Rule Of 40 Saas Free Cash Flow

The idea is that growth plus profitability should be 40 or greater once at scale (double digit millions of revenue).

As an example, if a SaaS company grew 100 year-over-year, and had negative margins of 60 (burning lots of cash), then those combined percentages equal 40 (yes, theyre two different percentages, but the metric is more of a gauge rather than scientific).

As for another example, if a SaaS company grew 20 year-over-year, and had EBITDA (profit) margins of 20, then those combined percentages equal 40, and hit the mark.

The Rule of 40 for SaaS companies provides a general metric that takes into account both growth and profitability.

Also, there could be technology differences as well that cause more efficiencies in datacenters as well as potentially Fastly being subscale compared to its steady-state so theyre not leveraging their COGS as much as they potentially will in the future (meaning 58 gross margins are lower than they expect to be at eventually).

Rule Of 40 Saas Free Cash Flow

Similarly, investors fall into the shorthand of using multiples whether revenue multiples, gross profit, EBITDA, or free cash flow (FCF) multiples.

Shorthands are only useful if you fully understand the underlying business and its associated economics.

It times of FOMO when an asset class performs uniformly well (similar to what weve had with the majority of SaaS companies recently), investors broadly tend to move away from actually valuing companies and instead use shorthand relative comparisons to arrive at what is thought of as an appropriate valuation based on other companies.

If youd like to read more about business models or qualitative factors of business analysis, please read the post embedded below.

This blog post will be more focused on the quantitative side of things.

Recently, Ive seen a bunch of investors putting charts together of all the SaaS companies and plotting them against the Rule of 40.

As a reminder, the Rule of 40 means that when a company is growing revenue 0 YoY, it will have 40 FCF margins.

But lets dig deeper into what this shorthand rule implies.

FCF margins are a huge number.

Theres not many companies out there who have those kind of margins currently.

These are best of breed companies at massive scale that have huge competitive advantages.

Below is a typical chart that I see nowadays comparing the Rule of 40 across a variety of companies.

If you are interested in SaaS, I highly encourage you to follow Daves blog posts.

Again I think this is super useful especially to broadly compare across a number of different companies.

The rule of 40 is great for companies with high gross margins lets say in the 75-85 range.

But if you have higher gross margins than that perhaps a rule of 45 or 50 would be better.

If you have lower gross margins, perhaps you should be following a rule of 20 or 30.

Its also important to look at how gross margins are calculated especially with freemium businesses these days.

Some companies classify freemium costs in SM while others classify them in gross margins.

I have to give a shoutout to nongaap on Twitter for helping me think through this one.

So heres Cloudflares S-1: The key point above is that bandwidth and co-location costs for free customers is included as SM expense.

Cloudflares gross margins are reported as 78 but is it an apples to apples comparison with other companies Lets examine Fastlys S-1 to see if theres clues: Here we can see that Fastly doesnt split freemium customers bandwidth and co-location costs between cost of good sold and SM.

Meanwhile, Fastlys gross margins are reported in the 58 range.

There are a variety of factors that could be attributed to the difference here.

Gross margins in infrastructure benefit from scale as more volume allows you to spread costs over a wider customer base and also have more bargaining power with suppliers.