The world of SaaS (Software as a Service) is a rapidly expanding and highly competitive industry, with new companies popping up every day. As a result, valuing these businesses can be a complex and challenging task. One metric that has gained popularity in recent years is the “Rule of 40,” a benchmark for a company’s “investability” in the eyes of venture capitalists and private equity investors. In this article, we will explore the history of the Rule of 40, how it is used in SaaS valuations, and its specifics.
What is the Rule of 40?
The Rule of 40 is an investment guideline that was proposed nearly ten years ago by a private equity investor to venture capitalist Brad Feld. The rule states that a SaaS company’s growth rate plus profitability rate should be at least 40. In other words, a company’s annual revenue growth rate and EBITDA margin (or net income margin for some investors) should add up to at least 40%. For example, if a company has a 30% growth rate, it should have a 10% EBITDA margin, or if it has a 20% growth rate, it should have a 20% EBITDA margin. The Rule of 40 suggests that if a SaaS company meets or exceeds this benchmark, it is considered investable.
History of the Rule of 40
The Rule of 40 was initially proposed in the early 2010s as a response to the rapid expansion of the SaaS industry. At that time, many investors were concerned that the high valuations of SaaS companies were not justified, and they were looking for a way to assess a company’s potential for long-term success. The Rule of 40 was seen as a useful tool for determining which companies were worth investing in and which were not.
Over time, the Rule of 40 has become widely accepted in the SaaS industry as a benchmark for evaluating a company’s performance. However, as the market has evolved, some investors have suggested that the Rule of 40 is no longer sufficient and that a new benchmark, the Rule of 50, may be more appropriate. This updated benchmark requires companies to have a growth rate plus profitability rate of at least 50, reflecting concerns about companies’ profitability and runway.
Using the Rule of 40 in SaaS Valuations
The Rule of 40 is one of several metrics that investors use to assess a SaaS company’s potential for success. Investors typically consider a range of factors, including market size, competition, team, product, growth potential, and financial metrics. However, the Rule of 40 has become a useful shorthand for investors to quickly assess a company’s performance and determine whether it is worth pursuing further.
In practice, investors will often use the Rule of 40 as a starting point for valuing a SaaS company. They may look at a company’s revenue growth rate, profitability margin, and other financial metrics to determine whether it meets the Rule of 40 benchmark. If a company falls short of the Rule of 40, investors may consider it less investable, although other factors may come into play.
SaaS Valuation Multiples and the Rule of 40
Valuation multiples are a key metric used to assess the value of SaaS companies. The SaaS Capital Index (SCI), a curated index of public B2B SaaS companies, provides a useful benchmark for tracking valuation multiples over time. According to the SCI data, the median valuation multiple for SaaS companies increased slightly to 7.2x current run-rate ARR (Annual Recurring Revenue) as of February 2023, up from 6.2x in November 2022. However, this is still significantly lower than the high of 16.9x in August 2021. The standard deviation of company multiples has also decreased to 3.61, last seen in mid-2018, indicating that the market has become less volatile.
Despite the recent cooling of the market, the SCI data shows that SaaS companies are still burning cash, with the median and mean GP (growth + profitability) ratio for the SCI companies only at 8%. Additionally, 25 companies in the index have a negative GP ratio, although most of these are the more recently IPO’ed companies. Relatively few companies in the SCI currently meet the Rule of 40 benchmark.
It is worth noting that while the Rule of 40 is a useful tool for assessing a SaaS company’s performance, it is not a definitive measure of success. Other factors, such as market size, competition, and team, may also play a significant role in determining a company’s potential for success. Additionally, the Rule of 40 is not a one-size-fits-all benchmark, and investors may adjust the threshold depending on a company’s specific circumstances.
In conclusion, the Rule of 40 has become a popular benchmark for evaluating a SaaS company’s performance and potential for success. It is a useful starting point for investors to quickly assess a company’s growth and profitability, although other factors may come into play. The recent SCI data shows that while the market has cooled, SaaS companies are still burning cash, and relatively few companies currently meet the Rule of 40 benchmark. As the industry continues to evolve, investors may need to adjust their valuation metrics to reflect changing market conditions and investor preferences.