The “Rule of 40” for software companies: Are growth and profitability in conflict?

Why is this topic relevant to me as a software entrepreneur?

Due to the critical importance of acquiring and retaining new customers, software companies often have to accept temporarily lower profitability and margins in order to achieve high growth rates.

It is not uncommon for young, rapidly growing companies to become unprofitable or even loss-making due to high marketing and sales costs for customer acquisition. On the other hand, it may happen that a company already holds significant market share and therefore grows only slightly, while being highly profitable due to economies of scale from its already large customer base.

  • How do corporate buyers assess this conflict?
  • Do buyers place greater emphasis on one of the two aspects than the other?
  • Is my company better positioned for a sale in one of the two phases?

To answer these questions, in this article we examine the so-called “Rule of 40,” which has established itself primarily in the software industry as a key financial metric to ensure comparability between companies.

What do I need to know about it?

The Rule of 40 states that a (software) company is particularly attractive from a buyer’s perspective and is growing sustainably if the sum of its revenue growth and its (EBITDA) margin exceeds 40%.

  • For example, a company with a negative margin of -10% but growth rates of more than 50% could meet this rule,
  • just as a company with a margin and revenue growth of 20% each could.

Despite its widespread acceptance, various limitations and implications should be considered in the practical application of this metric:

  • Applicability in the SaaS Context: While the interplay between growth and profitability generally applies to most companies, the level of the threshold reveals why the rule is primarily used for software or SaaS models.
    • Growth: SaaS models were, and continue to be, increasingly targeted by early-stage investors. Since only a fraction of such investments are actually successful, significant growth rates are expected in the industry to offset losses from other investments and achieve the respective return targets.
    • Profitability: As already discussed in our previous article, SaaS companies generate their profits over a longer period of time. Companies typically incur high costs in customer acquisition, which are usually only amortized over a longer period due to lower long-term customer payments. Manufacturing companies, on the other hand, usually already achieve a positive margin at the time of sale, which covers their costs. For this reason, investors, more than in other industries, overlook significant losses as long as they counteract the resulting growth.
  • Applying the Right Margin: In practice, the use of the EBITDA margin to calculate the Rule of 40 has become widely established. However, growth companies in particular often incur costs that are not or only partially included in EBITDA. Depending on the extent to which product development is performed internally or externally and the extent to which such costs are capitalized on the balance sheet, the EBITDA and EBIT of two otherwise identical companies can differ significantly, impairing comparability. Therefore, the cash flow margin is often used.
  • Hard Limit 40%: Finally, like any “rule of thumb,” the 40% limit should not be viewed as a hard limit, but rather as a guideline. Typically, a sustainable value of over 30% is valued higher than a one-time excess of 45%. Furthermore, there is a “fluid” positive correlation, meaning that each additional percentage point within the “Rule of 40” increases the average valuation. Thus, there is no “sudden” valuation step upon exceeding the threshold, although classification as a “Rule of 40” company does send a positive signal to buyers.

How can I use this information to my advantage?

Despite its practical limitations, sellers should be aware of the application of the “Rule of 40” and its relevance from the buyer’s perspective as a value-driving factor. Therefore, the following aspects should be considered in particular when preparing for a sale:

  • A low or even negative value for one of the two metrics (growth or margin) should not deter a company sale. It all depends on how high both metrics add up.
  • Depending on the market situation, the individual metrics of the “Rule of 40” are weighted differently. In our view, buyers, especially financial investors, currently place greater emphasis on profitability than sales growth due to the more challenging financing environment and economic unrest. In the current market environment, sellers should therefore consider ways to focus on margin stabilization rather than revenue growth.
  • In most cases, the objective should be to achieve sustainably high value from growth and profit margin, rather than exceeding value once at the expense of other processes or priorities.

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