The Rule of 40: Boosting Valuations for SaaS Companies

In the competitive SaaS landscape, maintaining a balance between growth and profitability is crucial for long-term success and higher valuations. The Rule of 40 has emerged as a valuable metric for companies to achieve this balance while attracting investors' attention.

The Rule of 40 asserts that the sum of a SaaS company's revenue growth rate and profit margin should exceed 40%. It is calculated by adding the percentage increase in MRR or ARR to the profit margin. For example, a 30% growth rate combined with a 15% profit margin results in a Rule of 40 score of 45%.

A recent analysis conducted by Allied Advisors, which examined 149 SaaS companies from January 2022 to March 2023, reveals a significant premium attached to companies meeting the Rule of 40. As to be expected, valuation multiples have decreased across the board for both companies meeting and not meeting the Rule of 40. However, the premium for companies adhering to the Rule of 40 has increased over time, demonstrating that investors continue to value these businesses more favourably.

The Rule of 40 serves as a useful benchmark for SaaS companies, especially for those further along in their development. However, it is mportant to recognise that earlier stage companies may struggle to meet this threshold. The Growth Weighted Rule of 40, introduced by Susquehanna Growth Equity, offers a modification to accommodate the higher emphasis on growth for emerging companies with ARR below $10m. By understanding these nuances and applying the appropriate metrics, SaaS companies can effectively balance growth and profitability to achieve long-term success in a competitive market.