'Rule of 40' Is in Fashion for Software --- The financial threshold is held up as a mark of success in the sector, but it often means less than it appears

"Like hemlines and haircuts, stocks go in and out of fashion. So do the ways companies communicate their performance to investors. Whatever numbers investors want to see, management will supply them, especially if they can be easily tailored to look flattering.

 

For so-called SaaS companies, selling software as a service, a favorite metric nowadays is something called the "Rule of 40." The first thing to know is it isn't a rule, because there is no standard definition for what it means. For some companies it has become a big deal to claim membership in the "Rule of 40 club" nonetheless.

 

In general, the rule holds that a company's revenue growth [1] plus its profit margin [2] should be 40% or greater. So if a company has 20% revenue growth and a 20% margin, it gets to be in the club. Same for 40% growth and no margin, or 30% growth and a 10% margin.

 

Brad Feld, a venture-capital investor, popularized this notion with a blog post back in 2015 called "The Rule of 40% For a Healthy SaaS Company." The term's first appearance in a company's Securities and Exchange Commission filing was in 2017, going by the results of a database search on the SEC's website. A 2021 study by McKinsey, the consulting giant, is credited for helping spread its usage and showed that the market rewarded companies with higher valuations if they are at or above the Rule of 40.

 

Here is where it starts to fall apart: While revenue has a standard meaning, there is no consensus on which measure of profit companies should use to calculate the margin component. Should it be operating income? Net income? Cash flow? Maybe some nonstandard version of earnings or cash flow? The numbers that companies are showing lack comparability because they aren't apples-to-apples, and the companies often don't show their math.

 

But say everyone could agree on a particular margin metric to use for the calculation. The traditional one that McKinsey recommended was free cash flow. This typically is defined as operating cash flow [3], which has a standard definition, minus capital expenditures. Even then, the metric's usefulness starts to crumble. Done this way, the rule favors companies that rely heavily on stock-based compensation to pay their employees, while punishing those that don't and instead pay more heavily in cash. That is because free cash flow, like operating cash flow, excludes stock-based pay, which is a real cost that counts in companies' reported profits.

 

David Zion, founder of Zion Research Group and a longtime accounting and tax analyst, in a December research note did his own Rule of 40 calculations for North American application-software companies with stock-market values of greater than $1 billion. For this exercise, he took the sum of revenue growth plus free-cash-flow margin using the latest reported four quarters. Of the 98 companies in the group, 33 of them met or beat the Rule of 40. However, when he adjusted free cash flow to treat stock-based pay as an expense, only 11 companies still met or beat the Rule of 40 under both methods. They included Palantir Technologies and Constellation Software.

 

At Freshworks, for instance, during the company's recent earnings call, Chief Executive Dennis Woodside said, "adding our revenue growth and free-cash-flow margin for Q3, we exceeded the Rule of 40 in the quarter." Indeed, Zion calculated that its Rule of 40 number was 41%, which put Freshworks at No. 29 on his ranking out of the 98 companies. Revenue growth was just over 20%, and so was free-cash-flow margin.

 

But when Zion adjusted Freshworks' margin figure to treat stock-based pay as an expense, its Rule of 40 number fell to 9% and its ranking dropped to No. 76. The reason: Its stock-based pay exceeded its free cash flow. In other words, if that compensation had been paid in cash instead of stock, Freshworks' free cash flow would have been negative, and its free-cash-flow margin would have been negative 11%.

 

Similarly, Workday's chief executive, Carl Eschenbach, at an investor conference last May said "we're a Rule of 40 company." Using free-cash-flow margin for the calculation, Zion showed its Rule of 40 number was 44% for the previous four quarters, but it was 26% if stock-based compensation was treated as an expense.

 

The reason that any of this matters, Zion says, is that the market has been rewarding companies with higher valuation multiples if they are at or above 40%, as McKinsey found in its study. However, it appears the market may not be distinguishing consistently between higher-quality and lower-quality Rule of 40 numbers.

 

"A big drop in the rankings for a company indicates to us that its Rule of 40 ranking is driven more by financial engineering (how employee compensation is financed) than its peers," Zion wrote in his note. Thus a big question for investors, he said, is "How much are you willing to pay for a Rule of 40 company that is primarily there because of how they've decided to finance their employees' compensation?"

 

Better yet, until there is some consensus on how to do this number, just 86 the rule." [4]

 

1. Revenue growth is the increase in a company's total revenue over a period of time. It's also known as top-line growth. 

Revenue growth is calculated by dividing the rate of increase in total revenues by the total revenues from the same period in the previous year. It can also be expressed as a percentage increase from a starting point. 

A healthy revenue growth rate is usually between 15% and 25% annually. Higher growth rates may be too much for new businesses to keep up with. 

Revenue growth is important because it can indicate a healthy and promising business. Companies with strong revenue growth can more easily access capital, which can be used for expansion and innovation. Investors are also more likely to invest in companies with consistent revenue growth. 

Some strategies for generating revenue growth include: 

• Setting goals
• Building a high-performing sales team
• Using revenue-focused marketing strategies
• Being flexible with pricing
• Continuously evolving products
• Focusing on upselling and cross-selling

2. Margin has many definitions, including:

Business: The difference between the price at which a product is sold and the costs associated with making or selling the product

3. Operating cash flow (OCF) is the cash a business generates from its regular operations over a specific period of time. It's a company's cash basis profit, as opposed to its net income, which is its accrual basis profit.

OCF can be calculated using two methods:

 

    Direct method

    Tracks cash movement using cash accounting. The formula is OCF = Cash Revenue - Operating Expenses Paid in Cash.

 

Indirect method

Adjusts net income to cash using changes to non-cash accounts. The formula is OCF = (Revenue - Cost of Sales) + Depreciation - Taxes +/- Change in Working Capital.

 

OCF is important for tracking where a business's cash is going. It can help identify if operational costs are affecting profits, and can help with inventory analysis. For example, high inventory levels can tie up cash flow, so OCF analysis can help identify slow-moving products and optimize inventory levels.

A company's free cash flow is its OCF minus any capital expenditure needed to maintain the operating efficiency of its assets. Free cash flow is the excess money a company has after maintenance spending, which it can use for expansion, debt repayment, or stock dividends.

4. 'Rule of 40' Is in Fashion for Software --- The financial threshold is held up as a mark of success in the sector, but it often means less than it appears. Weil, Jonathan. Wall Street Journal, Eastern edition; New York, N.Y.. 06 Jan 2025: B10.