Why you Should Care About the Rule of 40!

In previous blogs we have talked about the importance of metrics other than just revenue growth.  This is particularly important for established software businesses that are looking to pursue M&A.  Some buyers (and investors for that matter) use the Rule of 40 when evaluating prospective investments. But what is the Rule of 40 and why should you care?

What is the Rule of 40?

Rule of 40 basically is a balance between growth and profitability.  The rule states that a company’s growth rate plus profitability (we use EBITDA because its indifferent to capital structure) should be greater than 40%.  So, if your growth rate is 30%, your EBITDA margin needs to be 10% of better to be able to garner an attractive valuation.  If you’re EBITDA margin is negative, this negative margin gets subtracted from your revenue growth to arrive at your score.

Why should you care?

This rule is quite appropriate in today’s market where there is so much Private Equity money as it values cashflow (which PE investors care about) with revenue growth - which in today’s world of elevated multiples is the only contributor to valuation growth – because it sure isn’t going to come from multiple expansion.

Let’s take a look at a few examples so we can get a better handle on this.  Say for example that a company is growing revenue at 10% per year.  If the same company isn’t doing 30%+ EBITDA margins there isn’t much hope for the company to return much cashflow to shareholders because it can’t grow quick enough to deliver robust cashflow growth.

Where it becomes harder is to apply is hyper growth companies that are still growing extremely rapidly.  For example, a company that is growing 100% year-over-year but is EBITDA negative to the tune of -60% margins, will have a score of 40.  But at this point it becomes a question of access to capital, CAC/LTV ratio and other metrics that determine if that investment in near-term losses is economically attractive long-term.

Where the model doesn’t work

Obviously, the Rule of 40 doesn’t work in all instances.  For example, early stage companies looking to raise VC capital usually won’t fit this paradigm.  Especially if they are pre-revenue (obviously).  But even early stage companies with rapidly growing revenue might greatly exceed rule of 40 due to the law of low numbers that lead to a high revenue growth %.  So in our view its really only applicable to companies that are a little more established.

Ed Bryant