The 40 Rule For Startups – Does Your SaaS Company Meet The Standard?
Starting up a SaaS company is like walking a tightrope. You need a hit a fine balance between reinvesting your money for continued growth and holding onto the money to show a profit. There is a standard investors look at when deciding to invest in your SaaS company, or not. They use the 40 rule for startups to determine if you are on the right path.
What Is The 40 Rule?
The 40 Rule is simple to define and measure, but much harder to obtain and maintain. It basically states your subscription business is growing at a rate of 20% per year or greater while maintaining a profit of 20%.
But wait, it isn’t quite that simple. The 40 Rule for startups is actually a ratio, which is used to measure the trajectory of your SaaS Company. The ratio is based upon hitting a guideline of 40 being the addition of your growth rate percentage and your profit percentage. Let’s look at three examples to illustrate the rule:
Example 1 – Balanced Growth And Profits: As we alluded to before, you could have a great balance between growth and profits to hit the rule of 40 ratios. This could be with a growth rate of 20% and a profit percent of 20%. The 20% plus 20% hits the 40 standard.
Example 2 – High Profits With Slower Growth: If your company is targeting a narrow market your numbers could be extremely different and still be highly attractive to investors by hitting the rule of 40 a different way. You could be seeing slow growth of only 10%, but are consistently hitting a 30% profit percentage. That gives you a 30% plus 10% to maintain the rule of 40.
Example 3 – Explosive Growth With Low Losses: Yes, you can hit the rule of 40 and be losing money. That is why you often see venture capitalists pouring money into companies losing money. If your company is growing at a rapid 50% rate, you could be losing 10% and still hit the rule of 40. It would give you 50% plus -10% resulting in 40.
How does this make sense to an investor, or for your business? Rapid growth shows the potential for large profits in the future. Your business is growing an impressive subscription base and your client acquisition costs will start to decline over time, leading to profits.
On the opposite side, slow growth but high profits indicate laser focus on a profitable market. It shows you have done your research, know your market, and can make a profit from it. Each of our scenarios shows the potential for long term profits and success.
When you fall far outside of these ratios, you could be headed for trouble. Rapid growth with excessive losses may be impossible to maintain. Excessive profits and no growth shows a business in decline who is susceptible to competitors.
The 40 rule for startups should be used as a guideline to check the health of your SaaS startup. It does not guarantee success, but it does provide a simple way to verify if your business is on the right track.