Rule of 40

The Rule of 40 is a key metric that assists in evaluating the balance between growth and profitability in later-stage tech companies. This metric has become vital for investors and analysts examining Ecommerce, Software and Digital Services businesses.

Brad Feld popularised this principle, but it has broader implications across various tech sectors. For tech startups and early-stage companies looking to secure venture capital and needing valuation reports, growth expectations are typically higher. As a tech company scales, the Rule of 40 becomes an important aspect to consider.

Here's how it works:

Calculating Rule of 40:

  • Growth Rate %: The percentage increase in revenue compared to a previous period.
  • Profitability Margin %: The percentage of profit margin compared to a previous period.

The sum of these two components should ideally equal or exceed 40%:

  • Growing at 20% means generating a profit of 20%.
  • Growing at 40% can mean generating a 0% profit.
  • Growing at 50% might imply a loss of 10%, and so on.

Some key considerations:

  • Calculating Revenue: This can be straightforward by comparing the current month, quarter, or year against the previous period (e.g. Annual Recurring Revenue or Monthly Recurring Revenue).
  • Calculating Profit: This can be more complex and lacks a uniform approach. EBITDA tends to be used for simplicity. However, some may use everything from EBIT to Net Income and Free Cash Flow. The relevant calculation will depend on the industry, the company’s maturity and the investor or buyer preferences in the situation.

Implications for successful later-stage companies:

  • Sustaining the Rule of 40: Successful later-stage tech companies often sustain the Rule of 40 over a lengthy duration (e.g., many years), indicative of a balanced approach to growth and profitability.
  • Exceeding the Rule of 40: Some may even grow at a rate referred to as 'a multiple of the Rule of 40', such as 60% growth YoY and 20% profit margin, representing a “2x” for Rule of 40. This signifies accelerated performance.
  • Investor and buyer rewards: Investors and buyers often reward later-stage companies that align with or surpass the Rule of 40 with higher valuations. This is particularly true if the growth rate significantly exceeds the profitability margin (e.g., 30% growth and 10% profit might yield a higher multiple than 10% growth and 30% profit). Such alignment can be a critical factor in valuation reports and acquisition considerations

The Rule of 40 is more than just a metric; it's a philosophy that aligns sustainable growth with profitability, helping later stage companies navigate towards being truly successful.

Aligning with or exceeding the Rule of 40 can indeed lead to higher valuations for later-stage tech companies. But how do you determine what's considered high or low without understanding the market, its multiples, and comparable data from similar companies? At Clear Value we help founders of tech companies use comparable reports with structured market data to make better decisions around valuation well ahead of any investment or liquidity event. Find out how we can help here.

 

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