Rule of 40 for SaaS Business: Top 4 Recommendations to Achieve and Sustain It In Today's World

There is an endless list of metrics to measure the performance of SaaS businesses. However, Rule of 40 is certainly the most widely used and well accepted metric used by Investors, CEOs and Board Members to measure the health of the business, recalibrate strategies and to make investment decisions.

Here are the key takeaways you can get from this article:

1. What is Rule of 40?
2. Why investors focus on this metric?
3. How your business can achieve and sustain it?

What is Rule of 40?

Invented in 2015, the Rule of 40 has become the favorite metric of investors, board members and CEOs alike to evaluate the performance of SaaS businesses.?

It is calculated as: Growth rate + Free cash flow rate > 40

Free cash flow = sales revenue - (operating costs + taxes) - required investments in operating capital.

Why investors focus on this metric

It gives a great indication of how successful the management team is in keeping the business in a healthy state. Consistently missing this mark indicates that something is going wrong in the business. For example:

1. Businesses may not have checked and reduced their spending in proportion to the reduction in growth which SaaS businesses typically face at top of the initial S curve. This has the potential to seriously impact the profitability of business and limit its long term ability to invest in R&D.
2. A high customer churn rate may be responsible for the reduction of growth rate. High churn rate could in turn be due to a myriad of factors such as bad customer service, better products from competitors, lack of innovation etc.

How SaaS businesses can achieve and sustain it

1. Focus on Integrated Operating Metrics: Businesses must create a dashboard for getting a complete picture of the performance metrics to draw meaningful connections.?

For example:

• Expansion (up-sell, cross-sell) and Customer Success. If the investment in customer success is not bringing the desired results then businesses must reevaluate the effectiveness of the program. It can also point to the broken processes which may not be allowing the CS team to get quick resolutions from the Engineering team.

2. Focus on Net Dollar Retention: Companies like Salesforce, Monday.com etc. focus on retaining customers which helps them in maintaining high growth rate. Early stage SaaS companies should place even more emphasis on this metric as churn will inevitably erode their marketing efforts and cause reduced FCF, thereby missing the Rule of 40.?

Net Retention Rate or the Net Dollar Retention Rate is calculated as:?

Monthly Recurring Revenue (MRR) at Start of Month + Expansions + Upsells – Churn – downgrades / MRR at Start of Month

3. Focus on Key Sales and Marketing Metrics: Accurately tracking some key metrics and effectively managing the sales and marketing activities can not only help in reducing the spending but also increase the probability of generating revenue.?

For example:

• Marketing Lead to Sales Qualified Lead: If ToFu (Top of the funnel) activities are generating a high number of leads which are getting rejected by the Account Executive then a change in the content marketing initiatives may be required.?
• PoC to close ratio: Many businesses rush into the PoC stage without a detailed discovery and qualification using tools such as MEDDPICC. This results in increasing cost of customer acquisition especially when it involves spinning up instances. This also adversely affects the new business win rate due to the time invested in pursuing wrong opportunities by the Account Executives.

4. Leveraging AI and Data to Create New Products: SaaS businesses experience reduction in growth rate at the top of the S curve and successful businesses introduce new products to maintain growth. SaaS startups which leverage the Design Thinking approach often end up creating products which deliver unparalleled customer value and open new revenue streams for the business.?Furthermore, companies investing in AI/ML are able to present better up-sell or cross-sell proposition at the right time using right messaging. This increases the chances of boosting the growth rate through existing account base.

For example:

• During my visit to the office of AB InBev- the maker of Budweiser, Hoegarden and other famous brands- I noticed information on BEES. I learnt that it is an innovative SaaS based application developed by AB InBev to help retailers in generating more revenue and streamlining the sales process. They leveraged their enormous production and distribution data to provide insights into customer preferences through the “suggested order” feature in their app which helped retailers in maximizing their sales potential. Currently this application has more than 3.1 million Active Users (MAU)!!

Rule of 40 has proven its worth and SaaS companies across different stages would do well to recalibrate their strategies and tighten their operations keeping it in view to improve the shareholders return and also to get a better EV/Revenue Multiple.

Hope this was insightful and let me know in case you have any thoughts on this topic or feedback!