Over the last decade, Alexander Group has helped a growing number of technology clients build and scale subscription revenue models to accelerate recurring revenue growth. Yet, the creation of recurring revenue has been a key determinant of tech company valuation. It is no longer sufficient to demonstrate Annual Recurring Revenue growth alone. Companies must increasingly demonstrate an ability to grow revenue profitably to boost market value in public and private sectors. This is where Rule of 40 comes into play.

What Is the Rule of 40?

The Rule of 40 is an anything-as-a-service (XaaS) principle that establishes a percentage-based benchmark for the aggregate of revenue growth and profit. Under the Rule of 40, a business’s revenue growth percentage and profitability margin percentage must combine for a value of 40% or higher each year. The way it works is that surpassing 40% indicates successful growth, and reaching the 40% benchmark is the bare minimum for sustainability, but falling short of 40% means the organization is not generating enough recurring revenue to support its current size.

As a multifaceted measurement, the Rule of 40 represents a balance of its core metrics. A company can achieve the Rule of 40 with 40% revenue growth and 0% profit. Conversely, it can sustain 0% revenue growth with a 40% profit margin. Any combination of percentages that add to or exceed 40% qualifies.

XaaS organizations use the Rule of 40 to prioritize growth under a recurring revenue model. For example, a software-as-a-service (SaaS) company’s primary revenue streams are recurring monthly payments and subscription renewals. While consistent, these recurring streams are also prone to revenue stagnation. SaaS and other XaaS companies strive for growth through various sales, marketing, and pricing strategies that increase the number of subscriptions and extract more value from each subscriber. By applying the Rule of 40, SaaS organizations can establish the parameters of success and measure performance.

Rule of 40 Calculation

Companies calculate Rule of 40 by adding year-over-year ARR growth to a profitability measure (as percentages).

Year-over-year ARR compares the current year’s revenue from recurring streams to the last. To determine the growth percentage, companies subtract their previous year’s recurring revenue from the current year’s recurring revenue. They then divide the difference by the previous year’s recurring revenue and multiply the quotient by 100 to convert it into a percentage.

The profitability measure is usually one of two options. The first is the business’s earnings before interest, taxes, depreciation and amortization (EBITDA). The other is its free cash flow (FCF), which is the cash left over after subtracting operating expenses and capital expenditures. Although EBITDA is typically viewed as the best measure of overall investment for company comparison, FCF provides a better picture of the actual cash available to the business.

The Rule of 40 considers either profitability measure as a percentage. Businesses calculate the profitability margin by dividing the measure of their choice by the total revenue and multiplying by 100 to reach a percentage.

Why XaaS Revenue Leaders Should Care About Rule of 40

Driving profitable revenue growth in today’s highly competitive XaaS market isn’t easy. Every company faces countless options for allocating resources to fuel growth and profitability. The real challenge? Identifying the path that works best for your business—one that moves you toward the Rule of 40 and beyond.

Let’s detail four typical evolutionary situations leaders typically encounter as tech companies build their profitable subscription revenue capabilities.

• Situation 1: Subscription Revenue Acceleration: This scenario is categorized by strong and sudden ARR revenue growth with little regard to cost. In this situation, the primary goal is to either convert existing perpetual license customers to subscription, capture net new subscription dollars, or both. Because companies in this situation are growing a very small (zero) base, the ARR growth becomes difficult to maintain as ARR gets larger (law of small numbers).
• Situation 2: Profitability Engineering: This situation starts off when companies rationalize their spending on commercial resources —such as sales, marketing and service — in light of ARR growth decline. As it becomes more difficult to maintain ARR growth levels, companies reliably turn their focus to the profitability component of Rule of 40. Typically, this situation often arises as a pending liquidity event (private equity acquisition, IPO, share buy-back, etc.) nears. Companies attempt to demonstrate the ability to balance between growth and profitability to exhibit Rule of 40 to potential investors.
• Situation 3: Targeted Commercial Investment: Companies recognize they have to continue investing to sustain growth levels.  However, they also realize that these investments must be strategic and targeted to avoid stagnation. The result is focused commercial investment in revenue streams (segments, customers, use cases and geographies) that will drive revenue growth profitably. With this scenario, most companies focus on monetizing the existing base of customers to drive subscription performance. They do this by driving higher adoption and solution assurance, securing renewals and building expansion opportunities.
• Situation 4: Sustainable Profitable Growth: With this,Rule of 40 (and beyond) is a standard operating principle. The efficient production of ARR growth frees investment dollars for companies to concentrate on emerging areas. Companies must prioritize targeted geographic and product/solution expansion, through expanded internal product development or inorganic growth via acquisition. Companies are constantly attempting to think ahead of where the market is to uncover sources of incremental, profitable ARR growth.

At the end of the day, the key implication for XaaS leaders is that they must find the right profitable growth path for their business to help drive to Rule of 40.

Implications for Fiscal Year Go-to-Market Planning

When XaaS leaders prepare for their annual go-to-market (GTM) planning, they must consider that Rule of 40 is increasingly driving the need to think about the impact on operational decision-making. Although there are many components to an annual GTM operational plan, there are four core elements that ultimately drive the revenue and cost structure for any model:

1. Account Prioritization and Segmentation: Which customer groups and key accounts should the company focus on?
2. Coverage Model and Roles: What’s the right combination of roles and channels (direct [pre-sales, sales, post-sales] plus digital and partners) to effectively support each segment?
3. Capacity and Deployment Plan: How many team members do we need, and what’s the best way to position them?
4. Quota Targets and Incentive Compensation: What outcomes do we expect from each role, and what kind of rewards will keep them motivated?

Account Prioritization and Segmentation

As XaaS companies plan how they’ll approach account prioritization and GTM planning, leaders have to think about how Rule of 40 will impact operational decision-making. Consider the following scenarios that companies could find themselves in:

• Subscription Revenue Acceleration: Companies should create unrestrictive segments that allow resources to self-identify the best opportunities. This process also ensures  that organizations spend less time on easy, but low-value opportunities. During this phase, the companies who saw success had a relatively simple model (e.g., enterprise, commercial, SMB) and set a high bar for the Enterprise segment—which is the most expensive resources sit.
• Profitability Engineering: To start off strong in this process, companies should create a revenue algorithm using the concept of maximum share (i.e., “what do our best accounts produce and look like?”). By using a combinationof manual and data-based efforts, companies can  identify these customers. When mapped against key characteristics and potential use cases, trends emerge as to what defines a healthy opportunity.
• Targeted Commercial Investment: In this scenario, companies will begin to introduce more segments and sub-segments. Depending on coverage and profitability objectives, companies may now require between four to six segments to tailor coverage models (and costs) appropriately. These can includes horizontal segments based on overall opportunity size, and vertical segments where it has become clear that a specialized sales process is required (e.g., government, financial services, etc.).
• Sustainable Profitable Growth: From an overall structure perspective, this is where sSegmentation models typically maintain the status quo. That being said, governance becomes critical in ensuring leaders update account opportunity estimates accurately and leverage them for further coverage refinement. The segmentation model also guides other investments, such as digital tools.

Account prioritization and segmentation serve as the foundation for GTM planning, which is why revenue leaders need to continually capture and leverage customer data needs to accelerate their organization’s growth journey

Capacity and Deployment Considerations

To increase their chances of hitting lofty ARR goals set by the board and executive team, leaders may be tempted to add more headcount.. However, companies with XaaS recurring revenue streams have more nuanced capacity and deployment decisions because of highly differentiated motions: Land, Adopt, Expand and Renew. Where does Rule of 40 come into play?

• Subscription Revenue Acceleration: To grow ARR, companies will require extensive investments in organic quota-carrying resources (e.g., traditional field reps). Given today’s technology environment, the eventual market leader captures a disproportionate share of the sector’s overall valuation. That’s why at this stage, the goal is to capture market share quickly. To achieve this, companies should hire high-quality sales reps to test value proposition efficacy, profile sales motions (specifically to identify those that work and those that don’t) and source product improvement opportunities from early buyers and users.
• Profitability Engineering: In this situation, companies will experiment with strategic account models or hunter/farmer setups for their largest accounts. As such, rRevenue leaders are advised to place a handful of incumbents toward strategic accounts from which they can source profitable growth. With this, keep account loads to a minimum (10:1 or less). That way, account managers have ample capacity to engage new locations and buyers, as well as explore incremental use cases within this attractive set of customers.
• Targeted Commercial Investment: Companies will likely have an emerging customer success organization. However, customer success will strain Rule of 40 unless it has tangible impact on retention rates. This can be done through strong adoption and identification of at-risk accounts). Customer success also serves as a mechanism to identify upsell and cross-sell opportunities that other members of the sales organization can pursue.
• Sustainable Profitable Growth: Under this scenario, companies must examine all sales resources across different segments and geographies. This is because the key to profitable growth is contingent on territories yielding ample returns without excessive investment. Additionally, revenue leaders must conduct detailed territory sizing and equitability analysis to solve for coverage whitespace and insufficient workload.

Quota Targets and Incentive Compensation

One of the most important fiscal year planning activities is designing next year’s sales compensation plan and corresponding quotas. The stage a company is in will drive a different quota target and incentive compensation solution.

• Subscription Revenue Acceleration: Many companies will provide lucrative pay programs to attract talent, and this can range from high target pay levels or medium target pay levels coupled with lucrative equity. Due to the hunting nature of the job, the role will requires high-risk, high-upside plans. Plans usually are simple with one growth measure focused on new and expansion business. Quotas are generally the same size across different sellers due to large territories with equally significant potential.
• Profitability Engineering Although pPay packages are still lucrative to recruit and retain talent, they’re generally not as lucrative as in the previous scenario. Sellers still need to hunt, so pay mixes are still aggressive. However, total payouts are curtailed via lower upside, threshold and/or decelerator rates. Quota sizes will vary depending on assigned territory opportunity and must reflect different plan measures (land, expand and/or renewal).
• Targeted Commercial Investment: Companies still use more complex plans (measures and mechanics) to differentiate land vs expand vs renewal. They may also add adoption as a metric. Quota sizes still vary depending on assigned territory opportunity and must reflect different plan measures (land, expand and/or renewal).
• Sustainable Profitable Growth: Plans will include various solution measures/linkages to drive the new solution set. Sellers will have varied quota sizes dependent on territory assignments and potentially a strategic solution quota.

Driving Profitable Growth in Competitive Markets

Driving profitable revenue growth in today’s highly competitive XaaS market is no easy feat. Every business faces countless options for allocating resources to fuel both growth and profitability. The challenge, and the opportunity, lies in identifying the right path that positions your organization to achieve the Rule of 40 and beyond.