The Rule of 40 and its Impacts on Software Companies
The global economy is shifting before our eyes; over the past year, the IMF has cut global growth forecasts from 3% down to 1.7%. How does this slower pace of growth impact the tech industry? In the past, we have talked about other important metrics outside of revenue growth and during the bull-run of 2020-2021, investors were concerned with growth vs profitability. However, now CEOs are shifting to a mindset of sacrificing growth for profitability. This is where the Rule of 40 comes into effect.
What Is the Rule of 40?
The Rule of 40 is a framework that indicates the sum of a software company’s revenue growth and EBITDA margins should be equal to 40% or higher, if it is to be deemed “capital efficient”. Software management teams, industry watchers, and board members like this metric because it combines a company’s operating performance all into one number. [1]
Our analysis of 220 software companies found those that exceed the Rule of 40 traded at higher enterprise value (EV) / revenue multiples than that of their peers (Exhibit 1). We screened out companies with less than US$50mm in revenue or market capitalizations lower than US$100mm.
Why Does the Rule of 40 Matter?
Software companies are particularly affected by the Rule of 40 because they rely heavily on recurring revenue streams, which can be affected by changes in customer acquisition and retention. Companies with a high Rule of 40 score are typically seen as more attractive to investors because they are characterized as “capital efficient” and often have strong and resilient business models.
Exhibit 1: The Rule of 40 for Software Companies Traded on the NYSE, NASDAQ, and TSX
How Does the Rule of 40 Impact Software Companies?
While multiples over the last year have depressed and valuations are starting to impact the private market, tech start-ups are decreasing in value this year, mirroring the fall from their publicly listed counterparts.[2] However, companies that exceed the Rule of 40 are still trading at higher valuation multiples, which is putting pressure on CEOs to shift from a “growth at all costs strategy” to pursuing realistic growth targets while maintaining profitability (or at least some level of it). This means prioritizing net revenue retention and free cash flow, among other things.
Challenges Affecting Software Profitability:
Earnings multiples have fallen from their peaks during the pandemic, and many mega-cap tech stocks continue to look overpriced as profit outlook looks to be lowered further by rate hikes as the Fed may push the economy into a recession. One of the larger concerns for market participants is the impact Q4 results will have when they are released later in January, which could indicate continued weakness in demand and impose widespread layoffs at more tech companies. Overall, analysts estimate earnings for the S&P technology sector to be 20.1x earnings, above the 10 year average of 18.9x.[3]
Further, US based companies that generate revenue outside of the US may see earnings depress when the US dollar rises. This is because it cuts into revenue from abroad and a significant portion of software companies generate revenue from outside of the US. Historically, the broader technology and telecommunications sectors have more international revenue exposure than the rest of the S&P 500.
Limitations to the Rule of 40:
It is important to note that the Rule of 40 is not a one-size fits all valuation metric. This can be seen in many early-stage companies that are looking to raise VC capital. For example, early-stage companies looking to raise VC capital usually won’t fit this paradigm. Especially if they are pre-revenue. But even early-stage companies with rapidly growing revenue might greatly exceed the Rule of 40 due to the “law of low numbers” that leads to high revenue growth. Nevertheless, where this theory works is for companies close to exiting the growth stage and into a more mature lifecycle phase where consistent profitability is to be expected.
Written by Coleton Smith
Photo by Charles Deluvio