The Rule of 40 for SaaS: What It Is and How to Calculate It
Many B2B SaaS marketing strategies focus on growing revenue through customer acquisition and retention, especially in the early stages. However, the key challenge is balancing that growth with profitability.
While revenue shows how much a company earns, profitability tells you how much actual profit is after expenses.
The Rule of 40 helps you balance growth and profitability. It’s a simple metric that shows if your SaaS business is healthy and on track for long-term success.
In this blog, we'll break down the Rule of 40, explain its importance, highlight its benefits, and show you how to calculate it for your SaaS business.
What Is the Rule of 40?
The Rule of 40 is a financial metric that measures the overall health of a SaaS business by combining two key performance indicators: growth rate and profit margin.
The rule suggests that the sum of these two factors should equal or greater than 40% for a company to be considered financially healthy.
In simple terms, it is a benchmark that helps SaaS companies balance scaling quickly and maintaining profitability. A business can achieve this by focusing on solid revenue growth or attaining high-profit margins—often enhanced by strategic SaaS marketing services—but ideally, it should aim for both.
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SaaS Growth Rate is usually measured as the percentage increase in monthly recurring revenue (MRR) or annual recurring revenue (ARR).
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The EBITDA margin typically measures the profit margin, reflecting how much revenue is retained as profit after operational expenses.
Why Is the Rule of 40 Important in SaaS?
This rule of 40 provides a simple yet powerful benchmark for investors and founders, ensuring that aggressive growth doesn’t come at the expense of profitability—and vice versa.
1. Balances Growth and Profitability
B2B SaaS companies often prioritize growth, especially in the early stages. However, an excessive focus on growth can lead to diminishing returns if not balanced with profitability. The Rule of 40 SaaS ensures companies do not sacrifice one for the other.
2. Investor Confidence
Investors closely analyze SaaS businesses for scalability and sustainability. Companies meeting or exceeding the Rule of 40 are considered well-balanced, which attracts higher valuations and increases investor confidence.
3. Simplifies Performance Metrics
The Rule of 40 serves as an overarching health check, simplifying evaluating a SaaS company’s performance. It provides a quick and effective snapshot for stakeholders without diving deep into complex metrics. (Download our SaaS Metric Resource.)
4. Improves Strategic Planning
Tracking the Rule of 40 enables leadership teams to make informed decisions about resource allocation.
For example, companies exceeding the benchmark may invest in customer acquisition, while those falling short can focus on cost optimization.
How To Calculate the SaaS Rule of 40?
To calculate the SaaS rule of 40, add the growth rate percentage and profit margin for a given time. Here's the formula:
Rule of 40 = SaaS Growth Rate % + SaaS Profit Margin %
However, calculating growth rate and profit margin requires more precision to ensure accuracy. Let's break it down:
1. Revenue Growth Rate Calculation
SaaS businesses typically calculate the growth rate using Monthly Recurring Revenue (MRR) or Annual Recurring Revenue (ARR), reliable indicators of recurring income.
Monthly Recurring Revenue (MRR) is calculated as:
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MRR = Total Active Accounts×Average Revenue Per Account (ARPA)
Annual Recurring Revenue (ARR) is derived by multiplying the MRR by 12:
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ARR = MRR×12
Once you have the appropriate revenue figure, you can calculate the growth rate using the formula:
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Growth Rate = (Current Year Value − Prior Year Value) ÷ Prior Year Value × 100
This shows the percentage change in your revenue from one year to the next. This metric is particularly valuable for SaaS sales teams to track their impact on overall business growth.
2. Profit Margin Calculation
Profitability is typically measured using the EBITDA margin, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. This margin shows how profitable a company is based on its core operations.
To calculate the EBITDA margin, you use the following formula:
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EBITDA Margin = EBITDA ÷ Revenue × 100
This will give you the percentage of revenue that is converted into profits.
3. Add the Growth Rate and Profit Margin
Now, simply add your growth rate and EBITDA margin. If the sum is 40% or higher, your business is on track according to the Rule of 40.
Example:
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Growth Rate: 30%
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EBITDA Margin: 15%
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The Rule of 40 Formula: 30% + 15% = 45%
In this case, the company exceeds the Rule of 40 benchmark.
The Four Crucial Benefits of Tracking the Rule of 40
The Rule of 40 offers B2B SaaS Companies a framework for sustainable operations. Below are four key benefits:
1. Strategic Resource Allocation
The Rule of 40 provides insights into whether a company should focus on scaling growth or improving profitability. It ensurese that resources are carefully allocated to areas with the highest impact.
A SaaS company with strong profitability but stagnant growth can use this metric to redirect resources into marketing and sales.
2. Enhanced Market Valuation
Investors view the Rule of 40 as a critical benchmark for evaluating SaaS businesses. Companies adhering to it often achieve better valuations, particularly during funding rounds, mergers, or acquisitions.
3. Streamlined Decision-Making
The Rule of 40 calculation simplifies decision-making by offering a clear performance indicator. It allows companies to focus on areas that need attention without getting lost in complex financial metrics.
4. Resilience Against Market Changes
The Rule of 40 helps B2B SaaS companies maintain financial health in fluctuating markets. A balanced strategy ensures stability, even during economic uncertainty or reduced market demand.
When Should B2B SaaS Companies Use the Rule of 40?
The relevance of the Rule of 40 depends on the maturity and goals of your SaaS business.
Early-Stage Companies
For startups or early-stage companies, aggressive growth often takes precedence over profitability.
Due to heavy R&D and customer acquisition investments, tracking the Rule of 40 may not yield meaningful insights during this phase.
Scaling SaaS Businesses
As companies achieve a steady revenue stream (e.g., $1M MRR or $10–$50M ARR), the Rule of 40 becomes a valuable metric to balance growth and profitability.
During Funding Rounds
For SaaS businesses preparing for funding rounds, the Rule of 40 showcases financial stability to investors, improving the chances of securing favorable terms.
Time Period to Measure the Rule of 40
The time period chosen for calculating the Rule of 40 can affect the accuracy of the results.
Shorter timeframes, like month-to-month comparisons, can cause fluctuations and may not give a clear picture. Longer periods help reduce variability and provide more reliable insights.
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It is recommended that full-year performance data be used, as it captures the overall growth and profitability trends without being affected by short-term changes.
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For growth rate calculations, compare at least three months of year-over-year revenue, such as the first quarter of 2024 (1Q24) versus the first quarter of 2023 (1Q23).
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For EBITDA margin, use a trailing three-month or six-month average to account for temporary changes in profitability.
Conclusion
The Rule of 40 is more than just a financial metric; it provides a framework for balancing growth and profitability in the SaaS industry. Using this benchmark, SaaS companies can improve their valuations, attract investors, and set themselves up for long-term success.
With Saffron Edge, a leading SaaS marketing agency, you can easily track and optimize critical metrics, such as the Rule of 40, to help your business stay competitive.
Frequently Asked Questions
What is the Rule of 40 in SaaS?
The Rule of 40 is an important financial metric that combines a SaaS company’s growth rate and profit margin to assess its overall health.
Why is the Rule of 40 important?
It ensures a sustainable balance between rapid growth and profitability, attracting investors and improving valuations.
How do you calculate the Rule of 40?
Add your revenue growth rate percentage to your profit margin percentage. The total should be 40% or higher.
Is the Rule of 40 applicable to every SaaS company?
While it’s most relevant for mature companies, it is a valuable benchmark for any SaaS business aiming for long-term success.
Drive Efficiency with Data-Driven Metrics
Master the Rule of 40 to optimize your operational strategy. Calculating and balancing growth and profitability is key to scaling your SaaS business effectively.
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