🎙️ Hey there, SaaSpreneurs!🎙️

Welcome back to the SaaS Metrics School newsletter! We've got another insightful episode for you, and this time it's all about the Rule of 40. 📊

In today's episode, we dive into the intriguing topic of the Rule of 40 and why it's making a comeback. As a CFO, I believe financial discipline never goes out of style, and the Rule of 40 adds a crucial element to decision-making in our SaaS companies. Join me as we explore what the Rule of 40 entails, how to calculate it, and when to use it in your business.

Let's dive in! You can also listen to the episode here.

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📓Key Concepts to Learn💡

1. Understanding the Rule of 40: The Rule of 40 is a metric that evaluates the balance between profit and growth in your SaaS business. By adding your profit percentage to your growth percentage, you calculate your Rule of 40 number. Ideally, you want this number to be above 40, indicating a healthy balance between profitability and growth. 📈💰

2. Defining Profit: In private SaaS companies, the preferred metric for profit calculation is often EBITDA margin. Public companies, on the other hand, tend to use free cash flow margin. It's important to have a clear and consistent calculation of profit, whether it's through EBITDA margin or another appropriate metric. 💼💵

3. Measuring Growth: Growth can be evaluated using total revenue growth or recurring revenue growth. While there are no set definitions, focusing on recurring revenue growth is beneficial for SaaS companies as it indicates sustained and predictable revenue streams. 📈🔄

4. Time Period Considerations: For profit calculations, using the trailing three or six months provides a good proxy for your EBITDA margin. When measuring growth, it's best to compare year-over-year figures to ensure consistency and avoid cherry-picking time periods that may skew the metric. ⏰📊

5. Implementing the Rule of 40: The Rule of 40 becomes particularly relevant for companies that have achieved a certain scale, with investment firms often suggesting a threshold of $10 million ARR or higher. However, even for smaller companies, it can serve as a red flag if the metric falls below zero, indicating a lack of growth AND profitability. 🚩📉

📝 Episode Recap 🎧

In the latest episode of SaaS Metrics School, Ben delves into the resurgence of the Rule of 40. As a CFO, Ben believes that financial discipline is always in style. The Rule of 40 is a popular investor metric that helps strike a balance between profit and growth in a SaaS company. It is a key component of Ben's five-pillar metrics dashboard.

The Rule of 40 can be calculated by adding the profit percentage (measured using EBITDA margin for private SaaS companies) to the growth percentage (measured in terms of total revenue growth or recurring revenue growth). The ideal target is to have a Rule of 40 number above 40. While profit is often measured using EBITDA margin for private SaaS companies, public companies tend to use free cash flow margin. Growth can be measured as total revenue growth or recurring revenue growth, depending on the nature of the business.

To determine profit and growth, Ben suggests using a trailing three-month or six-month period for profit (EBITDA margin) and a year-over-year comparison for growth. By avoiding cherry-picking time periods, SaaS companies can maintain consistency and avoid subjective metrics.

When to implement the Rule of 40 within a company is subjective, with some big investment firms suggesting its relevance for companies with $10 million or $25 million in ARR or above. Ben calculates it for his SaaS companies, even if they have less than $10 million ARR, but emphasizes that its importance varies based on business objectives.

The Rule of 40 serves as a red flag if it falls below zero for companies with less than $10 million ARR, as it indicates a lack of growth and profit. Understanding the trade-offs between growth and EBITDA margin is vital in driving financial success for SaaS businesses.

Tune in to this insightful episode of SaaS Metrics School to gain a comprehensive understanding of the Rule of 40 and its implementation for your SaaS company. Don't miss out on the valuable insights shared by Ben!

Stay tuned for our next episode, where we dive deeper into important SaaS metrics and their impact on your company's growth and profitability.