The 40 Rule for SaaS: Tips and Recommendations for Healthy SaaS Growth
Growth and Profit
First, let's understand the growth and profit rates and how to calculate them. Since there are different ways to measure these indicators, each enterprise must choose its own calculation method.
The growth rate is defined as the percentage change from one time period to another. It is most often measured by year-over-year (YoY) or monthly recurring revenue (MRR). However, some companies consider growth as an increase in the number of employees or even market share.
The profit margin percentage is the amount by which sales revenue exceeds the cost of doing business. To calculate it, you should use the EBITDA indicator, which stands for earnings before interest, taxes, depreciation, and amortization. Currently, most software development companies use this principle to determine their net margin excluding taxes.
The 40 Rule is quite a challenge for companies that have been in the game for several years. Their growth rate may decline, but they remain profitable.
The most successful companies adhere to this principle due to high profitability. For example, Adobe, a computer software development corporation, was founded almost 40 years ago. Adobe balances between growth and profit, with the latter reaching 23.71% as of 2023. Such indicators indicate stable development and progress of the enterprise year after year.
At the same time, startups in most cases have no revenue immediately after launch and throughout the adoption stage of the SaaS lifecycle. Nevertheless, they have every chance to meet the 40% target because the growth rates of thriving new products tend to continuously increase.
The startup CultureIQ, which allows employers to receive feedback from their employees, showed incredible results. Founded in 2013, this company achieved a growth rate of 165% in the first half of 2019. Thus, despite having no revenue, their economic indicators still satisfied the 40 Rule for SaaS.
Now let's talk about the formula of the 40 Rule for SaaS itself, which is quite simple.
The best thing about this financial scheme is balancing the growth percentage and profit. For example, the growth rate could be 10% and net margin 30%. It could even happen that profit is 50%, allowing for -10% growth.
An undoubted advantage of this rule is greater room for creativity and a variety of strategies for developing a SaaS product. For example, you can choose a time to focus on leveling the growth rate while net margin remains stable enough to adhere to this principle.
When to Start Calculating and What Time Periods to Consider
This question remains quite complex for many software companies. Immediately after a project launch, it may not be necessary to apply the 40 Rule, as things can turn either way at any moment. Therefore, it is better not to rush and start entering these financial boundaries a few years after product launch.
An additional formula that can be applied here is known as the T2D3 approach. Under this formula, annual recurring revenue (ARR) should be tripled within two years, then doubled within the next three years. Most software companies use this formula and only after the first 5-6 years begin to apply the 40 Rule for SaaS.
T2D3
During all this time, your product will likely go through the first stage of the product lifecycle - the adoption stage without profit - and move to the next stage - the growth stage. Although this period can be difficult and unstable, you will finally start to generate some revenue, and then you can properly assess the prospects of your software business by applying the 40 Rule for SaaS.
Why Do We Need the 40 Rule?
At first glance, this principle for SaaS is aimed at comparing the service with others on the market. Through such observation, you can double-check whether your business is profitable or needs improvement. However, this rule goes much deeper than just a brief analysis, and essentially every SaaS company should use it to maintain stable development.
Despite delving into financial risks and prospects, the 40 Rule helps to formulate a plan for further development. By analyzing growth rates and net margin, you can outline a strategy for the coming years or even come up with new methods of business development.
Why is the 40 Rule mainly applicable to SaaS products?
The answer is simple: it best describes and matches the dynamics of SaaS product development. Unlike many subscription services, software is perhaps the only product that can both grow and decline incredibly quickly. That is, both net margin and growth rate can even exceed 100%.
Of course, non-digital products can also be analyzed using the same formula, but the final numbers will likely be insignificant because these projects grow more slowly. Even if they fall short of 40% according to the rule, it does not mean they are unprofitable or should be closed anytime soon.
The two main components of the 40 Rule are the company's net margin and its growth. Given that many popular software products are bought up within the first few years, 40 as the sum of these indicators is a quite achievable target to strive for.
Is the 40 Rule Enough for SaaS?
Undoubtedly, there are many ways and opinions on how to evaluate and measure SaaS solutions. The 40 Rule for software has become the most common scheme for this. By applying this formula, you not only compare and contrast the service with others but also check if your business is in ideal condition.
Similarly, it is difficult to move forward without any plan or direction. The 40 Rule for SaaS is also a certain benchmark for managing a SaaS company and making both short-term and long-term development plans.
When it comes to economics and financial success, the 40 Rule is a key indicator of a steadily developing company.