If you follow the software industry, you've probably heard talk of the Rule of 40. This is a shorthand rule of thumb for assessing whether a software-as-a-service (SaaS) business is investable.
What does the Rule of 40 mean in SaaS?
The Rule of 40 refers to the sum of a company's revenue growth and its free-cash-flow margin, or a similar profitability metric, such as its earnings before interest, taxes, depreciation, and amortization (EBITDA) margin.
If the number is above 40%, the company is considered healthy and worth investing in. For example, if a company has 20% revenue growth and a 20% free-cash-flow margin, someone using this metric would consider investing in the business.
Notably, a software company can reach the Rule of 40 by having strong revenue growth and a negative free-cash-flow margin, or it can be a slower-growing company with a strong free-cash-flow margin.
Many software companies rely on stock-based compensation to boost free-cash-flow margin or adjusted EBITDA. This makes the Rule of 40 target easier to achieve than it would be if generally accepted accounting principles (GAAP) numbers were used.
Where does the Rule of 40 come from?
The Rule of 40 was popularized by venture capitalists Brad Feld and Fred Wilson, who described the concept in blog posts in 2015. The pair learned about it in a board meeting from another investor, who used it to gauge software start-ups.
At the time, the Rule of 40 was understood to apply to start-up firms rather than publicly traded companies, which could be more easily valued by the market. But publicly traded software stocks have also adopted the Rule of 40 as shorthand for success. Achieving the Rule of 40 means that a business is delivering strong growth, strong profitability, or a good balance of both.
The rule caught on because it neatly sums up the balance between growth and profitability that start-ups and software stocks must navigate to be successful. Some companies with rates higher than 40 will use phrases like the Rule of 50, 60, and so forth to demonstrate the strength of their businesses.
Is the Rule of 40 useful?
The Rule of 40 is a good rule of thumb for determining whether a software business is delivering a good mix of growth and profitability. However, it shouldn't be the only criterion you use to decide whether to invest in a stock.
The rule can be dangerous if a business focuses too much on hitting one number. For instance, free-cash-flow margins can be boosted by using excessive share-based compensation or by delaying capital expenditures so they can hit a certain number for investors. Capital expenditures tend to be minimal for software businesses, but there are other tricks they can use to inflate free cash flow in a given quarter.
Overall, the metric is useful, but investors should consider other financial metrics, such as GAAP profitability, which can differ substantially from free cash flow.
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