For many SaaS investors when it comes to making a decision to either invest or pass on a company, it all comes down to balancing growth and profitability. Rapid growth in a business is exciting but usually comes at the cost of profitability, and vice versa. Considering such factors can make an investor’s decision difficult. Though for years, many have relied on an industry metric that demystifies the entire process called the Rule of 40.
The Rule of 40 is an industry rule of thumb that is used to quickly determine the health and attractiveness of a SaaS company. It takes into consideration growth and revenue— even if there are no profits yet. Essentially, if a company's growth rate plus free cash flow margin adds up to 40% or more, then the company is considered financially healthy.
But rules are made to be broken. According to Bain & Company 40% of selected software companies beat the Rule of 40 in 2017. Though, over the last three years only 25% of these companies continued to conquer the rule. Beating the Rule of 40 in a single year is commendable but is not exceptional. The greater test is balancing growth and performance year after year.
Five companies that continue to be an exception to the rule are Microsoft, Paycom, Adobe, LiveChat Software, and Tobila Systems.
Tech giant, Microsoft's free cash flow margin averaged 31.5% while its annual top-line growth averaged 14.05% over the last three years. This gives the company a score of 46.
American online payroll and human resources technology provider, Paycom outperformed Microsoft, earning itself a Rule of 40 score of 50. The company's annual top-line growth averaged 30.94% while its free cash flow margin averaged 18.77%.
Japan-based company, Tobila Systems has designed junk phone filtering systems, information processing platforms and other mobile products since 2005. Today, it boasts a Rule of 40 score of 53 due to its free cash flow margin and annual top-line growth averaging 23.94% and 29.42% respectively over the last three years.
San Jose, California-based computer software titan Adobe is a leader in multimedia and creativity software products. Over the last three years, its free cash flow margin has averaged 38.39% and its annual top-line growth averaged 24.03%. This gives it a score of 62.
LiveChat Software is a software company and developer of LiveChat, a SaaS help desk software and online chat platform for ecommerce sales, customer support and lead generation. Based in Wroclaw Poland as well as Boston, Massachusetts the company has one of the most impressive Rule of 40 scores, coming in at 76. Over the last three years its free cash flow margin averaged 48.53% and its annual top-line growth averaged 27.76%.