The Rule of 40% For a Healthy SaaS Company

There are lots of blogs and anecdotes on (a) how to build a successful SaaS company and (b) what a successful SaaS company looks like. Yesterday’s post by Neeraj Agrawal from Battery Ventures titled The SaaS Adventure is another great one as he describes his (and presumably Battery’s) T2D3 approach.

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I was at a board meeting recently and heard something I’ve not heard before from a late stage investor. He described what his firm called the 40% rule for a healthy software company, including business SaaS companies. These are for SaaS companies at scale – assume at least $50 million in revenue – but my Illusion of Product/Market Fit for SaaS Companies correlates nicely with it once you hit about $1m of MRR.

The 40% rule is that your growth rate + your profit should add up to 40%. So, if you are growing at 20%, you should be generating a profit of 20%. If you are growing at 40%, you should be generating a 0% profit. If you are growing at 50%, you can lose 10%. If you are doing better than the 40% rule, that’s awesome.

Now, growth rate is easy in a SaaS-based business. Just do year-over-year growth rate of monthly MRR. You can do total revenue, but make sure you do MRR also to make sure you don’t have weird things going on in your GAAP accounting, especially if you have one time services revenue in the mix. It’s always worth backtesting this with YoY growth of gross margin just to make sure your COGS are scaling appropriately with your revenue growth, regardless of whether you are on AWS, another cloud provider, or running bare metal in data centers.

Profit is harder to define. Are we talking about EBITDA, Operating Income, Net Income, Free Cash Flow, Cash Flow or something else. I prefer to use EBITDA here as the baseline and then back test with the other percentages. If you are running on AWS or the cloud, this should be pretty simple and consistent. However, if you are running your own infrastructure, your EBITDA, Operating Income and Free Cash Flow will diverge from your Net Income and Cash Flow because of equipment purchases, debt to finance them, or lease expense. So you have to be precise here with which number you are using and “it’ll depend” based on how your SaaS infrastructure works.

While the punch line is that you can lose money if you are growing faster, the minimum point of happiness is 40% annual growth rate. Now, some people will focus on MRR growth rate, others ARR growth rate, and yet others on weird permutations of year of year growth rate by month. Others will focus on the same strange permutations for GAAP revenue to justify growth rate. Regardless, you need a baseline, and I’ve always found simply doing year-over-year MRR growth rate to be the easiest / cleanest, but I always make sure I know what is going on underneath this number by using the other calculations.

I often hear – from sub-scale SaaS companies, “we can get profitable right away if we slow down our growth rate.” And – that’s often a true statement, but you will end up being sub-scale for a much longer time when you end up with a 20% growth rate and a 20% profit. So – if you are going to raise VC money, get focused on the T2D3 approach to get to scale, then start focusing on the 40% rule.

  • RBC

    I first noted Mattermark when you blogged about them…clicked through to their website. So slick! I hope they can deliver on the promise, but as their VCs are paying to subscribe it seems likely.

  • Rick

    Another good post. Your posts are better when they are longer. The don’t leave as many loose ends. Remember when I said you should have a “Don’t bother me” automated email response but pick one emailer a month and put forth some real effort to help them? I think your longer posts exemplify what I was talking about.
    .
    When a person commits a bit more the return is 10x the input effort.

  • Abraham Thomas

    Great post Brad. Always interesting to see the rules of thumb / pattern recognition that experienced VCs and operators use (T2D3, 40% rule, 1-10-100 etc) being shared explicitly.

    Talking about explicit knowledge, the public knowledge base for SaaS businesses is growing at a truly amazing rate. David Skok, Tomasz Tunguz and Jason Lemkin are the gold standard but there are tons more out there.

    I wonder, do you know of any similar resources for marketplace businesses? ie tactics for creating, scaling and monetizing online marketplaces; handbook of best operating practices; benchmarks to know what’s good and what’s bad etc etc? There aren’t anywhere near as many concrete online resources for marketplaces as there are for SaaS businesses; I was hoping that since “marketplaces” is one of Foundry Group’s theme, you might know of a few good references.

    • There is a little on the web about it but not much. And most of what I’ve seen is not consistent with my own experiences. So you’ve motivated me to add this to the list to write a little about.

      • Abraham Thomas

        That would be awesome if you do — I’m looking forward to reading those posts!

  • Very good post and a useful rule of thumb. It sounds about right and a nice way of balancing growth and profit which can be a tough one for investors and founders. I wonder if some of the analytic writers on SaaS might do some numbers to see how the 40% rule plays out in the market.

  • John Stoddart

    Really interesting quick rule to apply – hadn’t thought of it in those terms before, but it makes sense.

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  • campbellmacdonald

    Super interesting, but surprising. How do you square this with comments from Jason Lemkin which suggests SaaS companies that aren’t growing 10% MoM (which is> 200% YoY) are unfundable?

    http://www.quora.com/About-what-pre-money-range-should-I-be-looking-at-for-my-three-year-old-SaaS-startup-doing-1M-ARR-1-8M-total-rev-growing-100-year-over-year

    • I think his comment isn’t terribly helpful and he undermines it with his disclaimer.

      Recognize that size matters here. If you are a $1m ARR company, investors will want to see growth at 200% or more (10% month). But if you are a $50m ARR company, monthly growth is much more likely to settle in the 5% / month range.

      “Unfundable” always begs the question of “by whom?” Some VCs have no interest if you are below 10% monthly compounded growth rate. But some will, especially if they (a) focus on the early stage (b) buy your business premise, and (c) the founders are awesome.

      Of course, there are always exceptions also.

      • campbellmacdonald

        Thanks. The scale thing makes sense and that was part of the “squaring” I was after.

  • Will Sennett

    Cool perspective – thanks for sharing

  • Brad – super insightful post. Curious, however…do you see a lot of SaaS companies at scale growing 40% YoY while operating at or near EBITDA breakeven?

    • Some, and others that are actually profitable and growing this fast or faster.

  • Rule is clear but what’s the justification of 40%? why not 50% or 60%? Can you elaborate more on why 40% was chosen?

    • It’s based on an equilibrium determined by a lot of underlying data from the firm that mentioned it to me. I know that there is at least one person doing a lot of data analysis with posts coming soon. Subscribe to Mattermark Daily (www.mattermark.com) – it’ll headline the post when it’s out.

  • mike

    This rule seems rather aggressive and i’d be curious to know how this holds up against the recent software ipo’s

    • Analysis is being done now by another VC blogger who is going to write an article on it. Subscribe to Mattermark Daily (www.mattermark.com) to track / follow when it comes out.

  • Sujit Kalidas

    Insightful perspective!

    I just ran the rule on a listed (NZX:DIL) SaaS company called Diligent Board Member Services. Diligent’s key product is Boardbooks, an electronic portal
    for company Directors. ARR is forecast to grow 29% YoY (from $72m in FY13 to $91m in FY14) and the EBITDA margin forecast is 25%. A solid 54%. Balancing ARR growth and EBITDA margin is tricky for a SaaS company. The 40% rule is a good proxy for profitable growth.

    How does Diligent rank with US based companies of similar size?

    Full year results are due early March.

  • DC

    Nice rule of thumb here. I’m guessing this is non-GAAP – any thoughts on how to factor in stock based comp? Especially given the competitive environment for talent. How much credit do you give if a company is moving cash costs over to SBC?

    • DC

      Should have specified – from the lens of a public investor

    • I don’t factor stock based compensation Into this. Since I’m not a public investor I’m not sure my recommendation in that context would have any validity.

      • Rajiv Jha

        I THINK IT IS VERY GOOD DECISION…

  • Bob

    Correlates roughly with public market data from bankers lately, but maybe off by 5-10%. 40%+ is high growth, highest multiple, can still invest and be unprofitable to some degree particularly if CAC ratio is ok. Often find the 40% growers are always 12-18 months from profitability. 30% is good growth, decent multiples, need reasonable path to profitability, CAC ratio closing in acceptable. 20% is ok, deals get done but need a near term path to profit and CAC ratio within bounds.

    Ties roughly to the CAC ratio math of Beessemer and others. If you are growing over 50% at scale, poor gas in to capture market opportunity.