Venture capitalists have a simple method for determining whether to invest in a young SaaS start-up or to pass on the opportunity. Dubbed the Rule of 40, this calculation is a way of measuring revenue and profit growth in software companies (even if there are no profits yet). The math is easy. You take the annual revenue growth of a company as a percentage (say, 50% revenue growth) and add to that number the profit margin of the company (for instance, 10%). In this example, the hypothetical company would have a Rule of 40 score of 60, which is outstanding. A score of 40 or above constitutes a pass, while a score below 40 means the company fails the Rule of 40 test.
This model is very helpful for containing our exuberance. Growth investors have a tendency to get very excited when seeing impressive top-line growth. "Company X is growing at 100% a year. Wow!" And since growth investors are used to investing in unprofitable companies, it's easy to ignore the bottom line. That's a mistake. After all, some negative profit margins are far worse than others.
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