There are many SaaS businesses that focus more on acquiring and keeping customers rather than on increasing gross margins, especially during the early stages of the business. This approach is logical because a company can increase its revenue by attracting new customers and maintaining relationships with existing ones, rather than just selling more to the same customers.
However, there is an important point to consider.
Revenue growth refers to the increase in the total money earned from all sales. Gross margin growth, on the other hand, measures the profit left after subtracting the cost of goods sold, expenses, and taxes.
With this particular understanding, it is difficult to determine whether your company is developing sustainability, and whether you should focus on enhancing profitability or increasing your market share. The Rule of 40 in SaaS businesses becomes relevant in this scenario.
Understanding the Rule of 40
The Rule of 40 is a metric which is used by business owners when they want to determine whether the profit margin of he company and its revenue growth rate is at 40% or not.
Companies with a SaaS business model that exceeds this threshold are typically performing well and generating consistent profits. Those that fall below 40% may be experiencing challenges with cash flow or liquidity.
A brief look at the origins of the Rule of 40
Venture investor Brad Feld introduced and popularised the term “Rule of 40%” in February 2015m which means that the term and the concept have been there for a decade. The investor mentioned that the rule is typically applied to companies with annual sales exceeding $50 million.
How does the Rule of 40 work for SaaS companies?
Along with understanding the Rule of 40, it’s important to know how it operates. The Rule of 40 is SaaS helps determine whether your company is achieving a healthy balance between profit and growth, and there are different scenarios you should consider.
If you observe that your company is not growing, then your profit margin should be at least 40%. On the other hand, if you are not growing at 40%, you can have zero profit. Similarly, your profit should be 20% if your company is growing at a rate of 20%. If your company is growing at 50%, you can afford to have a loss of up to 10%.
The two main factors that determine whether you are above or below the 40% threshold are your revenue growth and your profitability margin. We recommend visiting the website Zingmatrix for more detailed information on the Rule of 40 for SaaS businesses.