Venture capitalists have a simple method for determining whether to invest in young software-as-a-service (SaaS) start-ups or to pass on the opportunity. Dubbed the Rule of 40, this calculation is a way of balancing revenue and profit growth in software companies (even if there are no profits yet).
The math is easy. You take the annual revenue growth of a company as a percentage (say, 50% revenue growth) and add that to the company's profit margin (for instance, 10%). In this example, the hypothetical company would have a Rule of 40 score of 60, which is outstanding. A score of above 40 is considered a passing grade, while a score below 40 means the company fails the Rule of 40 test.
This model is very helpful for assessing fundamental trade-offs between growth and profitability. Investors are often willing to tolerate low profits or net losses as long as a company is demonstrating strong growth. It's common for young companies to invest in growth by spending heavily on R&D or sales and marketing, even though those expenses will pinch profitability in the near term. Conversely, as growth slows the company should focus on improving profitability by reducing some of that spending.
The Rule of 40 was introduced to measure young, unproven companies, and that's where it really shines.
For example, consider Datadog (NASDAQ:DDOG), a cloud analytics company that IPO'd last week. Datadog reported an outstanding 82% revenue growth in its most recent quarter, compared to the same period last year. That's an amazing number. And its profit margin was negative 9%. Adding the numbers together, Datadog has a Rule of 40 score of 73. That's fantastic. While a negative profit margin is bad news, we can forgive it in this case because the company's revenue growth is so high.
The Rule of 40 is one metric investors interested in SaaS companies can use as they start their search for investments.