June 23, 2022

Eric Shepperd

Calculating the rule of 40 in SaaS metrics: An easy how-to guide

Many performance metrics can be used to determine the relative success of a business, and to project how it might grow going forward.

When it comes to attracting investors to a SaaS startup, the rule of 40 (R40) is a central metric used by venture capital firms in particular to determine whether a prospect is worth considering.

So how can we calculate this in a SaaS context, and why does it matter so much to investors operating in this market?

The importance of early growth

Whether you want to find an angel investor or get a full-blown VC on-side, you need to show that your startup is on a path that will lead to significant growth.

All investors want to see a healthy return on the capital they put into startups, and the faster this happens, the better.

The relevance of R40

With the rule of 40 in SaaS metrics, you can prove that a combination of your growth rate and profit margins will push to 40% or above.

The higher the percentage, the more rapid your growth will be. Of course as your business becomes more established, growth tends to level out, so it’s rarely always possible to breach the R40 barrier indefinitely. Instead, this tends to be something which only startups right at the beginning of their journey can hit consistently.

Carrying out calculations

Finding out where you stand on the R40 scale is simple, as it’s just a matter of taking your profit and growth percentages, then adding them together.

If the resultant figure is above 40, you’ve already hit this target, and investors will be clamoring to get involved with your business.

To get your growth rate, you need to look at various KPIs that are relevant to your total revenues. This means comparing your total customers with the number of newcomers who are signing up for your services, and also taking into account any customers that have left recently.

Knowing how many net new customers are being acquired quarterly or annually lets you plot out growth, and see how this impacts on your earnings.

Your profitability is also easy to calculate. If you are spending more than you are bringing in, then you won’t be in the black. If your costs are kept low and your revenue numbers are strong, your profit percentage will creep upwards and bring you closer to the R40 ideal.

Considering sensible growth strategies

It is one thing to have the ambition of hitting R40, but another to actually reach this point with your SaaS startup.

One important aspect is to recognize that your own ability to grow is partly constrained by the wider market. You’ll never enjoy 30 to 40 percent growth annually if the market itself is expanding at a much more modest rate.

This will in turn let you set realistic targets for growth, as well as inform your spending. If you’re anticipating an unsustainable level of growth, you might overspend, and shrink your profitability unnecessarily.

SaaS startups also have to build on their existing customer base through retention tactics, and not just allocate all of their resources to acquiring new customers. Sometimes the culprit behind slow growth isn’t bad marketing, but straightforward churn.

The last word

Without investment, it’s tough for SaaS firms to compete with established rivals. Working towards hitting R40 by measuring the right metrics, and also being careful with how you go about reaching this target, is the best way to wow would-be VCs and take your startup to the next level.