How does the Rule of 40 help you identify successful SaaS start-ups?

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How does the Rule of 40 help you identify successful SaaS start-ups?

Jun. 2nd, 2022

How does the Rule of 40 help you identify successful SaaS start-ups?

by Filip Van Innis

High-tech software entrepreneurship remains a risky journey, with only a few winners for a long list of strugglers. How does the Rule of 40 help to identify those businesses that will be successful?

For each USD billion software enterprise valuation, from Atlassian, Datadog, to Snowflake and UiPath, hundreds of companies had to close their doors, got absorbed, or had to scale down their ambition to well below the unicorn standard.

Whereas in previous articles we have delved into the key factors that differentiate successful start-ups from the rest of the crowd, this article goes into identifying those businesses that are likely to beat the market not just once, but several times over.

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What is the Rule of 40?

The Rule of 40 is expressed as the sum of the profit margin and the growth rate – which should be higher than 40% - and is a way of determining how strong a company could be.

This rule should be applied with caution, though, as it cannot predict the success with 100% certainty, nor can it accurately predict positive alpha (performance relative to the overall market) for SaaS companies. But the rule has, besides its merit of simplicity, more power than some believe.

This is what we found when we analysed the recent track records of hundreds of SaaS start-ups. The sample also includes PE and VC-backed companies that are still private (in addition to the top public SaaS companies). The analysis also uses trended multiples to prevent the possibly-inflated multiples during the pandemic.

1. Rule of 40 is a gateway to positive alphas

Typically, SaaS start-ups are valued based on revenue multiples, as margin levels are negative in the early stages before reaching the $10M top line. Our data panel suggests that the Rule of 40 explains up to half of the difference between SaaS companies’ current private and public revenue multiples.

SaaS business value

This means that the rule is rather effective in indicating the value of a SaaS business. In fact, the average trailing revenue multiple was just six times the revenue at the end of 2021, for a Rule of 40 composed of “30% growth and 10% earnings before interest, tax, depreciation, and amortisation (EBITDA) margin”.

Taking this revenue multiple, the implied EBITDA margin multiple becomes 60 and the current price earnings to growth rate (PEG) is 2 (PEG helps investors to calculate whether a company is under- or overvalued by comparing present and future earnings and growth). Assuming that someone would buy such a company today for its earnings growth, the implied minimal internal rate of return (IRR) would be about 25% - a rate of return that provides a strong positive investment alpha (where the IRR is the square root of the inverse of the PEG, without considering the scale effect).

A good IRR

Contrast this with SaaS companies with a (growth + margin) percentage that is only half of the profit and growth value components of the Rule of 40. For example, a 15% growth and 5% EBITDA margin. Our regression panel analysis then predicts that the revenue multiple decreases by 25%, leading to an EBITDA multiple of 90 and a PEG of 6. This PEG implies a rather low IRR (lower than 10%) which does not compensate for the risk of investing in a start-up. The only way to get a good IRR is to significantly reduce the sales multiple.

We can therefore conclude that the Rule of 40 is an important metric as it justifies IRR valuation with positive alpha, in the range of the top quartile of VC/PE investors. If the business does not meet this rule, valuation would be challenging and may even need to be deflated, meaning the IRR may quickly start flirting with negative alphas.

2. Growth beats margins early in the cycle

A balancing act

A business growing at 30%, with an EBITDA of 10%, is not the same as one growing at 10% with a margin of 30%. The Rule of 40 is based on the idea that business growth and margins are, at some point, somewhat negatively related, as growth needs to be fueled by marketing, sales, and R&D to sustain expansion. Of course, when size is established along with sufficient leadership, margins should scale.

Growth is king

Still, growth is always right. Our regression analysis suggests that extra marginal growth is worth up to twice the extra point of margin to drive the valuation multiple, in addition to the size of the company. In general, SaaS unicorns have managed to find the right balance. During the first six to seven years after having reached Series A, unicorns exhibit a strong exponential revenue growth, typically above 50%. Afterwards, EBITDA generally becomes positive and takes on its own exponential growth, on the tails of revenue growth which becomes more mature and inevitably begins to trail the original exponential curve.

Margin growth afterwards

The conclusion is that growth is the rule during the first years of scaling up, which then needs to be replaced by margin-led growth, to create a new value creation ‘S-curve’. These sequential waves are typical for successful SaaS companies that are operating on the Rule of 40.

3. Strong insurance, but ambition is also vital

Finally, one might wonder why 40% and not 20% or 60%. The Rule of 40 works because of its exponential impact on value. For example, after one decade, SaaS companies running at half of the Rule of 40 will, in absolute terms, be worth about 10% of the value of SaaS companies operating by the full Rule of 40.

Ensuring unicorn status?

Because the Rule of 40 basically amounts to good insurance, it might require more ambition for scale-ups at two levels:

  1. Meeting the Rule of 40 is not a one-off but must be persistent. However, sustaining it across years is challenging. Figures show that the probability of sticking to the Rule of 40 for one extra year decreases by about 20% each year. Therefore, every year, there are 10 times fewer SaaS companies that are able to stick to the Rule of 40 for 10 years than the year before.
  2. In addition, the Rule of 40 is not sufficient to ensure unicorn status. SaaS unicorns have reached their status in seven years after Series A, growing at a minimum consistent rate of 50% annual growth and reaching a minimum of 10% margin in average, going for the Rule of 60 at the time of becoming unicorns.

Running the portfolio with the Rule of 40 unplugged

What we have learned about the Rule of 40 also has practical implications for venture capitalists and private equity funds (VC and PE).

The right Portfolio

Ideally, one would love for all companies to have 40% and more. However, the constraint is the distribution of performance. Data shows that there are ten times fewer companies operating by the Rule of 60 than those following the Rule of 40. Consequently, one can easily argue that the scarcity of unicorn companies is due to a portfolio of SaaS companies following the Rule of 40 (and not 60).

A portfolio of five companies operating at the Rule of 40 and one operating at 60% is worth as much as two companies operating at 60%. But the first portfolio is twice as likely to grow than the second.

Sustainable success

The Rule of 40 gives a good indicator of sustainable success in SaaS businesses, hence its correlation with valuation. The Rule of 40 explains the 50% difference in valuation. Other factors that explain this difference relate to growth options and margin metric.

When it comes to Series A stage, the Rule of 40 has limited data validity, where companies at those stages are looking for product-market fit and initial traction. With this in mind, there might be another 40 number that could be put forward as an extra leading indicator for success, such as a product net promoter score (NPS) greater than 40.

Article by Filip Van Innis, Partner at Fortino Capital.

If you’re a Europe-based B2B SaaS company looking for advice and potential investment, we can help. Get in touch, and let’s get the conversation started.

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