The 40% Rule

I was catching up on Brad Feld’s blog this morning and saw that he had posted about the “40% rule” for SAAS companies.

I was at the same board meeting as Brad and came away similarly impressed by the simplicity of the rule and the logic behind it.

Here’s the 40% rule and it is aimed at SAAS companies:

Your annual revenue growth rate + your operating margin should equal 40%

So, if you are growing 100% year over year, you can lose money at a rate of 60% of your revenues

If you are growing 40% year over year, you should be breaking even

If you are growing 20% year over year, you should have 20% operating margins

If you are not growing, you should have 40% operating margins

If your business is declining 10% year over year, you should have 50% operating margins

I have never seen growth and profitability so nicely tied together in a simple rule like this. I’ve always felt intuitively that it’s OK to lose money if you are growing fast, and you must make money and increasing amounts of it as your growth slows. Now there’s a formula for that instinct. And I like that very much.

Thanks Brad for posting it.

#stocks#VC & Technology

Comments (Archived):

  1. Avi Deitcher

    Oh nice! I could have used that. Very simple way to explain the investment in growth and its impact.

    1. fredwilson

      yeah, isn’t it?

      1. Avi Deitcher

        I have a friend from B-school, first-class SaaS sales chief (founding VP Sales RightNow, then CRO at other SaaS firms), just sent it to him. He will love it.

  2. andyswan

    A few years ago I had the opportunity to sit with Ricketts….. founder of TD Ameritrade and now owner of the Chicago Cubs.I asked him the key to creating a multi-billion dollar company from scratch.”Grow 30% per year with double-digit profit margins…. for 35 years.”

    1. fredwilson

      oh hell yes. if you can do that, you are golden

    2. LE

      “Grow 30% per year with double-digit profit margins…. for 35 years.”Nice helpful detailed answer from Mr. Ricketts, a true roadmap and “the answer”.Then, there is this:…How much wealth Judge Howard Haralson will award each spouse hinges on the value he places on Hamm’s work during the marriage. The positions the rival attorneys are likely to take may seem counterintuitive. Hamm has an incentive to downplay his role, while his wife has an incentive to lionize him. If the oilman’s lawyers can show Continental’s value grew in large part due to market factors beyond his control, including the rising price of oil, he may be awarded the lion’s share of the wealth.

    3. Richard

      The most important, most practical, (and somewhat difficult) math concept everyone should know is Ln (the natural log).

    4. Allan White

      So, what does that make Slack’s growth rate, if they became a billion-dollar company in 2 years? Crazy.

      1. Matt A. Myers

        I am sure there are a few other factors that come into play in specific circumstances – the 40% rule above is probably the average that you should apply to most.

      2. menriquez

        its called the network effect, and way more powerful then exponential or logarithmic growth

  3. mikenolan99

    Awesome… I feel a research project coming on for my Master’s of Accounting/MBA students… hmmmmmm

  4. William Mougayar

    A SaaS business is becoming very driven by metrics. It’s almost like science and quite deterministic in what success and scale is. The most difficult part is getting to the $1M MRR / $10 ARR stage, then it becomes even more science and about operational execution.Compared to a consumer startup, it’s more difficult to scale a SaaS in the early stage than it is later, whereas the opposite might be true for a consumer startup where it’s easier to scale initially, but harder to maintain scale and go hyper-scale after that.

    1. pointsnfigures

      It is harder to scale it early. I am surprised at the SaaS people that don’t go out and knock on doors to sell at an early stage.

      1. William Mougayar

        well, in the early days of SaaS, you’re trying to figure out what your “repeatable science” will be.

        1. pointsnfigures

          right, I think actually talking to customers helps you think about that.

          1. PhilipSugar

            Exactly right that is the fourth tenet of my management philosophy. Talk to and understand your customers.

          2. LE

            People starting companies (“nowadays”) do whata) they see others do (and you can’t “see” people cold calling)b) what they see others talk (and most importantly blog) about [1] andc) what they personally feel comfortable with and have experience with.I would guess not many people at the core feel comfortable doing any type of cold calling. For that matter I’m always amazed at how little direct mail I get from any SAAS company. Literally nothing. [2]What I typically get is email. And it always looks like spam even if it’s not spam. Never personalized at all or specific. Spray and pray type approach.[1] Memo to all: Most good ideas and things that others do have to be reverse engineered. Most people are not giving away their secrets to success. Although it may sometimes appear that way to the newly hatched.[2] Yet I get literally 10 solicitations a month from Comcast and Verizon for new business internet service.

        2. JimHirshfield

          Right. I like to say reproducible with predictable outcome. That is, with a high degree of confidence, as a sales team, we know that if we do “A” that results “B” will come about.

      2. James Ferguson @kWIQly

        Out there knocking. Got our first significant answer today:)

        1. Mike Bestvina

          Out there knocking too! It’s pretty much a must. (very rare outliers that don’t)

    2. awaldstein

      One of your best comments William.Of course scaling consumer startups earlier is easier but certainly not with double digit margins.

      1. Matt A. Myers

        Economies of scale are nearly impossible to obtain without capital – the only new markets that really open up is when a product becomes available that people with money are willing to pay a premium for (organic/raw juice as an example) – which gives you a higher profit margin which you can cycle back into the business. First-to-market still has an advantage as you can gain efficiencies before others, leading them to needing more capital. There are geographic-based market share grabs of course which can make adoption easier.

        1. awaldstein

          All true…

    3. zackmansfield

      Agree totally that SaaS entrepreneurs are getting smarter about running via metrics; partially due to the depth of blog posts like this which demystify it all. In early days (call it 1-2MM in ARR) there is a danger in extrapolating the early data and believe you are ready to simply “pour gas on it” and expand to 10mm+, which is a big reason for your noted, and true, assertion that getting to 10mm ARR is the toughest.

    4. Joe Cardillo

      Curious, do you think it’s harder to find product-market fit for consumer vs. SaaS?

      1. William Mougayar

        I can’t think that it is a factor. The factors in play are related to your ability to iterate fast enough to find the large market. One difference I can think of is that virality & network effects might be easier to achieve in consumer markets.

    5. Saul_Lieberman

      When we use terms like “rule”, “formula” and “logic”, we should be clear that the 40% rule is a benchmark. It matches the experience of certain successful SAAS companies. There is no logic that it can’t (or shouldn’t) be 50%. (Or at least, the logic has not yet been explicated.)

      1. William Mougayar

        agreed…I think 40% is a minimum. I know that 200% growth is the bar for some VCs at the A-B level investment stage in SaaS companies.

    1. PhilipSugar

      Great deck.

  5. Andrew Kennedy

    This is one of the many AVC posts that I’d like to be able to tag: “golden nugget of knowledge” or GNOK.

    1. JimHirshfield

      – “GNOK, GNOK”- “Who’s there?”

  6. PhilipSugar

    I already used this in a board meeting. It is such a good way of looking at things. It works for different product lines as well.Implicitly you know: this one is growing so lets invest, this one is shrinking so we better make some money, but this just gives you a simple rule.

  7. LE

    I’ve always felt intuitively that it’s OK to lose money if you are growing fast, and you must make money and increasing amounts of it as your growth slows.I think that’s a total investor’s perspective. Obviously it makes a great difference (the details) on what exactly you are losing money on, the details do matter. [1] Exactly how and what you spend your money on is really important to survival.I think what investors some times miss with all this focus on numbers is how easy it is for those providing the numbers to structure things in a way to make the numbers look like what investors would like to see. (Um, Intuitively of course…) One of the reasons for this is that investors typically have never been on the other side (unless they are Mark Suster of course) to see what can be done.[1] Why at the core I don’t like any type of “rule” such as this one.

  8. carribeiro

    I always find fascinating how these “big numbers” show up and work time over time. In a sense, I believe that they are part of a self fulfilling prophecy; people initially settle down around this number because it seems reasonable, tie their projections around it, and then start using it – consciously or unconsciously – as a benchmark. So it ends up converging nicely over time.

  9. David A. Frankel

    Here’s a question for the community: how can this be an indicator of when is the right time to IPO?I’ve always believed that, if you are truly building a sustainable company for the long haul, you either need to be achieving profitability (or it needs to be in your 3-5 yr plan) before you even consider an IPO. Should consistently hitting or exceeding the 40% rule change that notion?On the flip side, can this be an indicator that it is time to sell? Interested in viewpoints.

  10. JimHirshfield

    I love saas MRR. How many companies in the USV portfolio are SaaS?

  11. JamesHRH

    Simple is good. Simple minded……

    1. Matt A. Myers

      Well, as long as someone understands the nuances … then it’s okay..

  12. Matt A. Myers

    Do you know what experience Brad has with SaaS companies? Boards he’s sat on, etc? Curious to see how they’re performing. 🙂

    1. JimHirshfield

      Before he was a VC he ran a SaaS company or three.

  13. Matt A. Myers

    Fred, what are your thoughts on platforms that are a combination of SaaS and other? Would you separate this and apply other metrics to the other parts of the business to best determine outcome?

  14. Alex Murphy

    Do you think this is the formula for just SAAS? It seems like it is good for all growth businesses ….

  15. Richard

    challenging Brad on an issue is always risky, but fucking with the Ln and its Mirror Image e is risky business. Add on top of that the missing dimensional analysis between Customers and $ and this rule leaves me a little wanting for something more. Add in customer acquisition costs $/Customer and Customer retention rate and the rule of thumb may be ready to eat.

  16. Salt Shaker

    In response to A. Swan’s Ricketts comment:The Ricketts family bought the Cubs for $700M in 2009. The team is now valued at $1,200M and is one of MLB’s most profitable, even though the team has continued to suck since the acquisition. Would like to say the increased value is the result of the team’s strong onfield performance but it frankly is more the result of a gen trend in rising team valuations, plus partial ownership of high margin media assets (20% of Comcast Sportsnet Chicago). Nonetheless, I bet the Ricketts family would forego an objective of “30% annual growth” and trade its financial gains for a WS ring any day.

  17. Alex Bugeja

    “If you are not growing, you should have 40% operating margins”…this assumes you’re already making a comfortable amount of revenue and are happy with it. If not, there’s no substitute for growth. The edge case is when you start and your revenue is zero. No amount of margin will be satisfactory.

  18. mikemikemikemikemike

    I’m starting a company tomorrow. Here’s my business model. I’ll be selling $100 bills for $80, and by my calculation I won’t have to spend much on marketing, so I think I’ve got a winner. Any takers?

    1. Brennan McEachran

      depends how fast you’re growing…

    2. menriquez

      what technology will you be developing to make that happen? can it span other printing industries?can it be used to print $200 bills after core adopters get used to the $80 ones?etc etc

  19. judegomila

    Plotting a graph of profitability vs. growth (if the company is running optimal) will be an arc of a circle (max retained profitability = least growth, max growth = least retained profit being the extremes of the arc). Hence the fixed number (40%) between the two added together is the radius of this arc. I guess there is some distribution on that ‘radius’ i.e. the 40% is the average answer of the distribution of the radius of the arc for optimal companies we see today. The 40% idea, seems to check in with a basic way to model profitability and growth.

  20. jsrand

    I wonder how this translates for law firms.

  21. cavepainting

    Growth and Profitability are mutually dependent variables.The choice to be profitable at a certain level in a specific period can fuel or limit growth. Similarly, extent of growth, the mix of customers and their life-time value drives how much margin flows to the bottom-line.Does the 40% rule apply at all times post PMF? I see the risk that it can be misinterpreted by companies to drive to wrong decisions. For example, when the underlying market is growing at 50% but your company is growing at 20% due to flawed execution or sub-standard product, you may want to address this by investing more in the short-term ( at the expense of profitability) so that you can get back to high growth.The size, dynamics and growth rate of the underlying market ( and its adjacencies) are critical to find the balance between how much profits to extract vs. how much to invest.The 40% rule is a great way to ensure you are not going over-board in any direction, but it cannot be used as a standard formula in all situations. Companies with multiple products and multiple customer segments also need to balance the different stages of market and product evolution, and find the best way to optimize across these opportunities.Each company at a point in time is a unique case. It’s level of spending / investments in any time period should ideally be the outcome of a deliberate and well thought out strategy that reflects the trade-offs made by the management team and board.

  22. Radnams

    why 40, why not 30 or 50? how did he come to the number?

  23. David Baratech

    I’d love to know which is the right ratio for a grocery site like, but taking an eventual and plausible long shot horizon with flat or poor growing –as it happens in offline models, then the right ratio would be around 5%. What do you think?

  24. Sam

    Looks like has been following the 30% rule for several years now.

  25. 4thaugust1932

    Why not 50%?

  26. Michael Bolton

    I have swell plan: I’m going to grow my business using the 50% rule and kick everybody else’s ass. (Noting that the 40% number was probably obtained by someone pulling it out of HIS ass.)I love this sort of thing: complete abstraction, arbitrary numbers, no reasoned justification. Pure and simple.

  27. lunarmobiscuit

    Seems like a great rule of thumb, but it makes me wonder… Do the same numbers apply to other high-growth business models? If another business has 10% COGS and likely 30% net margins, does the rule simply change to the “30% Rule”?Or in short, is this really the “Net margin Rule”, with Growth + Expected net margins = 100%

  28. george

    Smooth general rule! Brad needs to run for government!

  29. Jonathan Murray

    There is a relevant range for this metric, though, or if there isn’t, there should be. My sense is that it applies to companies that are past a certain size–I’m guessing $3 million in ARR, though someone with a data set should do an analysis. Growth rates can be very high over a small base for early stage companies, yet the company can also be running a high burn as it invests in market education, early adoption and, in enterprise sales, building a library of APIs that will carry over to other customers. This metric may be simple, but applying it to early stage companies may actually cause them to restrain spending when they should be pouring on the gas.

  30. fredwilson

    none of this matters until you find PMFthat is the single most important thing and you must do it before investing in growth

  31. awaldstein

    A truth that is never repeated enough.Since I’m spending some time in the perishable goods channels with an investment, need to say it is more complex as PMF is tied to delivery and innovation in delivery is really at its infancy in that sector.

  32. James Ferguson @kWIQly

    That’s easy in spaced like ours which is very black and white (wisely) nobody will invest until it’s clear you are onto something. Certainly keeps the burn rate in check! But also dilution.