What is the SaaS rule of 40?
If you work for a company that delivers a software-as-a-service (SaaS) product, chances are you've seen a bunch of references to the “rule of 40.” In this post I will explain what it is, how to calculate it, and why it's particularly useful during an economic downturn.
The SaaS rule of 40
The rule of 40 is a quick yet effective way to evaluate the overall health and potential growth of a company. It is widely used in the world of business-to-business (B2B) SaaS, and is calculated using two key metrics: growth rate and profit margin. The goal is a result greater than 40, which is a strong indicator of a healthy and sustainable business.
To calculate the SaaS Rule of 40, you simply add the company's annual growth rate to its profit margin, both expressed as a percentage. Any result under 40 is cause for concern and may indicate the risk of cashflow problems. The answer is to evaluate business strategy and make adjustments to promote growth while improving profit margins.
Now for some examples:
Company A has a growth rate of 25% and a profit margin of 20%. They score a 45, which is healthy. Though they do not need to make any changes, they should be aware that a 20% slow down in growth (which takes their rate down to 20%) puts them in the danger zone.
Company B has a growth rate of 30% and a profit margin of 5%. Their score is an unhealthy 35 and they need to either make efforts to improve their profit margin or growth rate. They need either a 17% bump in growth rate or a 100% improvement in profit margins to just clear healthy. Time for some real decisions!
How is it useful during an economic downturn?
During economic downturns, the overall market may be experiencing slower growth. This is when the SaaS Rule of 40 is most useful, as it can give you a clear idea of what changes you can make to reach health. By combining two key metrics that are often isolated, you can make decisions that contribute to balance and overall health. Once your score is above 40, your company should be able to weather the storm.
Turbulent economic times can make maintaining a score of 40 challenging. Companies that have been able to do it have focused on maintaining and retaining its existing customers, which is an easier way to keep growth trending in the right direction, while also carefully managing its expenses, which contributes to better profit margins. Check in with your existing clients to see if flexible pricing or payment plans would make staying easier. Take a look at your own expenses and look to reduce or even eliminate the non-essentials. And, of course, continue innovating and offering high-quality products and services that keep you competitive in the market.
By leveraging the Rule of 40, B2B SaaS companies can quickly evaluate their own performance and make adjustments to their business strategy as needed. This can help them to stay competitive and growing, even in spite of challenging economic conditions.