The ‘Rule of 40’ is popular among investors and analysts because it provides a simple, easy-to-understand metric for evaluating the financial health of software companies. As with any metric, there are pros and cons.
It combines two important metrics, revenue growth and profit margin into a single number that can be used to quickly assess the company’s overall performance.
Additionally, the Rule of 40 takes into account both growth and profitability, which are both important factors in evaluating the long-term viability of a company.
Companies that have a high growth rate but low profitability may not be sustainable in the long run, while companies with high profitability but low growth may not be able to keep up with competitors or adapt to changes in the market. The simplicity and broad applicability of the Rule of 40 also make it attractive to investors and analysts.
However, it is not a one-size-fits-all rule that can be applied universally – below are a few of those reasons:
1/ Different software companies have different business models and revenue streams. For example, a company that relies on recurring revenue from subscription-based services may have a different growth rate and profit margin compared to a company that sells one-time software licenses.
2/ It doesn’t take into account the stage of a software company’s growth. A younger company may prioritize revenue growth over profit margins as it seeks to establish itself in the market, while a more established company may focus more on profitability.
3/ It doesn’t account for external factors that may impact a software company’s financial performance, such as economic conditions, changes in industry trends, or unexpected events such as the COVID-19 pandemic (which really made some SaaS providers go up and to the right / others down to the left).
While the Rule of 40 can be a helpful guideline for evaluating software companies, it should be used in conjunction with other metrics and factors to gain a more complete understanding of a company’s financial health.