The 40% Rule for Software Companies

40% RuleThe 40% Rule is a metric used to evaluate Software (including SaaS) companies by investors or acquirers.

The 40% Rule essentially means that a company’s growth rate plus their profit should equal 40%.  So, if your company is growing at 40%, your EBITDA can be 0%; if you’re growing at 20%, your EBITDA should be 20%; if you’re growing at 50%, you can be losing 10% – you get the picture. The idea behind this is that companies focused on growth can afford to sacrifice some amount of profitability as they are reinvesting it into the company.  In the Tech sector especially, growth is one of the most important determinants of whether a company will be able to get funding, or if it will garner a premium valuation by a strategic (aka corporate) buyer. It’s important when using this rule to understand what is being used for the growth and earnings indicators, but frequently, YOY MRR (monthly recurring revenue) in SaaS companies is used for growth and EBITDA (earnings before interest, tax, depreciation, and amortization) is used for profit.

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