22/10/2022
Today let’s talk about Investement.while interacting with a Private Equity Investor, I asked him if he has to choose only one metric before investing in any Growth Stage company then what would it be?
He replied he would always keep a close watch on Rule of 40 performance.
If you are wondering about what is Rule of 40, this post will give you an idea.
The rule of 40 is a Company Health Metric that measures the trade-off between profit and growth
Rule of 40 suggests that Investors will only invest in companies with a combined Revenue Growth Percentage + EBITDA margin percentage above 40%.
Let’s take a simple example of Rule of 40 for a SaaS-based Business which is attached:
- Year on Year Revenue Growth Rate= ($30 million- $25 million)/ $25 million= 20%
- March 2022 EBITDA= $7 million
- 2022 EBITDA Margin %= EBITDA/ Total Revenue= $7m / $30m= 23%
Rule of 40= Revenue Growth %+ EBITDA Margin%= 20%+23%= 43%> 40%
If the number is:
Below 40%- if the company is in the early start-up stage, nothing to worry about. But if the company is in the growth stage, the Founder needs to take the matter more seriously
Exact 40%- Hitting the 40% mark means the company is eligible to be attractive as a business
Above 40%- Anything above 40%- 45% means the company is a profitable and growing company. However, they need to make sure that there is a proper balance between profit and growth otherwise this might be a fluke or short-term success.
According to Brad Feld, a good time to start measuring Rule of 40 is:
- when the company reaches $1 million MRR.
- and they have clearly separated and functioning departments like customer care, resources, CSM, R&D, distribution, and marketing.
- the main focus should be on Gross Margins, Operational Productivity, Sales Growth, EBITDA, etc
That’s it for today nice weekend
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