Understanding the Rule of 40 for SaaS success

Understanding the Rule of 40 for SaaS success

As the Software as a Service (SaaS) market matures, figuring out what it really takes to succeed in this field and how to measure that success can take time. With the cost of borrowing increasing and the level of acceptable risk decreasing, it seems the evermore common answer is the Rule of 40 – the sweet spot between growth and profit. 

It is important for SaaS startups to balance both growth and profit while hitting the 40%+ mark. It’s quite common for such businesses to try and prioritise rapid growth over profitability, which can lead to failure or other issues. 

So what is the Rule of 40 and how can it be used to navigate your private equity investor-level KPIs?

 

Strategies to follow

According to Cody Slingerland at CloudZero, it’s a principle that states a software company’s combined revenue growth rate and profit margin should equal or exceed 40%. If a company generates above 40%, that’s considered a sustainable rate of profit, but if they’re below 40%, they may face cash flow or liquidity issues.

Reaching the 40% margin is not about chasing growth at all costs. It’s about finding the balance between growth and profit. Achieving the Rule of 40 results in sustainable growth and maintaining profitability, leading to continuing success and (hopefully) avoiding any financial problems.

By achieving the Rule of 40, SaaS companies set themselves up for long-term success, so we’ve put together a list of strategies that can help in reaching that golden number:

  • Focus on sustainable customer acquisition – Take time to understand who your target customer segments are and how they align with your product offerings and build a test acquisition programme across multiple channels. Each channel needs to be tracked clearly over time to look at the rolling CPA and ROAS.
    • By having this deep understanding of your customer’s needs and pain points you’ll be able to address them more, thus giving a higher likelihood to convert.
    • By optimising marketing and sales efforts towards these segments, CAC may be reduced over time which in turn will improve profit margins.
  • Implement pricing strategies – Pricing plays a crucial role in determining profit margins – conduct thorough market research to understand pricing dynamics and set competitive yet profitable pricing tiers testing with CRO software where possible. 
  • Reduce operational expenses – Controlling operational expenses is essential whilst you establish a sustainable business model. This is test and scale, not simply chasing growth or grabbing as much of the market as possible. Aim to streamline operations to reduce costs, but without compromising quality. That means prioritising product and customer services over marketing channels (controversially as a CMO) until proven.
  • Focus on customer retention and upselling – Retaining existing customers is often more cost-effective than acquiring new ones. SaaS startups should prioritise customer success and satisfaction, offering excellent support and continually adding value to their product/s. Additionally, upselling extra features or services to existing customers can boost revenue without incurring significant acquisition costs. This is an area to “over-invest“ in as the ROI is so much greater. 
  • Monitor and analyse key metrics – Closely monitor KPIs such as CAC, and CLTV.  The key is to take a rolling look at these metrics to ensure that you stay within the parameters.
  • Make sure you’re calculating it right – We’ve spoken about the Rule of 40 but we haven’t yet mentioned how you calculate it correctly. First, you must work out your YoY revenue growth and profitability margin, then add these together. If you reach 40% or above, you’ve achieved the Rule of 40. 

 

Challenges of falling below the 40% threshold

There are some cases where SaaS startups unfortunately don’t meet the Rule of 40 and there are some rare cases where they manage to make a comeback, but for the majority, it’ll either lead to cash flow problems or liquidity. As mentioned above, it’s not just about hitting a number, it’s about setting the business up for future success. So falling short of the 40% is likely to leave SaaS startups struggling to maintain a successful business in the long run as other parts of the structure may feel the effects of lower financial resources. 

In essence, failure to meet the Rule of 40 usually signifies something bigger than just a numbers problem, it tends to reflect a broader challenge within an operation, that will eventually have a greater impact. That said, if your business investment plan has been predetermined based on an aggressive investment and growth plan, then this is a conversation at investment level. It should be guiding principles, not a straight jacket. 

 

Adapting to market changes as a SaaS startup

Another important aspect that SaaS startups should be aware of is the rate of market changes. It can feel difficult to keep up, yet it is essential to avoid falling behind. Be ready to adapt, be ready to innovate. These parameters can feel limiting, so it’s important to choose your bets carefully. 

The ability to swiftly adapt to the changing market dynamics keeps SaaS companies ahead of the curve and helps them reach the Rule of 40. 

Let’s recap:

  • The Rule of 40 is achieving a 40% balance of growth and profit
  • SaaS startups need to reach this number so they can set themselves up for long-term success
  • Falling below the Rule of 40 can lead to other areas of the business failing
  • Keeping up with the latest market changes is essential to staying relevant and maintaining success

At Moreno, we’ve worked with multiple SaaS startups, helping them scale their operations effectively. If you’re interested in hearing more about how we can help your SaaS business, drop us a message via LinkedIn and we can have a chat.

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