{"id":1,"date":"2022-11-08T09:27:40","date_gmt":"2022-11-08T09:27:40","guid":{"rendered":"https:\/\/3.84.196.179\/insights\/?p=1"},"modified":"2023-02-24T06:20:06","modified_gmt":"2023-02-24T06:20:06","slug":"hello-world","status":"publish","type":"post","link":"https:\/\/virtuaresearch.com\/insights\/?p=1","title":{"rendered":"Don’t let the Rule of 40 rule your company"},"content":{"rendered":"\n
Why I think the Rule of 40 is lame<\/h5>\n\n\n\n

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This Thursday I\u2019ll be participating in a virtual event OpenView<\/strong> is putting on to roll out their 2022 SaaS Benchmarking Report<\/strong>. I\u2019ve been a disciple of this report for +5 years, having built multiple annual operating plans off of the rich data set. To a CFO or FP&A professional in tech, it\u2019s the holy grail of SaaS benchmarking.<\/p>\n\n\n\n

Curt<\/a> and Kyle<\/a> at OV crunched the financial and operating metrics of 660 private SaaS companies<\/strong> so you don\u2019t have to.<\/p>\n\n\n\n

RSVP for the event and gain early access to the report here\ud83d\udc47<\/p>\n\n\n\n

In addition to the lucrative appearance fee I\u2019ll be collecting, I also received early access to the data. While thumbing through it, their recent analysis on the Rule of 40<\/strong> caught my eye. You may have heard of this metric – like the Undertaker, it\u2019s risen from the dead<\/strong> during the latest tech market correction.<\/p>\n\n\n

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\"Im<\/figure>\n<\/div>\n\n\n

At the risk of ruffling some feathers, it\u2019s time for me to come clean – I think the Rule of 40 is lame<\/strong>. Let\u2019s dig into why.<\/p>\n\n\n\n

Disclosure<\/em>: OpenView did not actually pay me anything to participate, however, I did stop by their office for happy hour two weeks ago and enjoyed two (free) Miller Lites and one (free) cupcake.<\/p>\n\n\n\n

What\u2019s the Rule of 40%?<\/h4>\n\n\n\n

The Art:<\/strong><\/h3>\n\n\n\n

Trying to measure efficiency when you\u2019re losing money can be a mixed bag of burritos. Some businesses raise a ton of money<\/strong> so they can prioritize growth at all costs (see: Gitlab<\/em>). Other businesses are designed to run like a money printer, spitting out free cash flow<\/strong> and fat dividends for shareholders (see: Qualcomm<\/em>).<\/p>\n\n\n\n

But for many businesses, the truth lies somewhere in the middle. Some investors validate a \u201cgood\u201d balance between growth and profitability<\/strong> by checking if revenue growth rate plus profit (or loss) rate exceeds 40%.<\/p>\n\n\n\n

The Science:<\/strong><\/h3>\n\n\n
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Rule of 40 = YoY ARR Growth + LTM EBITDA Margin > 40%<\/code><\/pre>\n\n\n\n
So, if you\u2019re growing at 50% y\/y and have a -15% EBITDA margin, your Rule of 40% = 35%\u2026womp womp.<\/p>\n\n\n\n
Where does the Rule of 40 go wrong?<\/h4>\n\n\n\n
I have four bones to pick with the Rule of 40:<\/p>\n\n\n\n
    \n
  1. It ignores where you are in your business lifecycle.<\/li>\n\n\n\n
  2. You can game it with superior growth.<\/li>\n\n\n\n
  3. It\u2019s a hard target to keep consistent in all periods, due to seasonality<\/li>\n\n\n\n
  4. It\u2019s a lowish bar if you want to be great.<\/li>\n<\/ol>\n\n\n\n
    I took a trip in the way back machine using Virtua Research\u2019s<\/a> <\/strong>lifecycle analysis tool to stress test a cohort of companies in the four quarters leading up to (Q-4 through Q-1) and immediately preceding (Q+1 through Q+4) their IPO (Q0).<\/p>\n\n\n\n
    The research is based on a selection of 60 PLG companies, in honor of OpenView.<\/p>\n\n\n\n
    Here are my arguments against a dogmatic adherence<\/strong> to the Rule of 40:<\/p>\n\n\n\n
    Thanks for reading Mostly metrics! Subscribe for free to receive new posts and support my work.<\/p>\n\n\n\n
    It ignores where you are in your business lifecycle<\/h4>\n\n\n\n
    WorkDay was a solid investment if you bought in when they went public, and maintains a strong financial profile to this day. However, their Rule of 40 took a major dip at time of IPO as they made some investments in the business to scale.<\/p>\n\n\n\n
    Nonetheless, their stock price jumped 72% on day of IPO. If you religiously followed the Rule of 40 you would have dumped them, and kicked yourself down the road.<\/p>\n\n\n
    \n
    \"\"<\/a><\/figure>\n<\/div>\n\n\n
    There are times to step on the gas pedal and say damn the torpedoes<\/strong>. There are also times to get to an efficient P&L<\/strong> in a hurry. Just because you are in one season rather than another doesn\u2019t mean you are necessarily a \u201cbad\u201d company.<\/p>\n\n\n\n
    Takeaway: Not all periods are the same. And not all periods should be 40%.<\/strong><\/em><\/p>\n\n\n\n
    You can game it by going big on just growth<\/h4>\n\n\n\n
    I also think there are diminishing returns<\/strong> past a certain growth rate. Investors aren\u2019t necessarily going to pay any extra for 125% growth vs 110% growth if you are losing 50% per year.<\/p>\n\n\n\n
    However, adhering to the Rule of 40 in a bubble would give you the vote of approval on growth of 140% and losses of 100%. Talk about false signals<\/strong>.<\/p>\n\n\n\n
    Takeaway: Not all growth percentage points are created equal.<\/strong><\/em><\/p>\n\n\n\n
    It\u2019s a hard target to keep consistent in all periods, due to seasonality<\/h4>\n\n\n
    \n
    \"\"<\/figure>\n<\/div>\n\n\n
    Here\u2019s SmartSheet. They oscillate between a low of 35% and a high of 48%. It looks like one of those Inflatable Whacky Willys<\/strong> at the used car markets.<\/p>\n\n\n
    \n
    \"Halloween<\/a><\/figure>\n<\/div>\n\n\n
    I highly doubt when they touched 35% their CEO yelled \u201cHALT THE PRESS! We must get back to 40!\u201d<\/p>\n\n\n\n
    It\u2019s difficult to run your operations and stay at a consistent<\/strong> Rule of 40 output<\/strong>. Life just doesn\u2019t work like that, especially if you skew heavily towards Q4 seasonality<\/strong> and an elongated enterprise sales motion<\/strong>.<\/p>\n\n\n\n
    Takeaway: The Rule of 40 is a a general target to work to in the long term, not something to nail period to period.<\/strong><\/em><\/p>\n\n\n\n
    It\u2019s a lowish bar<\/h4>\n\n\n
    \n
    \"\"<\/figure>\n<\/div>\n\n\n
    Peep Snowflake\u2019s<\/strong> Rule of 40. They have every right to rename the metric the Rule of 60, since that\u2019s where the Y axis starts. They were able to become efficient with scale, driving better bottom line margins at the same time their revenue grew leaps and bounds.<\/p>\n\n\n\n
    And here\u2019s DataDog<\/strong>. It\u2019s a similar story. The closest they come to 40% is 70%, a full 30% ahead of the \u201ctarget\u201d.<\/p>\n\n\n\n
    \"\"<\/figure>\n\n\n\n
    Finally, here\u2019s the average<\/strong> and median<\/strong> across that cohort of 60 PLG SaaS companies.<\/p>\n\n\n\n
    \"\"<\/figure>\n\n\n\n
    You can see the average is closer to 50% and median closer to 45%.<\/p>\n\n\n\n
    Takeaway: Hitting 40 is more average than excellent, and no one wants to build an average company.<\/strong><\/em><\/p>\n\n\n\n
    \n\n\n\n
    Conclusion<\/h4>\n\n\n\n
    As OpenView explains,<\/p>\n\n\n\n
    \n
    Rule of 40 has always been a solid gut check<\/strong> for the general balance of a company\u2019s growth and profitability. However, it\u2019s become increasingly important as a driver of how businesses are valued<\/strong>. For earlier stage companies, Rule of 40 can vary widely from quarter to quarter. Achieving 40 each quarter is not required<\/strong>. But, it is required to have a grasp on what caused a drop or spike, and what can be done to get to 40 long term.<\/strong><\/p>\n<\/blockquote>\n\n\n\n
    I\u2019d go a step further and amend the last phrase to: \u201cwhat can be done to consistently operate above 40<\/strong> in the long term.\u201d<\/p>\n\n\n\n
    Maybe it makes sense for stock market pickers to use the Rule of 40 as a \u201csanity<\/strong>\u201d check. But as someone responsible for making sure the trains run on time<\/strong>, I don\u2019t think the Rule of 40 is very useful, for all the reasons outlined above.<\/p>\n\n\n\n
    Agree? Disagree? Come tell us at the event on Thursday November 12th at 12 EST. When you register you\u2019ll get a copy of the report<\/strong>.<\/p>\n\n\n\n
    What I\u2019ve Been Reading<\/h4>\n\n\n\n
    Speaking of PLG\u2026 I was recently turned on to Top of the Lyne<\/a><\/strong>: Hard data. Deep research. Jaw-dropping insights. And the freshest memes. The art and science of product-led growth. Recommended by 7,000+ revenue leaders from Canva, Stripe, Notion, Figma, and 1,000s of other PLG companies.<\/p>\n\n\n\n
    Subscribe to Top of the Lyne<\/a><\/p>\n\n\n\n
    Quote I\u2019ve Been Pondering<\/h4>\n\n\n\n
    \n
    \u201cIf you can fill the unforgiving minute<\/strong><\/em><\/p>\n\n\n\n
    With sixty seconds\u2019 of distance run,<\/strong><\/em><\/p>\n\n\n\n
    Yours is the Earth and everything that\u2019s in it\u2026\u201d<\/strong><\/em><\/p>\n\n\n\n
    <\/p>\n-Rudyard Kipling, If<\/em><\/cite><\/blockquote>\n","protected":false},"excerpt":{"rendered":"
    Why I think the Rule of 40 is lame This Thursday I\u2019ll be participating in a virtual event OpenView is putting on to roll out their 2022 SaaS Benchmarking Report. I\u2019ve been a disciple of this report for +5 years, having built multiple annual operating plans off of the rich data set. To a CFO or FP&A professional…<\/p>\n","protected":false},"author":2,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_kad_post_transparent":"","_kad_post_title":"","_kad_post_layout":"","_kad_post_sidebar_id":"","_kad_post_content_style":"","_kad_post_vertical_padding":"","_kad_post_feature":"","_kad_post_feature_position":"","_kad_post_header":false,"_kad_post_footer":false,"footnotes":""},"categories":[1],"tags":[],"class_list":["post-1","post","type-post","status-publish","format-standard","hentry","category-uncategorized"],"_links":{"self":[{"href":"https:\/\/virtuaresearch.com\/insights\/index.php?rest_route=\/wp\/v2\/posts\/1","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/virtuaresearch.com\/insights\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/virtuaresearch.com\/insights\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/virtuaresearch.com\/insights\/index.php?rest_route=\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/virtuaresearch.com\/insights\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=1"}],"version-history":[{"count":2,"href":"https:\/\/virtuaresearch.com\/insights\/index.php?rest_route=\/wp\/v2\/posts\/1\/revisions"}],"predecessor-version":[{"id":14,"href":"https:\/\/virtuaresearch.com\/insights\/index.php?rest_route=\/wp\/v2\/posts\/1\/revisions\/14"}],"wp:attachment":[{"href":"https:\/\/virtuaresearch.com\/insights\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=1"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/virtuaresearch.com\/insights\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=1"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/virtuaresearch.com\/insights\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=1"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}