SaaS Barometer Newsletter: Rule of 40 vs Rule of X

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Rule of 40 versus Rule of X The SaaS Metric Battle Begins?

The Rule of 40 was originally popularized back in 2015 by Venture Capitalists Brad Feld and Fred Wilson. They were both at the same board meeting, when another investor articulated the rule to them for the first time. Then they decided to post two different blogs about what was originally coined the “Rule of 40%”, before it became known as the Rule of 40.

The Rule of 40 is simple to calculate as it equals: Annual Revenue Growth Rate (%) + Operating Profit (%). The optimal result is 40+...why?? That answer is for another day!

The two variables that comprise the Rule of 40 can be debated, as to which growth rate and which operating profit measurement should be used.? For private companies the most common formula, which is aligned with the SaaS Metrics Standards Board definition is:

Rule of 40 = Annual Recurring Revenue Growth Rate (%) + Free Cash Flow Margin (%)

Some will argue that in earlier stage, private companies that use EBITDA? (Earnings Before Interest, Tax, Depreciation and Amortization) as the operating profit variable is an acceptable alternative to Free Cash Flow (FCF) margin.

Another factor to consider is the time period used for revenue growth. Leading public company benchmarks, such as those published by Meritech Capital will use current Year over Year (YoY) implied ARR growth rate and the Last Twelve Months (LTM) Free Cash Flow Margin. Others will use the YoY GAAP revenue growth rate, and some even use the Next Twelve Month (NTM) GAAP revenue growth rate.

The latest Rule of 40 median for Public Cloud and SaaS companies is at 32.?

Meritech Capital Rule of 40 Benchmarks *

The point of this edition of the SaaS Barometer newsletter is not to debate the Rule of 40 calculation method, or even to highlight the top performers in the public market.

The goal is to introduce the “Rule of X”,? a new Cloud and SaaS metric recently created and published by Byron Deeter and Sam Bondy at Bessemer Venture Partners (BVP).? You can read their detailed article on the Rule of X by clicking here .

The Bessemer Rule of X was created to address a key question that many SaaS founders, CEOs, CFOs and even investors ask on a regular basis which is: “Is Growth or Operating Profitability more important in the creation of a Cloud company’s Enterprise Value?”

The Rule of X premise is that over time, revenue growth should be valued ~ 2x - 3x higher than Free Cash Flow margin. The Bessemer argument is that margin increase has a linear impact on value, while a growth rate increase has a compounding effect on value. Thus the Rule of X uses a weighted multiple on growth rate resulting in the following Rule of X formula:

Rule of x = (Revenue Growth Rate x Multiplier*) + Free Cash Flow Margin (%)

Thus is you use the current Growth Rate multiplier (M = 2.3), a company with a 30% growth rate and 10% FCF Margin, the Rule of X calculation would be: (30% x 2.3) + 10% = 79

Below is a chart from Bessemer highlighting the relevant importance of growth rate versus FCF Margin over the past sixty (60) months:

* Source: Bessemer Venture Partners Atlas website

Below is a similar analysis conducted by Meritech Capital which was presented by Alex Clayton at Benchmarkit’s SaaS Metrics Palooza ‘23 which can be viewed by clicking here .

As you can see in the below chart, using a two factor regression analysis of NTM Revenue Growth and FCF Margin to ARR multiples, growth rate has had up to an 11.3x higher relative importance to Enterprise Value:NTM Revenue multiples than FCF margin.? The current weight? (January ‘24) of Revenue Growths’ relative importance to FCF Margin is ~ 2.3x.

* Source: Meritech Capital Presentation at SaaS Metrics Palooza ‘23

Below is a chart that highlights different combinations of revenue growth and FCF margin and how those combinations impact Enterprise Value:Revenue multiples:

* Source: Meritech Capital Presentation at SaaS Metrics Palooza ‘23

Meritech Capital also has an alternative to the Rule of 40, which they call the “Meritech Rule of 40”. It applies the same principle by using a multiplier times the growth rate using a two-factor regression of NTM revenue growth and NTM FCF margin to the ARR multiple.

Using January 2024 financials, the Bessemer Rule of X for publicly traded Cloud companies ranges from a high of 125 to a low of negative 156 (-156).? The Rule of 40 has a high of 66 and a low of negative 120 (-120).??

It is interesting to note that when comparing the top 16 companies as measured by their Rule of 40 vs Rule of X score, only one of those top 16 saw a material difference in where they ranked? by moving 4 places.? This comparative analysis was conducted by Dave Kellogg, author of @kellblog and a fellow metrics brother on the SaaS Talk podcast.

Using the Bessemer characterization of Good, Better, Best they recommend a Rule of X at:

Good:? ~12% Growth Rate *2 + ~16% FCF = 40+ Rule of X

Better: ~15% Growth Rate *2 + ~20% FCF = 50+ Rule of X

Best: ? ~25% Growth Rate *2 + ~20% FCF = 70+ Rule of X

It is important to note that the Rule of X is most applicable in “mid-stage” and “late-stage/public” companies that have reached a positive FCF Margin. For early stage companies with a Burn Multiple greater than 1 ( ~ 1.0x - 1.5x) and a negative FCF Margin, the Rule of 40 is a better metric to measure the balance of growth and profitability.

One of the most interesting points about the Rule of X is the correlation to Enterprise Value:NTM Revenue multiples.? As measured by R-Squared the correlation for the Rule of X is .64, whereas the Rule of 40 correlation as measured by R-Squared to EV:REV multiples is ~ .30.? However, it is important to note this could be viewed as circular logic, since the multiple (M) used for the growth rate was derived using a linear regression calculation.

The Rule of X is new, so it has not yet had the chance to be evaluated against the “test of time” across multiple quarters and different capital environments.? One of the key questions I have is who will be the authority that will calculate and publish the Growth Rate Multiplier (M), and how often will it change???

Based upon my experience with the lack of “standardization” of calculating even the most tried and trued SaaS metrics - like the Rule of 40 and CAC Payback Period, I am concerned about any metric that uses a sophisticated two factor regression model to determine the key variable in calculating a SaaS metric that is primarily an investor versus operator metric.

As a founding member of the SaaS Metrics Standards Board, I have seen how challenging creating industry standards can be.? I can only imagine how difficult it will be using a variable (M) that is constantly changing based upon public market investor trends and ever changing priorities.

If you are interested in learning more about the Rule of X, below are a couple good resources to look at:

• Bessemer Venture Partners Rule of X Article: bvp.com/atlas/the-rule-of-x
• SaaS Talk with the Metrics Brothers - Rule of X Episode: bit.ly/RuleofXSaaSTalk