SaaS and the Rule of 40: Keys to the critical value creation metric

Investors reward SaaS companies that hit this operating performance marker, yet a surprisingly small number have been able to do so. Here’s how more can follow their industry leaders’ example.

The purest test of a management team and its operational discipline is arguably how well it can maintain strong shareholder returns as the business matures. That’s especially true for software as a service (SaaS). Despite the sector’s image as a bastion of hypergrowth, only a small share of SaaS companies sustains growth rates above 30 to 40 percent. In fact, of 100 public SaaS companies in the United States with revenues above $100 million that we analyzed in May 2021, the median revenue growth rate was just 22 percent.

As businesses near the top of their initial S-curve, revenue growth tends to slow and free cash flow becomes more important. However, the 100 companies we analyzed had a median last 12 months (LTM) free cash flow of just 10 percent of revenue. Spending needs to align with realistic growth forecasts, and growth from existing customers driven by customer retention, cross-sell, and upsell takes on greater significance. Knowing which levers to pull and which targets to aim for is especially important in SaaS because of the lag between bookings and revenues, the upfront expense of acquiring customers, and the constant rate of R&D spend required to keep features and products current.

How well leaders do in balancing these demands is where the “Rule of 40” comes into play. The popular metric says that a SaaS company’s growth rate when added to its free cash flow rate should equal 40 percent or higher. The rule has become a favorite of SaaS industry watchers, including boards and management teams, because it neatly distills a company’s operating performance into one number. But McKinsey research finds that barely one-third of software companies achieve the Rule of 40. Fewer still manage to sustain it. Analysis of more than 200 software companies of various sizes between 2011 and 2021 found that businesses exceeded Rule of 40 performance only 16 percent of the time.

That’s a staggeringly small number and a major missed opportunity. Data show that investors reward companies that are at or above the Rule of 40 with consistently higher enterprise value (EV) to revenue multiples. Moreover, the higher the number, the greater the gain. Top-quartile SaaS companies generate nearly three times the multiples of those in the bottom (exhibit).

Investors reward SaaS companies that are at or above the Rule of 40 with consistently higher valuation multiples.
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The SaaS players that operate at the Rule of 40 consistently deliver these results by instilling much greater operational rigor and performance transparency than the average company. By embracing similar practices, others can do the same.

What the top-performing SaaS companies do differently

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Through our work with dozens of SaaS companies and performance analysis of 100 others, we’ve discerned a set of practices that are highly correlated with Rule of 40 success. Leading players keep the organization squarely focused on securing future growth, continually pivoting resources to core revenue drivers. And they spend based on today’s numbers, adjusting their growth and free cash flow objectives according to where they are in their life cycle to stay at or above the Rule of 40 (see sidebar, “Focus on the metrics that matter”).

Here’s how to follow their example.

  1. Set realistic growth targets. The commonly held perception is that SaaS companies have seen soaring rates of growth in recent years. But of the 100 SaaS businesses we analyzed in May, only the top quartile had growth rates north of 40 percent. Yet many SaaS players continue to set inflated growth projections and spend based on revenues that don’t materialize quickly enough. The reality is that a company whose total addressable market is expanding at a CAGR of 8 to 10 percent cannot realistically grow revenue by 30 percent in the near term. Doing so requires a large addressable market and the ability to be one of a few leading vendors in a concentrated space, much in the way Jira is to project management, ServiceNow is to IT help desks, and Salesforce is to customer relationship management. Only a handful of companies have this opportunity at any given time. Our research found that just 1.6 percent of 200 software companies were able to sustain consistently strong revenue growth of 30 percent or higher from 2011 to 2021.

    Rule of 40 leaders understand these fundamentals. They set revenue growth targets based on what is organically achievable within the existing portfolio over a three-year period and manage the entire business within that envelope. For example, when a $600 million enterprise SaaS company saw revenue growth begin to settle at 15 percent as it became a leader in its segment, management realized they could no longer spend as freely as when the business was growing at 30 to 40 percent annually. So they adjusted their cost structure, with a goal of generating a 20-percentage-point improvement in free cash flow (FCF) over a two-year period taking it to 30 percent. That rebalancing will keep them at the Rule of 40 and provide the means for them to invest in new, high-growth businesses.

  2. Prioritize net retention. SaaS businesses that aim to achieve higher growth put as much attention into caring for existing customers as they do into acquiring new ones, investing in specific postsales constructs to increase cross-sell, upsell, and retention and sourcing the right talent, tools, and analytics. These efforts, combined with strong pricing and product support, result in median net retention rates (NRR) of 120 percent or more—which means these businesses are able to deliver 20 percent growth every year without adding a single new customer. Top performers span different end markets, including companies such as Twilio (139 percent), Crowdstrike (128 percent), and Elastic (130 percent).

    Analysis of 40 public B2B SaaS companies shows that those with NRR of 120 percent or more also have higher multiples—with a median EV/revenue of 21-fold compared with ninefold for those below the 120 percent mark. This is because net retention is a core driver of growth and sales, as well as marketing efficiency.

    Many slower-growing SaaS companies underinvest in customer success, customer care, and professional services because the overwhelming focus is on gaining new customers and because existing SaaS customers generally don’t pay extra for postsales support. So the additional effort in courting them seems unprofitable. But neglecting existing customers ends up adding costs in the long run, resulting in more churn, lower cross- and upsell, and more pressure on sales teams just to stay level. By looking at customer success and related efforts as an investment in growth rather than as a cost center, companies can protect their installed base and gain scale and efficiency.

  3. Optimize go-to-market spend. Sales and marketing is one of the biggest expense areas for SaaS companies—amounting to 50 percent or more of revenue in high-growth businesses. The high ratio is partly a result of the business model, in which revenue lags behind investment. But it’s also because many companies are inefficient. Where SaaS companies with the strongest EV/revenue multiples are able to recover their customer acquisition costs in under 16 months, 1 bottom-quartile players take nearly four years to do the same. Top-quartile companies also generate revenue growth 3.5 times faster than the bottom quartile.

    Top-quartile companies optimize sales and marketing performance in four ways, underpinned by a data-driven growth engine.

    • First, they allocate sales and marketing resources based on future customer opportunity—not current revenue—giving high-growth accounts the most coverage. And they define total opportunity using a “retain-acquire-develop-optimize” (RADO) structure, 2 which allows them to set the level of resource intensity to the total growth potential. They understand the efficiency of their spend at a granular segment level and use it to adjust spending to segments that produce the highest returns (for example, by using relative customer lifetime value over customer acquisition cost for each segment).
    • Second, they pull granular operating data from across the business into integrated dashboards that make it easy for leaders to see the relationship between specific, often siloed, sales and marketing activities and overall growth outcomes (for example, marketing funnel to lead gen, sales quota attainment to win rate, and customer success to cross-sell/upsell and churn).
    • Third, they innovate go-to-market propositions that scale efficiently. For example, they may focus on product-led motions for small-to-midsize customers and marketplace-enabled models for the developer segment.
    • Finally, they use advanced analytics and machine learning to build a predictive view of customer health, which then helps drive proactive cross-sell/upsell, preventative churn measures, and positive feedback loops across sales, marketing, customer success, and product.
  4. Build new business—fast. SaaS businesses often reach the tip of their initial S-curve without a market-ready venture or offering ready to pick up the slack, so their growth dips. Rule of 40 players maintain momentum by standing up net new businesses more quickly. For example, a $400 million SaaS company built a new $50 million annual recurring revenue (ARR) business from concept in 18 months. Leading players incubate new businesses thoughtfully, selecting micro domains based on a deep understanding of customer personas. They supply them with dedicated resourcing and attend to the operational, organizational go-to-market aspects of business building with the same rigor they do product development. Given the challenge of maintaining growth over time, developing the capability to build new lines of business quickly is critical for long-term growth and value creation.

In addition to the four elements identified above, top performers insist on transparent data and metrics that allow them to gain an integrated view of growth and margin drivers. This visibility helps them to execute against bold growth, efficiency, and productivity targets, and to make decisions on new investments at a global integrated level.

This approach stands in contrast to the location-based resource allocation that many other businesses employ. Leaders also ensure that they unpack the software engineering black box by building world-class product-management capabilities and a data-driven engineering performance-management culture, investing in core developmental health and channeling resources into growth-oriented products and features.

Our experience with a $500 million SaaS company shows how management teams pull this together. The company was used to seeing revenue growth of 25 to 40 percent, but recently the rate had slowed to 10 percent. After analyzing their market opportunity and competitive environment, they landed on 15 to 20 percent growth as a more realistic model. They also took a hard look at their existing business. With churn averaging 15 to 20 percent and cross- and upsell levels modest, the company’s NRR was just 100 percent. Upskilling their customer success team helped put them on track to gain a ten-percentage-point improvement in NRR. They are also seeking to fast-track digitization efforts within marketing and sales—efforts that will lower costs within the function from 40 percent of revenue to 20 to 25 percent. To fund the improvements, leaders conducted cost analysis across the business, which identified $100 million in savings. Leaders plan to use 25 percent to support its transformation and reinvest in new business lines. Together, the improvements are expected to propel the company’s Rule of 40 performance from below 10 (owing to negative free cash flow) to over 40 within the next two years.

Getting ahead of the curve

Investors aren’t the only stakeholders keeping a close watch on Rule of 40 performance. Boards are increasingly engaging leaders on this point. A midsize SaaS company’s board recently created an operating committee to support the management team in building a path to the Rule of 40. And the compensation committee of another large SaaS company has devised incentive plans for top executives tied to progress achieved against the Rule of 40. The bottom line for a growing number of boards is that if the company is not doing its job with the Rule of 40, then leaders aren’t doing their job as a management team.

The best will act in enlightened self-interest. By taking a hard look at what rate of growth the business can reasonably maintain and steering the organization to maintain it in the most efficient way possible, leaders can turn the Rule of 40 into a winning proposition for the organization and all its constituents.

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