The Rule of 40 and the Funding Gap

How to use this simple rule to decide whether to move beyond bootstrapping your company

A common challenge I see is where companies have some initial traction in their SaaS business and they want to scale and they’re not sure whether to go for external investment or stay bootstrapped.

The Rule of 40 is a useful tool for every SaaS business beyond a million dollars or so in ARR, but even before then it’s helpful for forecasting. Here’s how.

What is the Rule of 40?
Firstly, the Rule of 40 if you haven’t heard of it or need a reminder, says that a healthy SaaS business needs its annual growth and profit margin combined to be at least 40.

As examples:
Company 1 - is growing at 50% annually and making a 20% loss.
50 + (-20) = 30.
That’s not a healthy score

Company 2 - is growing at 20% and has a 20% profit margin.
20 + 20 = 40.
Happy Days.

Company 3 - is growing at 100% annually with a burn that gives it a 50% annual loss.
100 + (-50) = 50.
Still healthy even though it is making a large loss.

Obviously this doesn’t make so much sense if you are in the very early stages of growth. If you do $100/month in January and then 12 months later you are at $200/month, the rule of 40 isn’t going to help you much. But once you get to $50k-ish/month it starts to make sense.

How does this help bootstrapped companies?
Firstly, if you are looking to spin something out that you’ve been previously funding yourself, the chances are you’ve been giving your time for free or for not very much and been borrowing time and help from elsewhere. Taking this to something decent will mean you’ll have to eventually pay people (and yourself) and this will often lead to what I call ‘the funding gap’. We had it…. twice. The trouble is that entrepreneurs, especially ones who have run consultancies entirely out of margins in the past, are notoriously bad at predicting what things are really going to cost and often think that the product is pretty much there already and just needs a superstar sales person to turn the corner.

So, use the Rule of 40 to help you figure out what a reasonable amount of spend a company like yours could tolerate.

Let’s say you’re at $50k/month today. Based on where you’ve come from and what you reasonably think will happen you believe you can maintain a 6%/month growth. That will mean your ARR roughly doubles over 12 months. 100% growth means you could afford to make a 60% loss. Whether you do or not is up to you, but you can see the potential range you have.

Massively over-simplifying things (by ignoring deferred revenue when you charge an annual fee in advance) let’s say each month your costs are now running at a steady 60% loss, at the end of the year you could have made a total loss of some of $1.3m.

If you think you could beat that growth rate then you could burn more. If you think you wouldn’t manage to get anywhere close, then you’d need to be spending less over the year.

For a bootstrapped company, this gives you a useful barometer. Because you’ll see your growth potential could be more if you spent more or whether you actually need to improve other things before you think about doing that.

If the conclusion is that you need to spend more: enough to give you a loss in profits, then it’s a question of whether you have the funds yourself and whether you are prepared to spend them to increase growth. Or whether you need to plug that funding gap some other way.

If the conclusion is that even as a profitable bootstrapped company, your Rule of 40 suggests that things aren’t healthy, then funding is probably not the answer. Remember there are 4 key things you can do to manage your Rule of 40

1. Win more clients

2. Charge more

3. Churn Less

4. Spend Less
   

In summary
The Rule of 40 can help you get a sense of whether you’re spending more or less than you should at your growth stage. It also gives you an idea of how big the funding gap between you today and you becoming EBITDA positive without impacting the potential your product has for growth in the meantime.

Give it a try and let me know if I can help. :-)