Is the Rule of 40 dead for SaaS?

Recently, I was reading the article published by Bessemer Ventures talking about the Rule of X and fallacies in the Rule of 40. So, it got me intrigued as I did fall in the category of one of those operators and investors who did somewhat believe in the rule. As they suggest, was I behaving like the kid in the marshmallow study?

Article on Rule of X here.

The more I dug in, there are merits to some of the arguments, but like anything else in the world, the devil is in the details, and following any rule blindly only leads to bad endings.

For most investors, operators, founders, and CEOs, the Rule of 40 has become a mantra. I have heard investors say to me many times. It is - A clear guidepost. A metric. A golden rule.

Point taken: Simplify. It is easy to understand, easy to measure (mostly), and simple yet powerful.

Counterpoint: Simply but not be simplistic.

McKinsey's research reveals that only about one-third of software companies meet the Rule of 40 criteria. Even fewer can maintain it consistently. I believe they analyzed over 200 software firms and only 16% of the time companies surpassed the Rule of 40 benchmark.

Article on McKinsey Research here.

So what? Good, I say. Still, a good benchmark for a company to set for and march towards.

Rule of X (as Bessemer puts it) gets interesting addressing the core issue with the rule of 40, which unfortunately gives equal credit to both free cash flow margin and growth rate. Everybody wants profitable growth. VCs do want growth metrics for early-stage and PE investors like the FCF metric for companies already at the top of the S-curve.

Per Rule of X, the growth metric is fudged with a multiplier (based on the stage of the company) and then added to the FCF margin.

I think it is fair, as every company is in a different stage of its evolution and at no stage should be burdened to meet an arbitrary metric. However, Rule of X, I believe is good from an analytical exercise point of view and difficult to implement as an investment or operating metric.

For example, an early-stage company looking to grow and sign on new customers, should not strive to preserve margins but at the same time cannot be blind to what it takes to gain new customers.

In the end, if you have high customer churn and need to continuously acquire new customers by spending insane Google or Facebook ads and having a large support team, you are bound to go out of business. So, was growth an important metric? Hmm. Not so much if you cannot turn a profit at some point.

In my opinion, Rule of 40 attempts you to at least be disciplined about margins and think about efficiency so as a Founder/CEO you have a plan in place to manage costs in the future or know exactly what you are doing and why!

In summary, following any rule blindly is problematic. You have to look at other important metrics (SAAS World cannot get enough of metrics! I can count about 24). But, as a business manager, you have to be constantly asking;

• What I am spending to acquire and keep a customer?

• How much value ($) do I expect over the life of the customer?

• Am I generating enough return on the employed capital?

I think that’s all I want to say about these rules.. Please comment or DM me for your take on this rule.