Are you a new SaaS business trying to maintain steady revenue growth and profitability? Then the Rule of 40 will be very helpful for you to determine the health of your company and build a successful business. If you are still unaware and don’t know how to go about it, then worry not! In this blog, we will explain it in detail, along with its benefits, use cases, and best practices. So keep reading till the end!

What is the Rule of 40?

According to the Rule of 40, the combined value of the revenue growth rate and the profit margin should exceed or equal 40%. Most SaaS companies that can achieve this can generate healthy and sustainable revenue growth and profit margins, while companies that cannot may face issues with cash flow and liquidity.

The concept was first popularized in February 2015 by venture capitalist Brad Feld. In his famous blog post titled “The Rule of 40% for Healthy SaaS Companies”, he shared how he first learned about this rule from a late-stage investor. In the same meeting with them was Fred Wilson, whose blog about the Rule of 40 also became quite famous, but Brad Fled is considered the one who popularized it.

According to this theory, investors can determine the financial health of companies and decide on their suitability before investing in them. While the investor considered only companies with an annual revenue of $50 million were suitable for it, Brad Fled believes that this rule also applies to companies earning an annual revenue of $1 million.

Simply put, the Rule of 40 applies to early-stage SaaS companies that are not yet profitable or barely profitable to still get a reasonably higher valuation if their growth rate can neutralize their burn rate. Combining a company’s recurring revenue growth rate and profit margin actually helps companies get investors to boost their business and even investors can avoid downside risks.