The Rule of Forty (RO40)

The Rule of Forty postulates that a SaaS company’s combined growth rate and profitability should exceed 40%. The Rule of Forty acts as a yardstick that allows SaaS companies with a wide variety of go to market strategies to benchmark their growth. Some SaaS companies, particularly series B to C companies, seek to maximize growth to achieve breakout and dominate their space. Such companies spend heavily to realize the growth required to accomplish these objectives. More mature SaaS companies solidify their market positioning and typically seek to reduce their burn rates through pricing power and increased reliance on efficient upsells and cross sells strategies. The Rule of Forty also drives your financing strategy. SaaS companies pursuing category creation strategies may need higher levels of sales and marketing expense in the short term in order to achieve growth much later. Those seeking to build complex products may require above average R&D expense to bring their products to market. Enterprise SaaS companies fall into this category due to long sales cycles and extensive implementation processes. Such companies will perform lower on the Rule of Forty metric.

For the calculation, the growth rate is best measured using the year-over-year comparison of Annual Recurring Revenue, although Subscription Bookings is a valid approach. Profitability is best measured using the Free Cash Flow definition, which is the sum of the company’s annual growth rate and the Free Cash Flow margin.

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