that if an SaaS company's revenue growth rate is added to its profit margin, the combined value should exceed 40%. In recent years, the 40% rule has gained widespread adoption as a popularized measure of growth by SaaS investors.

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.

Enter the Rule of 40….

The rule states that a company's growth rate plus its profit margin should equal at least 40%. For instance, if a company is growing at 30% annually, it should also have a profit margin of at least 10% to meet the Rule of 40 threshold.

In recent years, the Rule of 40 has been a standard benchmark used to define a healthy SaaS company. This rule states that the sum of a company's percent ARR (Annual Recurring Revenue) growth and its margins (free cash flow) should be greater than or equal to 40 percentage points.

The Rule of 40 is a popular “back of the envelope” calculation used to assess the value of public SaaS companies based on the trade-off between growth and profitability. Companies will meet the Rule of 40 if year-over-year revenue growth rate plus profitability margin equals 40%.

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.

The Rule of 40 is a simple and widely used metric in the SaaS industry to assess a company's performance. The Rule states that the sum of a SaaS company's annual revenue growth rate and profit margin should equal or exceed 40%.

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.

The Rule of 40 helps SaaS companies balance growth and profitability. It states that the sum of a SaaS company's revenue growth and profit margin should be equal to or greater than 40%, which is the threshold at which the company is considered financially healthy, sustainable, and attractive to investors.

Is rule of 40 only for SaaS companies? ›

It should be noted that the Rule of 40 only applies to SaaS businesses. This is because software companies that leverage their services to other businesses are known to manage higher margins between 70% and 90%. However, this rule of thumb can still be applied as a useful benchmark for other subscription companies.

The Rule of 40 measures a company's growth rate against its profitability, providing a clear benchmark for assessing business performance. Strategies for improving your Rule of 40 score include focusing on revenue growth, optimizing your cost structure, and prioritizing customer success and retention.

This rule states that a SaaS company is healthy if the sum of its revenue growth and profitability margin (EBITDA, EBIT, or free cash flow) is higher than 40%.

In its first-quarter earnings report Wednesday, Meta disclosed that its Reality Labs unit recorded a $3.85 billion operating loss. Revenue in the metaverse division was $440 million, up about 30% from $339 million a year ago and representing only around 1% of Meta's total sales for the quarter.

The rule stipulates that the sum of a company's revenue growth rate and its EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) margin should be equal to or exceed 40%. This equilibrium is seen as a sign of a healthy and sustainable business.

JPMorgan analyst Tien-Tsin Huang said Block could set its Rule of 40 targets to come in earlier than expected. The rule of 40 references sustainable profits with revenue growth and profit margins over the 40% level when combined. The analyst has an Overweight rating and $90 price target.

Organic revenue growth figure for full Hg portfolio. The Rule of 40 is a principle that states a software company's combined organic revenue growth rate and profit margin should equal or exceed 40%. Past performance is not a reliable indicator of future results.

VCs often use the shorthand phrase “two and twenty” to refer to the 2% of annual management fees a venture fund might take and the 20% carried interest (or “performance fee”) it would charge.