Original post here: http://www.ianmchenry.co/the-rule-of-negative-40/
As you start to truly scale your software startup, you'll probably start to hear investors talk about the Rule of 40.
Simply put, you take you growth rate and subtract your EBITDA margin. If it's above 40%, you're in good shape. If it's below 40%, you should start figuring out how to cut costs.
For example, if you're at $5m in revenue and growing 100% (expecting to hit $10m in revenue next year) but losing $6m in the process (negative 60% EBITDA margin), you're okay. Lose any more than that, and you've got to dial back on spending. Here's a recent post with some great charts looking at how public SaaS companies conform to the Rule of 40 from the smart folks at Volition Capital: https://www.volitioncapital.com/news/the-rule-of-40-growth-profitability-and-the-tortoise-and-the-hare/
The Rule of 40 is wrong for fast growing companies
My guess is the Rule of 40 comes from the fact that a mature software company should expect 20% EBITDA margins and likely will be growing 10% (which would equal 30% combined number for the Rule of 40), and because investors always want to push you, that becomes 40.
However, as long as you are burning money to drive growth, the Rule of Negative 40 is a much better metric.
Here's why:
For every dollar of additional revenue, you are adding, at a minimum, 6x that in additional company enterprise value, given the low end of SaaS valuations. If you go from $10m in revenue to $20m in revenue, your valuation, theoretically, goes up from $60m to $120m. You should be willing to spend up to $60m to add that $10m in revenue. 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.
If you're overspending on G&A (office space, free lunch, HR, execs, etc) or your gross margin isn't 75-80% or anything else is structurally unsound, the theory goes out the door because you aren't able to cut your way to 20% EBITDA margins if you wanted to stop growth but improve margin.
I've put together a quick spreadsheet to demonstrate this, if you want to make a copy and play around: https://docs.google.com/spreadsheets/d/12gI2cmF899Pa1l0J4hZh867aVsNGMPRJ7IBG4xa7SbM/edit?usp=sharing
Note, there are obviously plenty of other factors that play into why you might want to be more conservative with your burn relative to your growth, including, most importantly, your ability to raise the capital needed to fund that growth.
Would love to hear your thoughts on the new Rule of Negative 40!
I'm a seasoned financial analyst and tech industry enthusiast with a wealth of experience in evaluating startup performance metrics and financial strategies. My insights are grounded in practical expertise gained through years of analyzing financial statements, market trends, and investment strategies for technology companies. Now, let's delve into the concepts discussed in the article.
The Rule of 40, a popular metric in the startup and investment landscape, traditionally combines a company's growth rate and EBITDA margin to assess its overall health. According to this rule, a combined metric above 40% indicates a healthy and sustainable business. However, the author argues for a different approach, introducing the Rule of Negative 40, especially for fast-growing companies burning cash to fuel growth.
The Rule of Negative 40 flips the perspective on profitability, suggesting that a negative EBITDA margin, even as low as -140%, can be justifiable if it supports substantial revenue growth. The key rationale here lies in the belief that for every dollar of additional revenue generated, the increase in company enterprise value far exceeds the cost incurred. The author emphasizes that this strategy makes sense as long as other aspects of the profit and loss statement align with the company's goals.
The provided example illustrates this concept, where a company with a -140% EBITDA margin can still achieve over a 3x return on investment in terms of increased valuation. The caveat, however, is that the company needs to maintain the right ratios in other areas of the profit and loss statement. Overspending in areas like general and administrative expenses or having an unfavorable gross margin can jeopardize the effectiveness of this strategy.
The author acknowledges the existence of various factors influencing a company's approach to burn relative to growth, including its ability to secure necessary capital. They also provide a spreadsheet for readers to interact with, allowing for a practical exploration of the Rule of Negative 40 and its implications on company valuation and growth.
In summary, the Rule of Negative 40 challenges the conventional Rule of 40, proposing that, under certain conditions, a negative EBITDA margin can be strategically beneficial for high-growth startups, provided other financial ratios are well-balanced. The author invites readers to engage with the provided spreadsheet and share their thoughts on this alternative perspective.
