Rule of 40 Rules All

Rule of 40 Rules All

Since 2018, YoY revenue growth has been the primary metric explaining public market software valuations. Now, the "Rule of 40" is the predominant driver, signaling that efficiency matters more than ever.

For those of you not familiar with software metrics, the "Rule of 40" is a standard metric used by software investors to measure the efficiency of growth.

Rule of 40 = YoY ARR Growth (%) + FCF Margin (%)

“Rule of 40” is the principle that a high-performing SaaS company’s combined YoY growth rate and FCF margin should generally meet or exceed 40%. Simply put, Rule of 40 says that growth and profitability should be considered in tandem: a company growing at 40% should target at least breaking even.

When analyzed in tandem with growth and retention, the Rule of 40 provides great insight into a company’s efficiency.

So why, after 4 years of "growth at all costs" has efficiency  3x'd in importance while growth as a driver has declined?

Simple, the cost of capital, both debt and equity, has gone up.

The fed has indicated they'll aggressively increase interest rates this year to battle inflation. This move has three primary capital effects:

  1. The easiest to understand is debt. Much like your mortgage, when the federal interest rate rises so does the borrowing rate for companies.
  2. Investors, those that back venture capital and private equity funds, allocate capital to several asset classes including credit and bonds. Those markets both tend to be better investments in environments where interest rates are rising. This means less capital available for funds, and consequently less money for private companies.
  3. Venture capital and private equity investors take their cues from the public markets - this is more true the more mature the company - and public growth stocks are hit the hardest by rising interest rates. When those comps go down, so do valuations in the private markets. Lower valuation = higher cost of equity.  

Taken together, these factors increase the cost of capital, increase the risk for raising capital, and increase the bar for return. As a result, companies that are less likely to need capital in the short and medium-term are moving into favor with investors.

The good news? Some of the most iconic companies are built during these types of economic conditions. Most recently, Airbnb, Dropbox, Stripe, etc... were launched during the '07-'08 recession, and before that Amazon and Google were founded in the throes of the '01 tech bubble.

So, while the next few quarters will be unquestionably hard for companies looking to raise capital, for those that are capital efficient and able to maintain solid growth the opportunities remain greater than ever.

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