The 'Rule of 40' has long been the gold standard for evaluating the health and potential of SaaS companies. However, as the industry evolves and matures - recovering from a much slower Q4 2022 to Q1 2024 18 month period - the need for a more comprehensive metric has become increasingly evident. In this article, I propose a new benchmark – the 'Rule of 100/3' – as a more nuanced and effective tool for assessing SaaS companies in today's dynamic market. One that identifies growth, profitability, and retention - but, in aggregate, also one that demonstrates stability and resilience.

The Limitations of the Rule of 40

The 'Rule of 40' has been a fundamental metric for assessing SaaS companies. By combining revenue growth rate and profit margin, it balances the often competing objectives of growth and profitability. For instance, a company growing at 25% annually with a 15% profit margin would satisfy the Rule of 40. This rule helps investors and analysts quickly evaluate whether a company is achieving a healthy balance.

Despite its usefulness, the Rule of 40 has limitations. It provides a snapshot based on a single year's performance, which can be misleading for companies in an industry characterised by rapid innovation and fluctuating market conditions. A company might meet the Rule of 40 one year due to a temporary boost in growth or profitability, but fail to maintain this balance in subsequent years. This short-term focus does not necessarily reflect the long-term health and potential of a SaaS company.

Introducing the Rule of 100/3

The 'Rule of 100/3’ (100% over three years) is a proposed metric that aims to provide a more holistic and forward-looking view of a SaaS company’s performance. Instead of evaluating a single year, it assesses cumulative performance over a three-year period. According to this rule, the sum of a company’s revenue growth rates and profit margins over three years should total at least 100(%).

Advantages of the Rule of 100/3

1. Long-Term Perspective: Evaluating performance over three years smooths out short-term fluctuations, offering a more accurate representation of a company’s sustainable growth and profitability.

2. Balanced Evaluation: This rule maintains the balance between growth and profitability but does so over a more extended period, which can accommodate the dynamic nature of SaaS business cycles.

3. Strategic Flexibility: Companies can prioritise different strategies at different times, such as focusing on aggressive growth initially and shifting towards profitability later, or vice versa.

Applying the Rule of 100: Practical Examples

To illustrate how the Rule of 100 might be applied, let’s consider two hypothetical SaaS companies: TechWave and CloudMinds...

Example 1: TechWave

Year 1:

• Revenue Growth: 30%

• Profit Margin: 5%

• Combined Metric: 35

Year 2:

• Revenue Growth: 25%

• Profit Margin: 10%

• Combined Metric: 35

Year 3:

• Revenue Growth: 20%

• Profit Margin: 10%

• Combined Metric: 30

Three-Year Total: 100

TechWave’s performance shows a balanced approach where growth is strong initially and profitability improves steadily, meeting the Rule of 100 with a combined three-year total of 100.

Example 2: CloudMinds

Year 1:

• Revenue Growth: 40%

• Profit Margin: -5%

• Combined Metric: 35

Year 2:

• Revenue Growth: 35%

• Profit Margin: 0%

• Combined Metric: 35

Year 3:

• Revenue Growth: 10%

• Profit Margin: 20%

• Combined Metric: 30

Three-Year Total: 100

CloudMinds demonstrates a different strategy, with high initial growth even at the cost of profitability, followed by a significant shift towards profitability in the third year. This strategy also meets the Rule of 100, showcasing flexibility in achieving long-term goals.

Wider Industry Analysis and Commentary

The SaaS industry is experiencing a significant shift in how growth and profitability are valued, driven by changes in the economic environment and investment perspectives. According to TechCrunch, as interest rates return to historical norms, there is a renewed focus on cost of capital and free cash flow (FCF) generation. Many executives believe that FCF margins are equally, if not more, important than growth. This shift highlights the need for metrics like the Rule of 100/3 that emphasise long-term performance and the balance between growth and profitability.

Subscript points out that the traditional Rule of 40 is no longer adequate in a dynamic market where growth and profitability should not be viewed as interchangeable. The focus has shifted towards metrics that consider the varying importance of growth and profitability at different stages of a company's lifecycle. This is where the Rule of 100/3 can provide a more nuanced and long-term perspective.

SaaS Capital argues that the Rule of 40 has been misleading for many companies, especially those in different stages of growth. They emphasise that growth should be prioritised over profitability, particularly for companies that have not yet reached significant scale. Their research shows that in times of economic tightening, profitability becomes more critical, but growth remains the primary driver of long-term value. The Rule of 100/3 aligns with this by allowing for strategic flexibility and emphasising sustained performance over multiple years.

Implementation Steps for SaaS Companies

For SaaS companies considering the adoption of the Rule of 100/3, here are three key considerations:

1. Strategic Planning: Develop a comprehensive three-year plan that outlines periods of investment in growth followed by phases aimed at improving profitability. This plan should be flexible to adapt to market changes and internal performance.

2. Continuous Monitoring: Regularly track and analyse revenue growth rates and profit margins. Use these metrics to adjust strategies (including “what” you build [Product] and “how” you build it [Tech]) and ensure alignment with the three-year targets.

3. Transparent Reporting: Maintain clear communication with investors and stakeholders about the long-term strategy and progress. This transparency builds trust and aligns expectations with the company's evolving performance metrics.

CONCLUSION
While the Rule of 40 has been a valuable metric for the SaaS industry, the evolving nature of the market calls for a more nuanced approach. The Rule of 100/3 could offer a comprehensive, long-term perspective that aligns with the maturing SaaS landscape. By focusing on sustained performance over multiple years, this new rule provides a more accurate measure of a company’s health, potential, and resilience.