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Your guide to the magic number
The good, the bad and the ugly
The magic number is dead – long live the magic number!
In 2015, venture capitalist Brad Feld penned a blog post about a metric he used to evaluate the health of SaaS startups, and it caught fire.
In the piece, Feld wrote SaaS companies might be considered healthy and sustainable if the sum of their revenue growth rate and EBITDA margin were at least 40%. In other words, if the entity has a revenue growth rate of 30%, and its EBITDA margin were at least 10%, the combined sum would be indicative of a good investment. This metric known as the “magic number” or the “Rule of 40” became popular, fast.
Since then, it’s become a standard for investors examining SaaS startups. Like all trends, it has come under criticism. Nonetheless, the magic number is an important metric to be aware of for any FP&A professional working at a SaaS startup .
Let’s take a closer look at the rule, why it’s popular and what criticisms it’s faced:
How do I calculate the Rule of 40?
To calculate the Rule of 40, you need to follow these steps:
Determine the company's revenue growth rate for the past 12 months. This can be calculated by subtracting the revenue for the past 12 months from the revenue for the previous 12 months, and then dividing the result by the revenue for the previous 12 months. Multiply this result by 100 to get a percentage.
For example, if the revenue for the past 12 months is $10 million and the revenue for the previous 12 months is $8 million, the revenue growth rate would be:
(($10 million - $8 million) / $8 million) x 100 = 25%
Determine the company's EBITDA margin for the past 12 months. This can be calculated by subtracting the company's EBITDA for the past 12 months from its revenue for the past 12 months, and then dividing the result by the revenue for the past 12 months. Multiply this result by 100 to get a percentage.
For example, if the revenue for the past 12 months is $10 million and the EBITDA for the past 12 months is $2 million, the EBITDA margin would be:
(($10 million - $2 million) / $10 million) x 100 = 80%
Add the revenue growth rate and the EBITDA margin together to get the Rule of 40 score.
For example, if the revenue growth rate is 25% and the EBITDA margin is 80%, the Rule of 40 score would be:
25% + 80% = 105%
Thus, common wisdom has it that Rule of 40 score above 40% indicates that the company is in good financial health and has good growth potential. Or is it?
Why the Rule of 40 is helpful?
Provides a quick snapshot of a company's financial health: The Rule of 40 allows investors and analysts to quickly assess a SaaS company's financial health and growth potential without having to dig into complex financial statements or performance metrics.
Helps identify potential risks: A company that is growing too quickly without generating sufficient profits may be at risk of financial instability. Conversely, a company that is highly profitable but has low growth may be at risk of being overtaken by competitors.
Can be used as a benchmark: The Rule of 40 provides a benchmark that can be used to compare different SaaS companies, and to track a company's progress over time.
Encourages a balance between growth and profitability: The Rule of 40 incentivizes SaaS companies to balance their growth ambitions with the need for profitability, which can help to ensure long-term financial stability.
Why the rule of 40 is not helpful?
Ignores other important metrics: The Rule of 40 focuses solely on revenue growth and profitability, but there are other important metrics that can impact a company's success, such as customer acquisition costs, churn rates, and the lifetime value of customers. Focusing too much on the Rule of 40 can lead investors to overlook these other critical metrics.
May incentivize short-term thinking: In order to meet the Rule of 40 threshold, some companies may prioritize short-term growth over long-term profitability, which can lead to unsustainable growth and long-term financial instability.
One-size-fits-all approach: The Rule of 40 is a general guideline that may not be appropriate for all SaaS companies. Different companies have different growth strategies, target markets, and competitive landscapes, and what works for one company may not work for another. For instance, the rule
Not applicable to all stages of a company's growth: The Rule of 40 may be less useful for very early-stage SaaS companies that are still in the process of establishing themselves in the market and may not yet be profitable. Feld, for instance, believes it’s relevant only once a company passes $1M ARR.
What other metrics are there?
There are several alternative metrics to the Rule of 40 that investors can use to evaluate the performance of a software company:
Gross Margins: Gross margins are a measure of a company's profitability, calculated by subtracting the cost of goods sold from revenue and dividing the result by revenue. Higher gross margins indicate that a company is able to command higher prices for its products or services and is more efficient in its operations.
Net Dollar Retention: Net Dollar Retention is the percentage of revenue retained from existing customers after accounting for any losses due to churn or downgrades. This metric is particularly useful for subscription-based businesses and indicates the strength of a company's customer relationships.
CAC Payback Period: Customer Acquisition Cost (CAC) Payback Period is the time it takes for a company to recover the cost of acquiring a new customer. A shorter payback period indicates that a company is generating revenue more quickly from its new customers and is more efficient in its sales and marketing efforts.
Overall, while the Rule of 40 can be a helpful metric for evaluating the health and growth potential of SaaS companies, it should not be the only metric used, and it should be evaluated in the context of other important metrics and factors.
As Feld himself wrote, “I always make sure I know what is going on underneath this number by using the other calculations.”