Decoding the Rule of 40
Rule of 40 holds a critical role in SaaS, serving as a litmus test for investors to gauge valuation potential. This metric underscores the importance of striking the right balance between revenue growth and profitability. Rule of 40 is the sum of Free Cash Flow Margin and ARR Growth Rate. According to the investor perspective, companies that hit a value greater than 40 typically see exponentially higher revenue multiples.
The Significance of FCF and Sustainable Growth
Recently, SaaS companies have been quick to adapt to profitability challenges brought on by the higher interest rate regime. This is evident in the “roller-coaster” dip in FCF Margin, which took a hit in mid-2022 but rebounded in 2023.
Seeing growth rates slow, SaaS companies turned their focus to Marketing and Sales tactics. High sales and marketing expenses are not necessarily a red flag to investors, assuming there’s a healthy CAC Payback. The ideal CAC Payback period usually falls within 12 to 18 months.
However, because Sales and Marketing expenses form a substantial part of a company’s overall costs, it’s worth taking a closer look at these areas when searching for ways to increase efficiency. Especially with the rise of GenAI, sales and marketing teams now have the ability to increase productivity without increasing headcount.
Starting in Q3 2022, many SaaS companies made the strategic move to downsize their sales teams. They held onto their most efficient sales representatives, expanding their individual territories. The result? An increase in sales efficiency demonstrated by greater Bookings per Ramped AE.
On the marketing front, while the cost per Marketing Qualified Lead (MQL) remains relatively consistent between high and low-performing companies, the differentiator is the ability of high-performing companies to convert leads further down the sales funnel. So, it’s not just about generating leads; it’s about getting the right leads and converting them into qualified pipeline and, ultimately, paying customers.
The Other Side of the Equation: ARR Growth
According to the investor perspective, in the current business landscape, most companies have seen a slowdown in ARR growth between Q3 2022 and Q2 2023.
In recent quarters, high performing companies have seen pipeline conversion actually increase, likely due to more stringent deal qualification. However, healthy pipeline coverage is needed to ensure they hit their bookings targets and fuel ARR growth. While a general rule of thumb suggests maintaining 3x pipeline coverage, companies should target a coverage ratio based on their individual conversion rate trends.
Given the importance of retention rates to investors, it’s no surprise that most companies have also placed a stronger emphasis on customer success. Between Q3 2022 and Q2 2023, customer churn rates have remained relatively stable, but companies still saw an 8-9% drop in Net Revenue Retention (NRR). This decline demonstrates existing customers reaching their limits in expansion potential. Regardless, investors expect companies to prioritize expansion as a lever for high Net Retention Rate.
The Rule of 40 is a multifaceted metric with many components that can influence a company’s overall performance and health. To instill investor confidence and boost your company’s valuation, it’s vital for the entire organization to grasp the inner workings of the Rule of 40 – not just the finance team. This understanding will help pinpoint the areas across the business that require fine-tuning to improve top-level performance.
About Discern
Discern is a data analytics and business intelligence platform, connecting go to market performance with financial data. By breaking down functional siloes and driving cross-functional collaboration, Discern is on a mission to help SaaS companies drive sustainable growth as efficiently as possible.
