Rule of X - beyond the Rule of 40

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, the 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.

Go together just like biscuits and gravy, Ray.

Dave, you're making me hungry again. Now, I love your analogies, but can you try to find some non-food analogies going forward?

I think you've got sour grapes, Ray.

Well, at least we're getting to fruit now. Well, CAC, last week we swan dove down the rabbit hole into the ERG ratio, the enterprise value to revenue to growth ratio. Also known, wait for it, I'm going to get it right, the growth-adjusted enterprise value to revenue multiple.

Yep, Ray, that's right. That's an investor metric used to determine how pricey a stock's enterprise value to revenue multiple is relative to its growth. It's a great metric for both kind of value shoppers and momentum buyers.

Dave, do we give investment advice on this podcast?

No, we don't, Ray. And you need to listen to our disclaimer again, because even if we did, It'd probably be wrong. So no investment advice here. We do this solely to study and get interested by metrics. So what's on tap for today, Ray?

Well, we are going to be talking about another investor-centric metric, and it's part of our 2024 predictions, our top 5 metrics predictions. And that's the Rule of X.

Got it. So let's jump in here, Ray. The Rule of X is a kind of new and improved Rule of 40. So let's start by reminding readers— listeners of what the Rule of 40 is. So the Rule of 40 is a balanced growth profit metric. The Rule of 40 score is a growth rate added to a profit metric. The growth rate is either ARR growth or revenue growth. The profit metric is usually free cash flow margin, sometimes EBITDA margin. And you add those 2 together and you get what I call a Rule of 40 score. And the intent is to basically say companies should kind of shoot for a balance of growth and profit.

Yeah, and this, we're not going to get into all the different combinations to get to Rule of 40, but let's talk about some of the leading public cloud companies out there and what Meritech Capital's benchmarks data site's giving us. And that is leaders like Zscaler, CrowdStrike, and Monday.com. They have Rule of 40 score of 66. Snowflake, a Rule of 40 score of 57. The median is 32. So it doesn't even achieve the Rule of 40. And then we have some of the laggards currently on the public stock markets like Domo. They have a -5 Rule of 40 score. And C3 AI, they have a -25 Rule of 40 score, Dave.

Yeah, they do indeed.

So as you mentioned, right, the median Rule of 40 score is 32. So half of all, more than half, of all public SaaS companies are not Rule of 40 compliant, which is the language I use to describe whether your Rule of 40 score is above or below 40. So more than half are not Rule of 40 compliant. Those that are, however, usually command about, I think it's a 60% premium in valuation multiple relative to those who are not, which is one of the reasons people kind of pay attention to and kind of strive to have a good score on this metric.

Well, and another way to understand the importance of the Rule of 40 is looking at the R-squared of the Rule of 40 to enterprise value to ARR multiples. And that R-squared today is about 0.30. And that sounds pretty good. And for those of you who don't follow R-squared, minimum 0, max is 1. So about 30% of the enterprise value to ARR multiple can be just explained by Rule of 40. But growth is still king because Next 12 months revenue growth has an R-squared of 0.47, Dave.

Yeah. So if you look at the market over time, Rule of 40, I believe, usually predicts valuation better than growth alone, certainly better than profit alone and better than gross margin, better than NRR, better than a lot of metrics. So it's a reasonably good predictor, but Bessemer has come along and said, we think we've got a better one. And that's what they're calling the Rule of X.

Well, and it's one of the founding fathers of SaaS metrics. I still remember when Byron Dieter, the general partner there at Bessemer Venture Partners, actually came out with his 10 Laws of Being SaaSy in 2009. But it's interesting, he talks about the rule of X and how cloud leaders should think about growth versus profit. So I'm thinking that maybe he thinks growth is more important than profit?

Yeah, the short answer is yes, they do. They think it's about twice as important to just cut to the chase. Um, but we're going to drill into that for a minute. You know, this, this article by Byron Dieter and Sam Bondi, both of Bessemer, um, it kind of previewed on TechCrunch or debuted on TechCrunch. Uh, and then recently they put up a slightly revised and improved version of it on Bessemer's own site, their, their Atlas kind of subsite, uh, of the Bessemer Venture Partners website. So personally, for listeners, I'd go to the Bessemer version. I think it's more up to date and a little bit more polished than the TechCrunch version.

Yeah, and fundamentally, even though they are a little bit different, you know, fundamentally what Byron and Sam are saying is that assigning equal weight to growth and profitability, especially for later stage, you know, B2B cloud businesses, is flawed, and it might even misguide where you're focusing growth versus profitability. Margin and profitability.

Yeah, these are, these are 4 quotes we took from the article here. Ray read the first one, I'll do the next one. So, so, uh, the next one is the world is over-rotated to a free cash flow margin mindset over a growth mindset. So these are their beliefs and why they did this thing. Uh, the next one I'll show you is that long-term models show that even in tight markets, growth should be valued at 2 to 3x times free cash flow margin. And I'll just finish, right? And the reason for that is basically while a margin increase has a linear impact on value, right? If I take margins up from 20% to 30%, I've increased one time a 10% increase in my EBITDA margin or free cash flow margin, whereas growth increase has a compounding value, right? Because we bring these people into the customer base and not only do they stay with us, hopefully they grow at a healthy NRR over the years. So they kind of both derive from first principles. i.e., the compounding argument, why growth should be weighted more than free cash flow margin. And then they do a bunch of math. So the old Saturday Night Live skit, Chevy Chase goes, it was my understanding there'd be no math. Don't read the Vests over Wights paper if you think there's going to be no math. There's plenty of math in there, but they do the math. So from both first principles saying, hey, one compounds, the other doesn't, and from regressions, 2-factor regressions, they say, Growth really needs to be counted more than profit.

Well, I'm going to talk a little bit about what the calculation formula is, but there's a variable in there that I'm going to ask you to kind of explain a little bit more. And the Rule of X score is you take your free cash flow margin plus— 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 remainder of 2026. All episodes we have ever recorded are still available on your favorite podcasting app. You can reach Dave at Kellogg and Ray on LinkedIn at Ray Reich. Thank you so much for listening to the Metrics Brothers podcast. The growth rate times this M or multiplier. And that multiplier, as you said, is kind of in that 2 to 3 range. But isn't that M multiplier— that's not a constant variable, is it, Dave?

Well, they're a little bit funny that way. Uh, in the newer version of the article, they just— in my opinion, they tend to assume it's 2. So, but in the original version of the article, they emphasized, I think, a little bit more that it varies. It varies as a function of stage. And it varies with the market over time. For example, I think they said at peak GAC, growth at all cost era, or peak ZIRP, whatever acronym you want to use, I think it got up to what, 6 or 9 times they felt— not they felt, that mathematically growth was 6, I think it was actually peak of 9 times more important than free cash flow in determining valuations. And at the trough, growth was only 0.8x as important. And now I think today, I'm sure we're back in the normal range of between 2 and 3. And I think for the second version of the article, they just kind of assume it's 2. So the multiplier, while it's still variable, it feels a little bit more like a K than an M. It feels a little bit more like a constant in this version of the article.

Yeah, you're right. I think back in December of 2020, that M was 9. I also looked at Ameritech, kind of similar 2-factor analysis. And they said back in early 2021, it actually got all the way up to 10. But Bessemer only does their 2-factor analysis on the BVP Cloud Index. So it's a little bit different bucket of public companies than what Mary Tech does theirs.

But important, important stuff there, Ray.

Yeah.

I mean, the point stands the same is it's the relative weighting between growth and profit varies, but growth is almost always more than profit. And it's usually 2 to 3 times. That's kind of the net of the math.

So I'm going to let you be the positive one here. So what are some of the good things that you like about this rule of X?

Yeah. So, so look, the reality is they're making a very important point that I think, Ray, both of us, because we work with a lot of small companies as well as bigger ones, we felt like rule of 40 was overapplied to small companies. And one of the reasons is it equally weights growth and profit. And certainly for a small company, that's just not correct, right? You need to grow first and then get an install base and then you can kind of NRR it and milk it and grow it more. So I think it points you in the right direction by saying, hey, founders, growth matters more. Growth and profit both matter. Okay, we're not— it's not, you know, 2021, so they both matter, but growth matters more, and 2 to 3 times more if you want to quantify it. So I think the intent of this article is dead on. Why don't you cover some of the bads? The good is it points you in the right direction. The intent is absolutely correct. Growth matters more. Now, Ray, what about the other side of that coin?

Well, probably the thing that jumped out at me the most, especially when I looked at Bessemer versus Meritex's 2-factor analysis of what that M value was, it's like, where are we going to get the right M for this particular period in time? Is it 2.1 or 2.8? So I'm not sure where we're going to get that and who I count on, Dave.

Yeah.

And the issue is if M is a variable that's changing every day, It's very like, well, is some FP&A guy gonna go, when he's making the board deck, go try and do a 2-factor regression to get the current M against which set of companies? Or is Bessemer gonna release a daily official M? It becomes impractical. I think conceptually it's correct to say, hey, this thing varies. Well, it does. But practically speaking, what do we wanna do? By the way, the other thing that's virtually impossible to do is give good, better, best advice, because that advice is gonna vary. If the multiplier's 9, it's gonna be very different from the multiplier is 0.8. So that's why I'm saying, Ray, I think in the second version of the article, they more kind of settled into a 2x multiplier. And that's why in that version of the article, but not the first, they actually did give good, better, best advice on what a good score looked like, because that was one of our joint primary criticisms of the first article. It's like, hey guys, you've defined this new metric, but you haven't told us where the bullseye is.

Yeah, well, they— it's funny, they did attempt to give that good, better, best, you know, in the Bessemer way. But the other thing that really kind of jumped out at me is, is it stage relevant? And the original article on TechCrunch, they showed how it's less relevant in early stage where you have negative F, you know, free cash flow. Even in early stage growth companies, they're saying, hey, you should have a burn multiple kind of closer to 1 to 1.5 to use it, but use Rule of 40 instead. And it wasn't until mid-stage growth where they said that the Rule of X becomes more relevant. So It's almost like it's scaling of when it's important and when it's not.

Yeah. I mean, look, this has always been an issue with Rule of 40 and its derivatives, which is there's a question about when to apply it. My interpretation of the V2 of the Bessemer article was basically if you're small or very small, focus on burn multiple, period. Focus on growth and burn multiple, not Rule of X. And then as you get bigger, focus on Rule of X. And I think it's correct. And just to finish the other thought, the good, better, best advice they give, right? If Rule of 40 is kind of binary, you're either compliant or you're not, i.e., you're above 40 or below. Bessemer in V2 of the article on their site gives good, better, best. So they say a good Rule of X score is 40+, a better Rule of X score is 50+, and a best Rule of X score is 70+. And frankly, I think it was really important that they did that. And in order to do that, by the way, they had to fix the multiplier, which they did at 2.

Yeah.

One of the things I love about doing this podcast with you is you pull out spreadsheets and you actually go and test these metrics. And you kind of looked at with the M being at 2.3 at median, you saw the Rule of X score broad range from all the way high of like 125, all the way down to a negative 156. But my question is, did Rule of 40 versus Rule of X materially change the ranking? Of the top companies?

Yeah, that was the funny thing because when I made that spreadsheet, Ray, first it did produce a much broader range of values, um, and second it didn't actually change the ranking. I think only one company changed by more than one position. I think Confluent went from like 12th on my list to 8th, right? Which was because— why? Because it's a fast grower with pretty bad margins. So, so it got boosted a lot by the rule of X, but nobody else really moved. So in terms of ranking, the scores changed a lot. But in terms of ranking, it didn't change that much when you did that particular math. Look, the other thing about this metric. So overall, I'd say both Ray and I like this metric. We think it's doing entrepreneurs a service by telling them explicitly that growth matters more than profit. It is superior to Rule of 40 in that regard. There is another way to come at this though, which I'd like to talk about, which is to do a growth-weighted Rule of 40. You want to do that, Ray, or you want me to keep going?

No, I'm just happy that you actually used the word growth-weighted because sometimes I use it incorrectly. What is it?

So look, the funny thing about Rule of 40 is it's kind of like an average multiplied by 2. This is kind of mind-expanding, but you're taking 2 numbers and adding them and then not dividing by 2. So it's not the average, it's just double the average, right? The Rule of 40 score is double the average of the 2 numbers, and that average is equal weighted, right? It's 1 plus 1. And the best number does with Rule of X is continue that. They just add the 2, but they multiply 1 by a multiplier, right? They say that, you know, free cash flow plus 2.3 times growth rate equals Rule of X score. The alternative way to kind of overweight growth is something I saw Software Equity Group do quite some time ago, which is what they call a growth-weighted rule of 40. And it's in effect 2x the 2x growth-weighted average of growth and profit. Okay, what the hell does that mean? It means if we were to do a weighted average of growth and profit, let's just start there. We'd say, hey, wait a minute, we want to balance the coefficients. So we'd say, let's weight growth at twice times profit. So we'd weight growth at 1.33, we'd weight profit at 0.67, we'd add them up and divide by 2 to get a growth-weighted That would be a 2x growth weighted average of growth and profit. The trick with Rule of 40 is you never do the last step. You never divide by 2. So that's why I say in English it's kind of confusing because it's 2 times the 2x growth weighted average of growth and profit. Just like Rule of 40 is 2 times the unweighted average of growth and profit. So it may be complicated words to say, but what you're doing is you're producing a Rule of 40 score. So that same notion of above 40 is good, below 40 is bad applies. But you're still producing something, a number to me that's more comparable to a Rule of 40 score. It's just weighted, right? I've created a Rule of 40 score, but I'm weighting it more towards growth. Whereas with Bessemer, you're not producing a Rule of 40 score because of this multiplier. Just say the multiplier's at 3x, right? You're gonna start producing, I don't know, very large numbers 'cause you're gonna multiply growth by 2 and then add it to profit. So—

But isn't that the soft record group? It is simple and it's constant. But when I look at that and I take the 1.33 that they apply to growth and the 0.67, it's a 2XM. So M remains constant at 2X, right?

Yeah.

I mean, basically, in some ways, the rule of X with a multiplier of 2, the rule of X is the SEG growth-weighted rule of 40 score. It's the same thing. And they're both—

is that right?

No, no, because you're not going to get the same number because one is doing 1.3 plus 0.67 and the other one is just doing 1 plus 2, right? So it's actually 3 times the— oh God, I don't want to do the math here, right? I'm going to rabbit hole, but it's not quite the same score. Yeah, because basically the sum of the coefficients on the SEG is 2. The sum of the coefficients on Bessemer is 3. So that's going to change the number.

Jethro, let me ask you this. If you took your calculator out and did you kind of look at the rule of 40 versus the rule of X from an R-squared perspective?

Well, I didn't have to because Bessemer did it for us in the article, right? So, and this was really their goal. I think some of the things that I object to, like the broad range of values or maybe the less intuitive compared to Rule of 40 scoring, I don't think they care about because they're trying to make a better predictor. I think in many ways the mission was how do we make a balanced growth metric that better predicts enterprise value than Rule of 40 does? Because as you mentioned at the start of the podcast, Rule of 40 isn't always the best predictor. Sometimes growth alone is better.

Right.

And I think they achieved that. If you look at today's market, the Rule of X explained the coefficient of determination for the Rule of X versus enterprise value to revenue multiple is 0.64 versus around 0.3 today for the R40 to ARR, which is kind of mixing sources there. But basically, or basically it's 0.64 compared to 50 when Bessemer does it themselves, right? To 0.50. So either way, the R-squared is higher. Basically, I'm mixing up Maritech and Bessemer, and I think Maritech does trailing revenue and Bessemer does forward revenue, which explains some of the mess. But the point remains, right, that they wanted to get a better predictor of enterprise value revenue multiple, and they did.

Okay, and the last thing, and I get this error in Excel quite often where it says I have circular logic. You've said that you, as you really think about Rule of X, It struck you to have some circular logic in it. Can you explain that?

Yeah, I've kind of backpedaled a bit on that position because I actually swapped emails with Byron, and, um, I think I heard an implied kind of surprise that wasn't there. Like, like when I read the article the first time, I think my brain heard— they didn't write this, but my brain heard— and look, the really good news is, surprise, it predicts EV/DR better. And they're like, oh, then I kind of heard that. They never said that, but that's what I heard. And the reality is, when I went to them and said it was circular, their argument was, well, no, it's not circular. The whole point was to get a better predictor. So we were trying to get a better predictor, and we're not surprised at all that it predicts better. So to me, it was just kind of almost a tone question. So to be fair to them, I always go look for circular logic. I look for flaws in the argument, but they really weren't saying, oh, by some miracle, this thing is a better predictor. They're basically saying, we went out and did a bunch regressions and we determined that on average, a 2x weighting better predicts EV to R and it does. And it's like, okay, great. So that's really how you should think of this thing. I mean, if there's 2 lessons from this metric, one is that growth matters and growth matters about twice as much as profit in determining value and predicting value. And the other lesson would be this thing's a better predictor. So if you want to try and predict your value, this score is going to predict it better than Rule of 40.

And I'll tell you, we got to wrap up here, but I don't bet against Bessemer Venture Partners when it comes to SaaS metrics very often, especially Byron. I mean, they are some of the thought leaders in CAC and CAC payback period, their cash conversion score. And they don't always get it right, but they evolve the metric. And I think the rule of X is going to evolve. And Dave, I'm gonna let you put your, your CMO hat back on. Don't you have a new acronym for it?

Uh, for the rule of X or RX, um, you can call it RX, the prescription for value. That's my joke. So look, I think I'm not betting against them at all on this metric. I think it's a good metric. I think it's going to be successful. We can argue it's a strength of Bessemer that they take second and third swings at these things. I think, and this could be wrong, the CAC payback period eventually resulted from being a new and improved CAC ratio because I didn't like the way they defined CAC originally. I thought they defined it upside down, and I think they did it based on gross margin, not revenue. That just didn't make sense for me for CAC, but then they evolved and put their focus on CAC payback period. Now they talk about both, but just my recollection of the 10-year history of this was CAC was the first thing they came out with. I didn't love their definition. I've actually got some screenshots of the original definition on Kellogg, but that CAC evolved into CPP, CAC payback period, which has become probably the number one standard VC metric, much more so than CAC, or it's probably up there with NRR in terms of just things all VCs look at. So, so I think they're good at this. I think it's a strength that they revise these things over time. And look, we've already seen some improvements between V1 of the article and V2. Just, just kind of fixing the multiplier and offering the good, better, best was a big improvement.

So I encourage everyone to go to the bvp.com website, look for Atlas, look for the Rule of X, give it a good read because I think this is going to be an important metric going forward. Dave, thank you again for going down the rabbit hole with me.

Yeah, thanks, Ray. Take care.

Bye-bye, everyone.

The Metrics Brothers: AI, SaaS, and More is a production of the Metrics Brothers Growth and CAC and a member of the Benchmarket 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.

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