The Lion's Den Vol. 11 - The Fallacies of the Rule of 40 (Part I)

With so much focus on the R40 output, many have forgotten that it's the quality of the inputs that actually determines a company's value

Over the past two years, rising interest rates and an economic slowdown have driven tech companies to shift continuously (and necessarily) from pursuing growth at all cost to focusing on efficient/profitable growth. Through that transition period, the buzziest of buzzwords (excluding anything with AI of course…) in board rooms has been the "Rule of 40” as a gauge for a company’s operational efficiency. In this two-part post I’ll point out important reporting nuances and walk through how the different inputs of a R40 calculation can materially impact a company’s perceived value. Let’s go!

Rule of 40 in a Nutshell

Simply put, the Rule of 40 states that a company's combined growth rate and profit margin should be close to 40% or higher for it to be considered a high-quality asset valued at a premium. While this metric is a relatively new concept in venture circles, it has been used as a measuring stick by public investors for many years. Gradually, as more venture and growth companies adopted the R40 metric, the reporting started to diverge quite dramatically and the output 1-liner (“we’re a Rule of [x%] company”) became more important than the actual components of the metric. To some extent, the tech ecosystem went from not really caring about efficient growth to over-relying on the Rule of 40 output as the main goal, at times at the expense of appropriately valuing the quality of each of the underlying inputs.

Applying the Right Ingredients

In analyzing numerous companies, I've observed significant variations in how the Rule of 40 is reported. Common nuances (and my suggested best practices) include:

1. Minimal size: In my view, the R40 metric only becomes relevant and interesting once a software company crosses the $15-20M ARR mark. For instance, a small venture-backed startup with $5M ARR growing 150% but burning (110%) is not really a R40 business and there’s no operational efficiency to be gauged yet. When underwriting an investment in smaller companies, growth prospects and product market fit are what matters. The one exception here might be small bootstrapped companies, but I still view this metric less telling below $15-20M ARR

2. Growth: Revenue or ARR? The choice between ARR and revenue growth should be based on the company’s business model and revenue composition. If the business is predominantly subscription-based with minimal non-recurring revenue, ARR might be more appropriate. Conversely, if the company has a significant portion of its revenue from non-recurring sources (e.g. services, hardware) or if its revenue is lumpy and unexpected, revenue would be more appropriate. If one of those metrics is growing significantly faster than the other, it would be best to look at R40 using both metrics

3. Margin: EBITDA or FCF? This is particularly meaningful for SaaS companies in which EBITDA is often not the most instructive metric. EBITDA does not account for important factors such as capitalized R&D and other CapEx (e.g. infrastructure costs), and does not reflect changes in deferred revenue - an important indicator of a SaaS company's ability to grow. Given that most of my investments are in software companies I typically prefer to look at FCF margin. One exception to this rule are companies with massive stock-based compensation expenses. As I wrote in one of my previous posts, ESOP is a real expense that impacts shareholder value and FCF margin does not capture the magnitude of that line item

4. Mismatching Periods: It's essential to align periods when pairing growth and margin for the Rule of 40. The best practice involves a 12-month lookback period, capturing a sufficient span of growth and cost initiatives. Quarterly view can also work so long as all metrics are indeed quarterly. Matching quarterly performance with an annual metric (e.g. ARR growth paired with quarterly FCF margin) can create a distorted picture of a company’s actual operational health and may even point to the wrong trend if there’s seasonality or lumpiness in the business.

Let’s look at CrowdStrike as an example to illustrate some of the above:

CrowdStrike is one of the more impressive software performers of all time and a poster child of a Rule of 40 company (actually more like Rule of 70). The company was founded in 2011 and in only ~12 years has reached over $2B of ARR with incredible growth as well as meaningful cashflow generation. The chart below shows how meaningful the difference is when calculating Rule of 40 with different metrics (based on the company’s FY23):

In this specific case, CrowdStrike’s revenue is almost 95% recurring and is not yet at a point where ARR is slowing down and revenue is catching up (in FY’23 CRWD added more ARR than revenue in absolute terms). Thus, the right metric to use here is ARR growth. On the profitability front, CrowdStrike reports both FCF and non-GAAP operating income (mostly adding back stock-based compensation), which along with D&A gets close to what I would define as EBITDA. As I mentioned above, I generally find that FCF reflects more accurately the actual profitability of software companies, but the stock-based comp of CrowdStrike is very meaningful (~29% of opex) so you could go with either EBITDA or FCF.

CrowdStrike is obviously well beyond the Rule of 40 benchmark and whichever metric you decide to use will show it’s a unique business. The point, however, is that there is a meaningful 18%(!) delta in the R40 calculation depending on the metrics being used. Now imagine, for example, the same nuance with a slightly lesser company that might report as either a R40 or a R20 business and how meaningful that difference will be to the valuation.

The other piece is the period matching. CrowdStrike reports R40 on a quarterly cadence and therefore uses quarterly revenue (not ARR) YoY growth and quarterly FCF margin (see below from one of their most recent quarters).

I would have preferred to see each quarter on an LTM basis as I find it more telling, but as long as the periods aren’t mismatched (e.g. quarterly metric with an annual metric) this way of reporting works just as well.

To summarize, just like it’s important to have best practices for how ARR, net retention and other software KPIs are calculated and reported, it is equally important to have alignment on how the Rule of 40 should be calculated. In my next post, I will walk through why the R40 inputs, growth and profitability, should not be weighed equally (hint: growth matters more, but only above a certain threshold) and why different R40 combos are valued drastically differently by investors, which should guide CEOs as they navigate through the next 12 months.

Wishing everyone a happy and fruitful 2024!

Onwards!

Omer
Follow me on Twitter and LinkedIn