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Metrics

Exceptions to the Rule of 40: Why Good SaaS Companies Sometimes Fall Below the Threshold

Sean Cantwell
Volition

The Rule of 40 has become an increasingly popular metric to evaluate SaaS companies at scale. The basic premise is that companies generally command a premium valuation if their year-over-year revenue growth rate + profitability margin = 40% or higher. 

In our analysis of the Rule of 40 earlier in 2020, we looked at 65 publicly traded SaaS companies in 2018 and 2019 using Capital IQ. We found that The Rule of 40 is a generally useful metric at a high level, as the 18% of companies that beat The Rule of 40 in 2019 did command higher valuations than those that didn’t. However, on an individual level, there are still exceptions to The Rule of 40. This indicates that the Rule of 40 is a surface metric that can provide base-level insights that should then be investigated further.

The purpose of this article is to explore the limits of The Rule of 40, highlight a high-profile example of a good company that doesn’t meet The Rule of 40 threshold, and explain why it can sometimes be beneficial to drop below The Rule of 40 as a private company in pursuit of longer-term growth.

Limits of The Rule of 40

As metrics go, The Rule of 40 is relatively simple. It really only looks at two inputs: revenue growth rate and profitability margin. This means that other relevant metrics or factors that can provide important context are not considered.

For example, The Rule of 40 ignores retention, an incredibly relevant metric for SaaS companies. It’s also just a snapshot in time, and because it’s a percentage metric rather than an absolute metric, it isn’t really useful until a company has reached a certain degree of maturity. Growth at scale is significantly more impressive than early-stage growth when the customer base is relatively small. 

Furthermore, if your company has been capital inefficient, by the time you reach The Rule of 40 consistently, you might not own much of the company. In this case, even if you command a premium valuation, you won’t see much of that capital.

Finally, The Rule of 40 does not speak to the value of your specific market. You could beat The Rule of 40 in a sector that investors do not care about, and it would hardly move the needle in terms of valuation. 

A Notable Exception to the Rule of 40

If you look at our graph of 65 publicly traded SaaS companies in 2019, you’ll see several companies in green that fall below the diagonal line. This means that they command 20x+ EV/R multiples but do not beat The Rule of 40. One prominent example is Okta, an identity and access management company. In 2019, Okta experienced nearly 50% growth, but its EBITDA Margin was at nearly -30%, falling well short of The Rule of 40. Nevertheless, it was one of the highest valued companies on the list, and it’s stock price has continued to soar in 2020.

65 Publicly Traded Companies Charted Against The Rule of 40. Source: Capital IQ

As we begin to investigate the reasons for this high valuation, the picture becomes clearer. Situated at the confluence of three wildly important tech trends — cloud, digital transformation, and security — Okta is in a massive and growing market. 

Additionally, over the last several years, markets have rewarded companies that pursue growth over companies that pursue profitability. Companies in the bottom right quadrant saw nearly double the EV/R multiples on average than the companies in the top left quadrant. 

While analysts at SeekingAlpha have consistently viewed Okta’s stock as overpriced, they do cede that the company’s fundamentals are strong, and it has consistently overperformed their predictions. They also note that the pandemic’s impact on digital transformation has buoyed its stock price to all time highs, despite a SG&A expense margin that is quite high. As of April 2020, the company was spending 104% on SG&A plus R&D relative to its sales margin, which means they’re investing heavily in future growth. (note: SeekingAlpha calculates The Rule of 40 using free cash flow margin, which accounts for the difference in figures between our analysis and theirs). 

The Rule of 40: More What You’d Call a Guideline than an Actual Rule

In our last post, we compared the Rule of 40 to the story of the tortoise and the hare; sometimes it pays to be fast and chase growth, but other times it pays to be slow and steady and chase profitability. Another reference that seems apt comes from Pirates of the Carribean. When asked about the Pirate’s Code, Captain Barbosa indicates that the Code “is more what you’d call guidelines than actual rules.” 

The Rule of 40 is very much the same. It gives you a limited snapshot in time and acts as a valuation guideline. Companies should evaluate their specific market and capital availability to determine if sacrificing short term profitability in pursuit of responsible growth is the correct decision.

In many cases, investing in R&D and new products can have a huge payoff in the long run. You might dip below The Rule of 40 threshold, but, as we’ve seen with Okta, this doesn’t make you a bad company. In fact, investors might have significant appetite for negative EBITDA margins in the right circumstances. If you have a huge market and captive and happy customers, it might make sense for you to make investments in your company that take you below The Rule of 40 but help your valuation in the long run.

Meet the Authors:

 

SEAN CANTWELL

Managing Partner

Sean Cantwell is a managing partner and member of the founding team at Volition Capital. He focuses primarily on companies in the Software and Tech-Enabled Services sectors.

Connect with Sean:

LinkedIn

 

Pete Keenan

Sr. Accountant

Pete joined the Volition Capital team in the Fall of 2019 to support the investment team with fund administration, financial modeling, and legal document review.

Connect with Pete:

LinkedIn

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