Why Rule of 40?
For the last seven years, Alexander Group’s (AGI) technology practice has assisted dozens of tech companies in building and scaling their subscription revenue models. Those efforts have primarily focused on helping companies reconfigure their commercial resources to accelerate the growth of recurring revenue. Creation of recurring revenue has been a key determinant of tech company valuation.
As more customers become amenable to recurring revenue (usually sold as a subscription), and converting tech purchases from CapEx to OpEx, the market has entered a second phase of determining valuation. It is no longer sufficient to demonstrate ARR (Annual Recurring Revenue) growth alone; companies must increasingly demonstrate an ability to grow revenue profitably in order to attain higher multiples in public and private markets. Enter Rule of 40.
Simply defined, Rule of 40 measures the ability of recurring revenue businesses to grow revenue profitably. Companies calculate Rule of 40 by adding year-over-year ARR growth to a profitability measure (as percentages), usually EBITDA or Free Cash Flow (FCF, the cash left over after a company pays for its operating expenses and capital expenditures). While EBITDA is perhaps the best measure of overall investment for company comparison, FCF is more reflective of the actual cash available to the business. In a snapshot at the beginning of 2019, about 50% of companies in the publicly traded SaaS market adhered to Rule of 40, and those companies comprised 80% of total market valuation.
In this blog, we will examine four typical evolutionary situations we encounter as tech companies build their profitable subscription revenue capabilities.
Situation 1: Subscription Revenue Acceleration
To examine these situations appropriately, we will divide the tech universe into two categories: hybrids and pure-plays. Hybrid companies are traditional tech companies that have legacy on premise, perpetual license businesses and are attempting to migrate toward subscription. Pure play companies are either newer companies that began as recurring revenue businesses or traditional companies that have elected to migrate most or all of their business to subscription.
Situation 1 is typified by strong, often explosive ARR revenue growth with little regard to cost, particularly for pure play companies. The main objective in Situation 1 is either capturing net new subscription dollars, converting existing perpetual license customers to subscription, or both. It is the norm for pure play companies to operate in negative EBITDA/ FCF mode during this situation. Even mature hybrid companies are generally content with trading a dollar (or more) of cost for a dollar of ARR. Because companies in this situation are growing a very small (zero) base, the rate of ARR growth becomes difficult to maintain as ARR gets larger (law of small numbers).
Situation 2: Profitability Engineering
Situation 2 begins when companies start rationalizing their spending on commercial resources: sales, marketing and service in light of ARR growth decline. This happens naturally with all companies as they begin to reach scale and as market entrants drive enhanced competition. As maintaining ARR growth levels becomes more difficult, companies reliably turn their focus to the profitability component of Rule of 40.
Notably, this situation often occurs in proximity to a pending liquidity event (private equity acquisition, IPO, share buy-back, etc.). Companies attempt to demonstrate the ability to balance between growth and profitability to exhibit Rule of 40 to potential investors. It is important to note that Rule of 40 is a snapshot in time of how the business is performing and not necessarily a guarantee of future results. Often, Situation 2 equilibrium is not sustainable over the longer term; companies commonly pare their commercial organizations down to reach a (temporarily) desirable profitability result that may not sustain revenue growth.
Situation 3: Targeted Commercial Investment
Situation 3 begins with a recognition that companies must continue to invest to sustain growth levels, but must do so in a strategic, targeted manner to avoid stagnation. The result is focused commercial investment in revenue streams (segments, customers, use cases and geographies) that will drive revenue growth profitably.
To drive subscription performance, most companies focus on monetizing the existing base of customers by driving superior adoption and solution assurance, securing renewals and building expansion opportunities. As the install base becomes a greater portion of ARR, there is a general shift in resources from net new hunters to those focused on growing and maintaining the base such as customer success managers, account managers, cross-sell expansion specialists, renewal reps, and many others. Based on data from AGI clients, growing ARR via existing customers is about four to five times more profitable than growth through net new lands. While acquisition of new customers will always be important, it seems clear that monetization of the base is the key to driving better commercial yield in a subscription model. Data from AGI’s most recent SaaS market survey indicates that consistently profitable companies drive at least 92% ARR renewal retention and 20% CAGR in existing accounts. When added to net new acquisition, we’d expect net churn in this phase to approach or exceed 120%.
Situation 4: Sustainable Profitable Growth
In Situation 4, Rule of 40 (and beyond) is a standard operating principle. The efficient production of ARR growth frees investment dollars for companies to concentrate in emerging areas. Companies must prioritize targeted geographic and product/solution expansion, through expanded internal product development or inorganic growth via acquisition. Companies may also expand investments in customer success (to smaller customers) and digital acquisition resources to improve net new acquisition. The challenge in Situation 4 is grounding investments in strong ROI opportunities and avoiding the temptation to blanket the entire market with resources. Companies in Situation 4 are constantly attempting to think ahead of where the market is to uncover sources of incremental, profitable ARR growth.
Implications for Revenue Leaders
Achieving the objective of profitable revenue growth in an increasingly competitive XaaS (everything as-a-service) market is a difficult challenge. For every company in every situation of development, there are an infinite number of possible resource allocations that may drive growth and profitability; the key is finding the right profitable growth path for your business to help drive to Rule of 40 and beyond.
The experts in Alexander Group’s Technology practice can help get your company on the right path to profitable growth, irrespective of your current state. Contact us today to arrange a live briefing on how Alexander Group can help design the strategy, structure and management of your commercial organization to maximize your performance and valuation.