The rule of 40 is not only correlated with valuation, it is also a strong indicator of company survival and the persistence of its competitive edge
The rule of 40 is something most of the VC/PE ecosystem lives by, especially for SAAS . We certainlty do it at FortinoCapital.
Like every rule, we follow it- but it is also important to dig further and make sure of its relevance and importance- here are more reasons why.
1Why “the rule of 40”?
From LinkedIn (bought by Amazon) or Twitter going to IPO , there is a myriad of tech companies , and especially Saas companies, which went public, or got bought, at billion dollars valuation , despite exhibiting negative earnings and cash flows (P.S.: for memory, Linked/Twitter got to more than twenty billion each at time of purchase/IPO (1) ).
In those cases, traditional ways to get a sense of pricing do not make sense (2). EBITDA multiple can’t work as EBITDA may still be negative, while Discounted Cash Flow analysis may be complex, because cash flows are not necessarily stable and perpetuity value to define terminal value is difficult to develop as growth can be higher than weighted cost of capital, especially in the early years of life of companies ( PS, for memory, the SAAS market has been growing at about 20% in last 15 years, and most mature SAAS companies have weigted cost of capital lower than 15%).
Many authors (3) instead have promoted the rule of 40 , — that is the sum of revenue growth and of profitability- as a strong predictor of enterprise valuation. The idea is that the rule is solid enough for high tech as it measures profitable growth, and it clearly shows the trade off between profitability in late stage and growth in early stage of a venture.
2. Rule of 40 at the light at evidence
Does the rule resist the evidence? We have recently looked at a sample of 100 Saas companies which went public in the last 10 years, and also offer a positive EBITDA as well a positive free cash flow.( PS: By the way, and contrary to wisdom, a large amount of SAAS tech generate very strong cash flow, eg, Salesforce, a cloud-based software company that provides customer relationship management software solutions, has recently announced free cash; Adobe generates more than USD $3.6 billion while Shopify, an e-commerce platform that provides online store management software is nearing to USD 1 billion).
Based on regression analysis, where we regress enterprise value on one factor, -rule of 40-, where profitability is measured in various ways (EBITDA, EBIT or Free cash flow), we find that “the rule of 40” explains about 1/3 of the variance among SAAS firms- especially when profitability is measured by Free Cash flow . This is surprisingly encouraging as traditional Fama-French multifactor cross-sectional models of stock returns typically explain 40–50% of observed variance (4).
Thus, by this benchmark, the rule of 40 can indeed be the main factor of valuation for (established) SAAS companies.
3. Rule of 40 is just much more than a valuation bench
Those results have also three other overlooked implications:
a) The first is that by definition of the regression, a SAAS firm valuation scales with top line revenue, and its profitable growth momentum. The difference can be striking — we also have collected data from a recent Capchase report on 400 early start up SAAS companies metrics by 2022 (5) — comparing the median Saas versus the top quartile of Saas companies. The median meets a rule of 30 (below 40), while the other goes up to 90, or much more than the rule of 40.
As the attached exhibit shows from our computation, top quartile SAAS companies would generate 3 times more revenue than the median Saas in a decade, while the net earning would become positive after 7–8 years but struggles to be cash positive for the median firm. Based on the regression, the net present value at cost of capital of 10% makes the top quartile valued more 5 times more than the median — provided that both groups converges in growth and cost of capital. In reality, however, mean reversion is limited in high tech and divergence and winners take most are the rule (6), rather than divergence. By the same token, cost of capital is better for top companies as their weight make them behave more like the fluctuations of the economy. In those circumstances, valuation of top quartile may be more 8 o 10 times the median.
b) The second implication is that meeting the rule of 40 for a companies gives a strong reinsurance of competitive edge. If one believes Bessemer Venture Partners (7) , the median free cash flow margin for public SaaS companies in 2020 was around 8%, — this implies that a SAAS company meeting the rule of 40 would exhibit a long term growth rate at 32%, annually -or twice the market rate of SAAS spending, or a rate that is often great in long term to consolidate a market. Think for instance of Adobe, born in the early 80’s who grew at a rate of 35% per year in the first 20 years of its existence — and was still growing at an average rate of 20% in the last 10 years. Based on such growth in the creative software market, and its popular products such as Photoshop, Illustrator, and InDesign,Adobe is now by far the dominant player with a market share estimated at around 75% by some sources.
3. In long term, margins of successful SAAS converge to 20%, thus they are to at least grow just above market growth, to meet the rule of 40 as well as sustain their edge.
But for early start ups, whose journey is still to be performed, falling beyond the rule of 40 is a real sign of danger. Gettign to grow at marekt rate at 20% is also a real no go as it shows no sign of grow beyond the help of the marekt. Extrapolating from arecent study by CB Insights (8) which found that startups with less than 20% of annual revenue growth had a failure rate of 92%, but only 1% for long term rate of 60%, we conclude that 40% systematicvgrowth rate is where the odds to fail become lower than the odds ot win. The rule of 40 is also a critical sign of ability to survive for enterpreneurs.
(1) Hottenhuis, B. (2020). Investigating an alternative approach to SaaS company valuation: using ‘Rule of 40’metrics as indicators of Enterprise Value Master’s thesis, University of Twente.
(2)Damodaran, A. (2001). The dark side of valuation: Valuing old tech, new tech, and new economy companies. FT Press.
(3) Depeyrot, T., & Heap, S. (2018). Hacking Software’s Rule of 40.
(4) Aharoni, G., Grundy, B., & Zeng, Q. (2013). Stock returns and the Miller Modigliani valuation formula: Revisiting the Fama French analysis. Journal of Financial Economics, 110(2), 347–357.
(6) Bürkner, H. P., Reeves, M., Lotan, H., & Whitaker, K. (2019). A Bad Time to Be Average. Boston Consulting Group.
(8)CB Insights. (2019). The top 20 reasons startups fail. Retrieved from https://www.cbinsights.com/research/startup-failure-reasons-top/
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