Rule of 40 - Measuring Technology Startup on Profit & Growth

It is tough to balance between growth & profits for startups founders. VCs reward startups with high growth. The rule of 40 became a well-adapted industry standard to measure technology startups. Rule of 40 says that a tech company can make losses, burn cash as in order to drive growth — as long as the company is scaling the business and growth is more than 40%.

The math is easy

• Growth = 100% you can have a burn rate of 60%
• Growth = 50% you can have a burn rate of 10%
• Growth = 40% you can't burn cash, you have to break even
• Growth = 20% you should have a 20% profit margins
• Growth = Flat 0% you should have 40% profit margins

 This is a simple rule of thumb to measure and track technology startups. It solves the complex question for founder on how to balance growth and profitability.

Rule of 40 was first written by Brad Feld

While the punch line is that you can lose money if you are growing faster, the minimum point of happiness is 40% annual growth rate. - Brad Fled

VCs want to see outlier hits in their portfolio. They invest in an illiquid asset class like startups for high returns. Big outsized returns are only possible if there is perpetual velocity and virality in startup growth. VCs guide startup founders to drive growth, hence the growth capital. Every VC fund has a life of 10 years, it has LPs (Limited Partner) which are the investor in fund managed by the VC (General Partner). So every investment made by a VC is driven by a timeline to return the capital back to the LPs with profits. This creates a situation for VC to drive founders towards growth.

VCs will get attracted to Company B if they are not running out cash. VCs are attracted to growth but not mindless growth. The unit economics has to have a path to profitability. If the company burns all the cash before it raises venture capital it's a failed idea. There has to be a proper plan to use funds, acquire growth and maintain unit economics. Startup founders once raise venture capital is on a treadmill seeking new rounds of funding and with new growth expectations. The Rule of 40 is for investors to measure a startup company and not blanket permission for founders to burn all the cash in the name of growth. Founder in the false of hope getting the next round of funding burns cash and drives themselves to point of no return. VCs evaluate companies basis on if the costs remain the same does the startup have capabilities to build profit margins. If yes then these startup ideas are breathing life and kicking their way to growth.

Use startup growth calculator by Trevor Blackwell

Once you're profitable, you control your destiny: you can raise more to grow faster if you want. - Trevor Blackwell

While VCs focus on measuring the startups using Rule of 40, Tech founders should focus on product-market fit by tracking 6 metrics Customer Churn, Revenue Churn, Customer Lifetime Value, Customer Acquisition Cost and Months to Recover CAC

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