Annual recurring revenue (ARR) growth: This measure reflects a company’s ability to drive topline growth, crucial for Rule of 40 performance since revenue lags behind ARR for SaaS companies (the median for top-quartile SaaS companies is 45 percent bottom quartile is 14 percent).These are the measures that companies should track. Of the roughly 20 operational metrics we assessed for SaaS companies, four have a high correlation with enterprise value to revenue multiples (exhibit).
#Time and expense software
Analysis of more than 200 software companies of various sizes between 20 found that businesses exceeded Rule of 40 performance only 16 percent of the time. But McKinsey research finds that barely one-third of software companies achieve the Rule of 40. The rule has become a favorite of SaaS industry watchers, including boards and management teams, because it neatly distills a company’s operating performance into one number.
#Time and expense free
The popular metric says that a SaaS company’s growth rate when added to its free cash flow rate should equal 40 percent or higher. How well leaders do in balancing these demands is where the “Rule of 40” comes into play. Knowing which levers to pull and which targets to aim for is especially important in SaaS because of the lag between bookings and revenues, the upfront expense of acquiring customers, and the constant rate of R&D spend required to keep features and products current. Spending needs to align with realistic growth forecasts, and growth from existing customers driven by customer retention, cross-sell, and upsell takes on greater significance. However, the 100 companies we analyzed had a median last 12 months (LTM) free cash flow of just 10 percent of revenue. In fact, of 100 public SaaS companies in the United States with revenues above $100 million that we analyzed in May 2021, the median revenue growth rate was just 22 percent.Īs businesses near the top of their initial S-curve, revenue growth tends to slow and free cash flow becomes more important. Despite the sector’s image as a bastion of hypergrowth, only a small share of SaaS companies sustains growth rates above 30 to 40 percent. That’s especially true for software as a service (SaaS). The purest test of a management team and its operational discipline is arguably how well it can maintain strong shareholder returns as the business matures.
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