Rule of 40: A Critical Gauge in Tech M&A

by | Jun 29, 2023

Home 5 Agile Thinking 5 Rule of 40: A Critical Gauge in Tech M&A

The software industry is no stranger to the world of mergers and acquisitions. Such transactions occur when company founders and shareholders opt to sell or during capital raising and growth-oriented acquisitions. In tech M&A, figures and ratios hold a dominant position. Both investors and software company founders require explicit performance and potential growth benchmarks. At Tetra Investments, it’s paramount for all involved parties in an M&A deal to understand these figures. One such benchmark, gaining widespread recognition due to its relevance, is the ‘Rule of 40’.

The ‘Rule of 40’ has become a crucial guideline for SaaS businesses, private equity establishments, and venture capital firms. The rule is integral to assessing a company’s equilibrium between growth and profitability.

Decoding the Rule of 40

The Rule of 40 asserts that a good software company’s growth rate and profit margin should collectively reach at least 40%. This rule verifies that the company is not sacrificing profitability for growth or vice versa. If your company’s yearly growth rate is 30%, your profit margin should be at least 10%. The harmony between growth and profit symbolises efficiency and shows that the company can develop responsibly without depleting capital.

Significance of the Rule

The Rule of 40 is a definitive measure of a company’s wellness and future potential. High growth rates are appealing, but excessivegrowth without considerable profitability may raise alarm bells for potential investors. The Rule of 40 assists in balancing the allure of high-growth possibilities with the assurance of profitability. The Rule of 40 is not a universal solution. Growth may be prioritised for companies in their early stages, while profitability might be more important for seasoned companies.

Rule of 40 in Practice

Consider the cases of two hypothetical software companies—SoftTech Alpha and SoftTech Beta.

SoftTech Alpha is growing rapidly at an annual rate of 60% but is operating at a loss, with a profit margin of -30%. Its Rule of 40 calculation is 60 + (-30) = 30, falling short of the 40% benchmark. Contrastingly, SoftTech Beta is growing more steadily at 20% per year but maintains a robust profit margin of 30%. Its Rule of 40 calculation is 20 + 30 = 50, comfortably surpassing the benchmark.

Though SoftTech Alpha might initially seem more attractive due to its high growth rate, the Rule of 40 suggests that SoftTech Beta is a healthier option due to its balanced growth and profitability.

Enhancing Your Rule of 40Score

For founders aiming to improve their Rule of 40 score, the answer lies in equalising revenue growth and profitability. This may involve tactics like optimising pricing models, emphasising upselling or cross-selling to existing clientele, and investing in customer retention strategies to minimise churn.

While it’s crucial for evolving companies to concentrate on top-line growth, adopting approaches leading to cost optimisation and improved operational efficiencies can significantly boost profitability—thereby positively affecting the Rule of 40 score.

Navigating M&A Terrain with the Rule of 40

As specialists in tech M&A, Cube Capital utilises the Rule of 40 as one of numerous tools to evaluate the wellbeing and potential of software companies. It serves as a valuable yardstick for both software company founders and investors, providing a comprehensive view of a company’s growth and profitability equilibrium.

Every company is distinct, and the Rule of 40 is one ofmany metrics to consider in an M&A context. It aids in sketching a detailed picture of the business, but it’s not a substitute for meticulous due diligence or comprehensive financial analysis.

The Rule of 40 is restricted in its scope. It doesn’t account for crucial elements like market potential, competitive standing, product innovation, and managerial quality. These elements are pivotal in an investor’s decision-making process for investing in or acquiring a company.

Rule of 40’s Genesis

The inception of the ‘Rule of 40’ isn’t credited to any person but has gradually evolved within the tech sector. Its groundwork is based on several years of observing the financial dynamics of successful software companies and identifying a pattern that harmonises growth and profitability.

The concept started gaining momentum in the late 2000s and early 2010s, coinciding with the surge of SaaS (Software as a Service) enterprises. Venture capitalists and private equity firms have widely accepted it as a yardstick to evaluate software companies’ growth and potential.

Final Thoughts

The Rule of 40 presents a compelling equilibrium between two fundamental parameters that all software companies must wrestle with—growth and profitability. It provides a quick assessment tool to evaluate whether a company is growing responsibly and sustainably, which can be a significant boon when seeking investors or potential buyers.

The most fruitful M&A outcomes are derived from a comprehensive understanding of a business beyond its numerical aspects.

At Cube Capital, we believe in pairing the Rule of 40 with an in-depth evaluation of the business—its product offerings, market presence, competitors, and more—to identify the most enticing opportunities for our investors and acquisitions clients.