Rule of 40 - Analysis of Meritech Capital Benchmarks at SaaS Metrics Palooza '23

Live from Schenectady, New York, it's SaaS Talk with the Metrics Brothers, Growth and CAC.

And I'm Growth, better known as Ray Reich, founder and CEO of Benchmarkit.

And I'm CAC, better known as Dave Kellogg, independent consultant, EIR at Balderton Capital, and author of Kelblog.

And together we are the Metrics Brothers.

And such a duo. Last time, Ray, we looked at the Cloud Ratings Historical SaaS Benchmarks Report. What do we have on tap for today, Ray?

Well, even though I would love to do another session on that, you know, Alex Clayton from Meritech Capital did a great presentation at SaaS Metricspalooza, and the Rule of the 40 was front and center. So I thought maybe we could talk about the Rule of 40 and some of the insights that Alex presented.

Well, you know, I loved his IPO teardowns. I don't know if he still does them. Well, no one's going public, so I guess we can't know, but he did some awesome IPO teardowns. And I did watch his session. I thought it was great too. Before we do that though, how's it going with the Katie O'Byrnes Irish Pub sponsorship, Ray?

Well, you know, I always like to try to be funny. So I think now it's the IPO breakdown process.

Oh, 'cause they broke down. That's funny.

Hey, I got CAC to laugh. I'm like, my episode's made, Dave.

There you go. There you go. So anyway, I think now is a good time for a word from our actual sponsor, Ray, is it not?

Yeah, let's go and hear a word from Maxio. The Metrics Brothers is proudly sponsored by Benchmarkit, the B2B AI and software industry's largest, broadest, and most contextualized benchmarking index. Dave Kellogg and Ray Groth Wright have put the Metrics Brothers podcast on hiatus for the remainder of 2026. All episodes we have ever recorded are still available on your favorite podcasting app. You can reach Dave @kellogg and Ray on LinkedIn @rayreich. Thank you so much for listening to the Metrics Brothers podcast.

So, are we ready to dive into the Rule of 40, Ray?

I am because this is such an uncontroversial topic.

Good. Well, let's jump in. I'm going to start with just a quick baselining here. So, first, what is the Rule of 40? It's a SaaS metric. It's an attempt to balance growth and profitability and to capture them into one number. The Rule of 40 does this by adding a top-line growth metric to a bottom-line metric. And the goal, the reason it's called the Rule of 40, is the goal is kind of to have a score, i.e., to have that sum, the 2 numbers add up to a number that's greater than 40. Thoughts, Ray?

Well, first of all, I, you know, I'm a little bit of a historian of metrics also. I don't know if you knew that, but a shout out to both Brad Field, And Fred Wilson, who were the first 2 people who I know coined this back in like 2014, 2015 timeframe. That sound about right, Dave?

I think it does. I think it's Brad Feld. I think he put an I in there. But yeah, when I search for Google, he seems to be the person credited with creating this one.

So Rule of 40. So I really like this metric for later stage B2B SaaS companies because it really does look at a balance of growth, and growth is still really important even in 2023, and some bottom line profitability. So I think it's one of the best compound metrics there is to judge the attractiveness of a SaaS company as an investment, later stage.

So let's talk about how it's calculated then, because we said it's the sum of a top line growth figure and a bottom line figure. So let's talk about what those figures are. Um, top line growth is relatively uncontroversial. It's either ARR growth for private companies that talk about such things. Or for public companies, it's usually revenue growth. So the top line is pretty easy, ARR growth or revenue growth. The bottom line metric is a little less standardized, let's say. I think the world is increasingly converging on free cash flow margin as the bottom line metric. But sometimes you'll see EBITDA, adjusted EBITDA, operating margin, net income occasionally. There are different uses on the bottom line. So, uh, we can talk more about that in a minute, but Ray, what do you think?

You know, I always highlight the SAS Metric Standards Board because this was one of the metrics we took on, and we definitely used revenue growth, ARR or GAAP revenue, just like you, plus free cash flow percentage as the number one method. But we provided a backup method, which was using EBITDA, because we found a lot of earlier stage B2B SaaS companies weren't calculating free cash flow, believe it or not, but most of them had EBITDA. So we think purists should use free cash flow, but EBITDA can be a proxy for younger companies.

Got it. So excellent point. My view on the bottom line metric is that, as mentioned, I think the world is converging on free cash flow margin, comma, for people who calculate that. What is free cash flow margin? It's operating cash flow, i.e., cash flow from operations, Minus CapEx. So we're going to take a quick trip down accounting lane here, but, but free cash flow thus includes interest and tax expenses and CapEx, but it excludes depreciation and amortization and stock-based compensation because it's a non-cash expense. EBITDA, by contrast, uh, and remember, EBITDA is not a GAAP metric. I forget this sometimes because it gets talked about so much. You know, it obviously excludes the D and the A, depreciation and amortization. It also includes— excludes interest and taxes, which is a difference from free cash flow. And technically it should include stock-based comp because while it's a non-cash expense, it is an operating expense. But many people then adjust out stock-based compensation and do what's called adjusted EBITDA. So this is just the beginning of the complexity on choosing the bottom line metric. In the end, personally, I say use free cash flow margin. And if you don't calculate it, maybe you should.

Yeah, but I think you said something really important, which is re-including stock-based comp. Because if you look at some of the accounting standards, right, it says that stock-based compensation should be either highlighted in the line item of operating expense, i.e., sales and marketing including stock-based comp, R&D including stock-based comp, or as a footnote in a line item on the income statement as a non-cash expense. So I think a lot of companies play loose and fast with stock-based comp accounting, Dave. Now I know that's not what this is about, but it's a concern of mine for using FCF.

Yeah. Now the other thing on FCF, Ray, and this I don't know the answer to, I couldn't figure it out in my prep for the session, but I worry that if it excludes D&A, i.e., depreciation and amortization, that there's going to be some sales commissions in there. So I don't know the answer to that one. I don't know if you do, but by my definition, using free cash flow margin will include sales expense. But if you're doing ASC 606, sales expense is gonna mean that you're kind of capitalizing and amortizing sales commissions. So sorry for this accounting rabbit hole, but it's another thing to think about. I don't know if you have a point of view on that one.

Well, I want to double-click on it just so everyone understands, because it was new to me, you know, a year ago, and that is Your sales compensation, instead of recording it as an operating expense right up front when it's paid or earned, it needs to be amortized over the life of a customer, which I think is silly. And I think that inherently inflates operating profit. I really do. Yeah.

And we talk about this with respect to the CAC ratio a lot, Ray. Like, should you accelerate commissions or should you leave them kind of amortized? And most people say accelerate. It's just not something we've really talked about on Rule of 40, but, you know, commissions expense are major. And the question is, do they go into, you know, in what way do they affect free cash flow margin, EBITDA margin, or adjusted EBITDA margin?

Yeah. You know, I think I haven't been counting, but I bet we've said Rule of 40 at least 10 to 15 times so far in our first 8 minutes. So what do you think about even the name, Dave?

Yeah, it's a great point. Look, I think it's a good metric with a bad name. You'll hear people say stuff like, my Rule of 40 is 26. And to me, that, like, the words just don't sound right. Or they'll often, some people will make it binary. Hey, are you Rule of 40 compliant? Which to me is, the answer to which is yes or no, right? It's not a number. And that's kind of information loss. So, I don't like either one of those. There's a couple other confusion points. Because Rule of 40 has a bad name, some people give it a different name. Like, Bessemer calls it efficiency score, which I accidentally confused with what Bessemer calls growth efficiency.

Right.

Because Bessemer calls what I call burn multiple growth efficiency, i.e., cash burn divided by new ARR, right? That's growth efficiency in Bessemer parlance, burn multiple in Dave Kay parlance. Bessemer calls Rule of 40 efficiency score. So, so because this metric has a crummy name, people have kind of tried to make new names for it that just add to the confusion. My simple take on this one, Ray, is just add the word score and all the sentences now make sense again. So I just say the metric to me is called Rule of 40 score. And I say, hey, Ray, what's your Rule of 40 score? And to me, that's how you thread this needle.

So I love Rule of 40 score. One of the probably most intense debates I've ever had in a LinkedIn post, it was when I said, oh, a good Rule of 40 means that your growth rate plus free cash flow is 40% or higher. And someone said, no, no, no, it's not a percentage. When you add 2 percents together that are from different variables, it's a score. It's not a percentage, which I was like, I was blown away. It's like, wow. So 30% plus 10% isn't 40%. Now there's a rabbit hole for you.

Yeah, it is a rabbit hole. I'd not thought of it before. I guess I accidentally solved that problem as well. Because it's a score. Can't claim to have thought of that in advance. So look, Ray, how do people use— before we dive into Alex Clayton's insights, why don't we just— and this is a good segue into his insights, in fact. How do people use the Rule of 40? Why do people talk about it? And what do people say about it?

Well, it's used very inconsistently. That's number one. And I would say it's more of an investor metric because they're looking at as a company scales. And we even had Byron Dieter at SaaSmetricspalooza kind of say, hey, It's, you know, before about $20 million, we don't pay as much attention to it, but at $20 million and above, we really want to see that there's continued growth. And he said growth at 30% and above in improvement in your operating margin profitability that's getting close to zero. And then once you hit $20 million above, we'd like to see you make progress to 10%. So investors really know that to go public, And to have the highest enterprise value to next 12-month revenue multiples, you need to have a balanced Rule of 40 at 40, 50, or even 60 in today's environment.

Yeah. And certainly not many people do 60, as we'll see in Alex's insights. I think there was literally one company in the 60 score, Rule of 40 score of 60 bucket, which was CrowdStrike. But I like what Byron said, and it's true that kind of sub-$20 million Maybe you shouldn't care about this metric that much. But as you're getting to be public, you do want to have a Rule of 40 score in the 40s, high 30s or 40s. And it can't be all one or all the other. It needs to be kind of a growth-weighted mix, as we will talk about as we move through the deck. So let's segue now, Ray, and start talking about Alex Clayton's presentation at SAS Metricspalooza. I'm going to be referring to slide numbers as we go through this. So if you don't have that presentation, Ray can tell you how to get it.

Yeah.

But Alex showed a bunch of really good slides here and there's about 4 or 5 of them we want to talk about in specific.

Perfect. By the way, can I just say one other thing? The other reason that rule of 40 before, definitely before $10 million, but usually before $20 million is irrelevant is the T2D3, right? If you're supposed to be growing, you know, 300%, 300%, 200%, 200%, 200%, your rule of 40 is going to be greater than 100% your first 3 to 4 years. So it just is an unfair and unuseful metric when you're growing 200% a year.

Yeah, I think we could agree it's a metric that becomes relevant somewhere in the tens of millions. Is it 20, 30, 40? I'm not sure. But it's not a, you know, a $5 million company. I mean, you can calculate it if you want to, but it's not a helpful metric in my opinion. So let's jump in now, Ray, to Alex Clayton's deck and talk about some of the points he raised. Overall, Ray, to answer the question I asked you a minute ago, I would say that investors use this metric And the fundamental argument is, if you can be Rule of 40 compliant or have a good Rule of 40 score, you're going to get a higher valuation multiple than somebody who doesn't have that, somebody who's not compliant or somebody who's a bad score. For example, I think it was from Bessemer presentation, I found that the, quote, Rule of 40 compliant index companies in the EM Cloud Index trade on average at 150% higher than their non-Rule of 40 compliant peers. So, so it is an investor metric. It does tie directly to valuation. And why don't we jump right in and go to slide 15 in Alex's deck, Ray, called Rule of 40 Buckets. Do you want to start here? Do you want me to?

No, I got it. So I love this because what he did was he looked at 2017, 2021, and today, and today was end of September, and he put it in 4 buckets where the Rule of 40 was 60% plus, 40 to 60%, 20 to 40%, and greater than 20%.

You know what was really interesting? Rule of 40 score.

I know I was reading, I was reading the slide versus being thoughtful. But what was interesting was at a Rule of 40 score of 60 or above, the median, and that was enterprise value in the next 12 months, was 10.6. Between 40 and 60 was 9.3. But then when you got below 40, like 20 to 40, the multiple went down to 6.2. So almost a 35% decrease. And if it was less than 20, it went all the way down to 3.8x. So it really shows the stair-step downwards based upon where you're at with the Rule of 40.

Yeah, absolutely. Slide 15 does a great job at that. And if basically, if you don't believe that Rule of 40 influences valuation, take a look at that slide because it shows it. And basically in this particular case, to just pick 2 data points, as Ray mentioned, if your Rule of 40 score is less than 20, you had a median 4x multiple. And if it's between 40 and 60, you have a median 9.3x multiple. So basically doubles your multiple to be kind of Rule of 40 compliant.

But Dave, there's this great debate and I get asked this question all the time. Well, what's the right mix or balance of growth to profitability? And I know you really love slides 16 and 17 in Alex's presentation. So why don't you give a highlight of that real quick?

Yeah. So slide 16, I really like because, look, a lot of people do regressions between They'll do a linear regression between Rule of 40 score on the x-axis and enterprise value divided by next 12 months margin. So enterprise value multiple on the y-axis, and they'll get an R-squared. And that's a fairly common analysis. What Alex has done here is less common, which is he's kind of broken it down into a matrix where he's got free cash flow margin of less than 10, 10 to 20, 20 to 30, 30 plus, and next 12 months revenue growth where he's done the same thing, less than 10, 10, 20, 20, 30, 30 plus. And the moral of slide 16 is pretty simple, which is that not all our 40 schools are the same. Not that— basically, he shows 3 different buckets here where the median Rule of 40 score is 37, 37, and 41. So let's consider them all roughly kind of bang on the target, right? They're all Rule of 40 scores around 40. And if you look at the median multiple, it's either 5.4x, 6.7x, or 9.6x, right? So, so 3 different companies have the same Rule of 40 score, but again, there's almost a 2x difference in valuation multiple. And why is that? And it all comes down to composition because they have the same Rule of 40 score, but the guy with the 9.6x multiple is growing in the 20-30% bucket with free cash flow margin in the 10-20% bucket. Whereas, you know, the company with the 5.4x multiple is not growing. They're less than 10% growth. But they're kind of printing money with a greater than 30% free cash flow margin. So the long story short on this is that a growth-weighted Rule of 40 seems to be important, that growth matters more. We're adding 2 numbers, right? Free cash flow margin and growth and getting this composite number called Rule of 40 score. But the growth number seems to matter more to your ultimate valuation.

And by the way, we're going to be sharing the URL to go look at all these charts at the end of the podcast. So stick with us. But Dave, my favorite slide and insight that Alex presented was slide 18, and it's a 2-factor regression model that looks at the relevant importance of growth versus free cash flow margin to multiples. You want to share a little bit about how that's trended over the last 3 to 4 years?

Sure. So for the reasons we talked about, I just want to introduce this notion of growth-rated Rule of 40 a little bit more carefully. But for the reasons we just discussed, smart people came along and said, hmm, maybe I shouldn't calculate Rule of 40 by just adding top line growth plus free cash flow margin. Maybe I should weight growth more. And the first time I saw this was the Software Equity Group did what they called a growth weighted Rule of 40, and it was 2x weighted. So they weighted growth at twice free cash flow margin in calculating Rule of 40. Now, Meritech has come along, which we'll see in a minute, And they now have a 3x growth-weighted Rule of 40 that they call the Meritech Rule of 40. But the basic idea is if you realize, once you realize that growth matters more than free cash flow margin, that you wanna start looking at their relative importance over time. So figure out what that weighting multiple should be. Did Software Equity Group have it right at 2x? Does Meritech have it right at 3x? So this chart here on slide 18 shows the historical progression and gosh, it's all over the place. It gets as high as 11x. So i.e., 1 point of growth is equal to 11 points of free cash flow margin, right? That's what 11x means. I would say today it's down in the 3 range, the 2.2 to 3.0 range in terms of the growth relative importance. Historically, look, I actually use this as a sentiment indicator and I would say in normal times, this number runs between 2 and 3. In heady times, it runs between 4 and 8. And in like bubbly times, it runs 8+. And so to me, this is actually a great kind of sentiment indicator for the software industry.

Yeah. And I love it when you can put numbers behind overused phrases like growth at any cost. I must admit, when I hear that anymore, it's like, what does that mean? This is exactly what it means from a capital markets perspective. When you're paying for a point of growth, 11x of what you pay for A point of profitability. That's pretty amazing, Dave.

Yeah, it is pretty amazing. And I like putting the kind of mathematical wood behind the turn of phrase arrow, as this chart does. So the question is, though, this chart makes it tricky because it does vary a lot. And the question is, if you're going to build your own kind of growth-weighted Rule of 40 metric, what multiple should you use? In the end, as I mentioned, Meritech opted for 3. So the Meritech growth-weighted Rule of 40 is a 3x weighted Rule of 40. And you can see here on slide 19 that today it has a correlation of 0.62. So the R-squared of Meritech Rule of 40 versus next 12 months implied ARR multiple is 0.62, which is pretty high. That's got a lot of explanatory power of the metric. And then on slide 20, they actually compare over time the Meritech Rule of 40 to growth alone to a traditional Rule of 40. And the kind of sad thing for the traditional Rule of 40 here is, is that in most time periods over the last 5 years, growth alone had more explanatory power of revenue multiple than the Rule of 40, which was kind of the whole point of the Rule of 40, was to be better than growth alone. Now, the really good news is the Maritech Rule of 40 consistently runs above 0.5. And has been as high as 0.7 or so on the R-squared. So it's a pretty good metric. I mean, if I were king of the forest, I would say we should kind of change the official definition of Rule of 40 to be 3x growth weighted. But what do you think, Greg?

I love the growth weight. And by the way, I don't know if you can standardize that and say it's always 3x. Maybe you can look at the trailing 12 months and say, hey, over the last 12 months, it's been What do you think about kind of having that where it's modifiable based upon macro capital markets conditions?

Yeah, personally, I don't love that idea because I would like the metric to be standardized. And I like the notion of that slide 18 there as a sentiment indicator to say, yeah, I know today mathematically it should be 8x growth weighted, but that's not normal. That's because we're in frothy times. And I think you'd lose that if the metric itself floated. I think you'd lose that. So personally, I'm more in favor of a growth-weighted Rule of 40 with a fixed ratio. And the further you get from that ratio, it's actually trying to tell you something.

We're already up on time, Dave. So to wrap it up, do you have any final comments on the Rule of 40?

I don't think so, Ray. I thought it was a fun episode. I thank Alex for his great speech. And more than anything, I hope people get used to this notion of growth-weighted Rule of 40, which I think is going to be in everyone's future. Yeah.

So, 2 things. You know, when you're doing a podcast, you talk about screens and slides, it's very hard. So, you can go to benchmark.ai/sash-metrics-palooza-23. That's benchmark.ai/sash-metrics-palooza-23. And for any of you who are at your computer right now, I would highly encourage you to bookmark Meritechcapital.com and go to the regression analysis tab. It is amazing. So meritechcapital.com.

Thanks a lot, Ray. Another great episode in the can.

Thank you so much. I'm off to Schenectady.

Take care.

Bye-bye now.

The Metrics Brothers AI, SaaS, and More is a production of The Metrics Brothers Growth and CAC and a member of the Bench Market Podcast Network. By accessing this podcast, you acknowledge that The Metrics Brothers make no warranty, guarantee, or representation as to the accuracy or sufficiency of the information provided or the humor content of the jokes told. Ray, information, opinions, and recommendations presented are, according to our spouses, probably wrong and provided for information purposes only. This podcast should not be considered professional or, for that matter, unprofessional advice. We disclaim any and all liability for any direct, indirect, indirect, misdirect, incidental, special, ordinary, consequential, inconsequential, or other damages arising out of any use of or God help you, reliance upon the information presented here. Ray Grothreich is based in New York City and available on X @RayReich. Dave Kellogg is based in Silicon Valley and available on X @Kellogg. Schedectady, which is French for unspellable, is not our actual production location. Thanks for listening.