The Rule of 40

The Rule of 40 is a principle that determines a software company’s growth sustainability.  The higher your “R40 Factor” the more growth efficient your company is.   Its one thing to have a ‘growth at all cost’ mindset, its another to achieve profitable efficient growth.

Rule of 40 Definition

Popularized by Brad Feld 10 years ago, the Rule of 40 is a metric that states the sum of your year over year revenue growth rate plus your profit margin should exceed 40%.

Rule of 40 = Y/Y Revenue Growth % + EBITDA %

So, if a company is growing 20% revenue year over year, and also have a profitability of 20%, then this combines to 40%. Any combination of growth and EBITDA would apply.  Growing 10% at a highly profitable 30% EBITDA, or growing 50% with a negative 10% EBITDA; both examples would achieve the Rule of 40.

Why is Rule of 40 so relevant?

Many growth equity, acquirers, and non-dilutive lenders look too this measure to evaluate the quality of a business.  According to a recent McKinsey & Co. study, technology companies that achieve ‘Rule of 40’ are valued at double the revenue multiple of the average performing company. 

How can you improve Rule of 40?

The two main metrics are profitability and Y/Y growth.  So how do improve these metrics?  We think it comes down to four main levers

Improve Win Rate %

To grow top line revenue, you need to record more revenue this year than last year.  This starts with more bookings.  The first thing to address, even before trying to jack up the marketing activity and spend, is your win rate.  Companies that have a low win rate – for enterprise software, anything under 20% would be considered low – you need to get that number up.  The fastest way to do it is:

1. Improved Sales Execution.  Defining the right sales motions, making sure the reps are doing the right work at the right time.  Giving your best leads to your best performers
2. Focus where you win.  You’ll probably have more success with some industries, geographies, partners, sellers, lead sources, or products; that do much better than others.  Focus there and dump all your efforts in underperforming segments. 

Increasing your win rate from 20% to 30% will have a 50% impact on your sales bookings.  Win rate has an oversized impact on your sales velocity.

Increase funnel size with winnable deals

Once you get your win rate to a good spot, then you can focus on increasing the size of your funnel.  To achieve Rule of 40, you’ll need to be go-to-market efficient.  Probably the best measure of this is something called the Sales Magic Number.  That is, how many dollars of ARR can you book from a single dollar of sales and marketing investment.  According to data collected by Sales Science, top performing public SaaS companies are very inefficient.  They book $0.36 on average.  However, the rest of us need to be in the range of $1-2 of ARR booked for every dollar spent.  Otherwise we’ll run out of cash.  How do you increase the size of your funnel efficiently?  Here you’ll need to analyze where you are getting your best leads and double down in those areas. 

Check out our blogs on Best Bang for the Buck Marketing Tactics and How we would spend a $1M sales and marketing budget for more information. 

Retain and Grow your Customers

Customer retention early with setting the right expectations with the customer during the sales process, selling your product to high fit customers.  But once the customer is onboard, there are many ways to increase retention rates to keep them at 90%+. 

First, customer onboarding.  Make sure you service delivery team is working from a consistent project plan and methodology.  Tie effort with impact, make sure you focus energy on delivering to a solution that solves their business challenges. Ensure a high degree of communication and information sharing.  This includes weekly status meetings, tracking RAID logs, and providing customers with self-service tools like knowledgebase and portal.

Second, nurture existing customers with content. Setup weekly/monthly webinars, setup up ‘office hours’ with your top consultants, send monthly newsletters, email your product release notes, do quarterly product webinars, setup an annual customer event, or at the very least a customer advisory board, create a knowledge base of how to articles and videos.

Third, build the best support engine you can. Automate case collection, make it easy for customers to submit cases across email, portal, phone, in app, or other method. Make sure email notifications fire out to update them on case progress and closure. Track escalations and SLA misses.

Forth, automate the renewal process. Make sure you don’t lose track of your renewal communication. Internally start getting ready 90 days before the end date, but communicate to customers in the 30 to 60 day window. Provide them with usage stats and a list of areas that are under utilized in your tool. Create a health check document with recommendations.

Finally, build a customer success model.  It will be impossible to shower all your customers with the same high level of service.  You’ll need to segment your customers taking extra good care of the big ones with good growth potential from the others that are simply happy with what they get from you.  Make sure all your customers benefit from the efforts above, but for the top segment customers, invest in a real customer success program; track their health proactively, align their business goals to your tool, become part of their team. Use the pareto principal on this one. 80% of your success will come from 20% of your customers.

Protect your Profitability

Getting the revenue in the door is important for growth. But many technology companies leak profitability because of poor visibility, bad forecasting, and inefficient processes. Some obvious examples include:

Poor sales forecasting which drive badly timed hiring investments or spending decisions