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This article was featured in Pitchbook's 2023 Annual US PE Middle Market Report.
Unpacking the Rule of 40: The real levers for SaaS companies to consistently outperform this elusive metric.
At
Stax, we work on hundreds of deals and PE-owned portfolio companies annually, spanning all sectors of the
software-as-a-service (SaaS) landscape. Recently, a leading large-cap software sponsor remarked to us that, even after decades of investing through various economic cycles, the Rule of 40 is still the dominant lens with which they assess the health and investment potential of new platforms. This metric, widely regarded in SaaS circles, combines year-over-year top-line revenue growth with EBITDA margin performance and remains a fundamental measure strongly correlated with
sustained value creation.
A recent analysis of publicly traded SaaS companies revealed that the valuation multiples for the highest quartile of Rule of 40 performers were nearly three times that of bottom-quartile
performers1. Given that publicly traded companies reflect only the most successful of SaaS companies, the valuation premium for high performance across the entire population of SaaS companies is undoubtedly much higher. Rule of 40 stalwarts represent an exclusive club. According to our estimates, less than 40% of SaaS companies have achieved the Rule of 40, and less than 20% are able to consistently achieve the Rule of 40 over a three-to-five-year period
What makes achieving the Rule of 40 consistently so hard? The metric elegantly encapsulates the difficult journey of balancing profitable growth from startup to maturity. The reality is that all leading high-growth companies eventually face a slowdown, reaching a point where operational profitability becomes a priority to ensure stability and fund future growth. Conversely, mature software firms may have attained efficient scale to generate highly profitable operating margins but encounter difficulties in sustaining high top-line growth.
At Stax, our experience provides insight into the primary levers of high Rule of 40 performers. Here is what matters with these top firms:
1. A compelling and expansive vision lifts the ceiling for faster addressable growth
PE investors utilize total addressable market (TAM) as an evaluative indicator to assess an asset’s potential for achieving high growth rates over an expected investment horizon. A well-performing SaaS company in its earlier stages, with ample strategic runway to expand, typically possesses a TAM that is at least 10 times its current revenue. This reflects a robust market environment capable of sustaining high growth rates against competitors. However, as these early-stage companies mature, maintaining accelerated growth becomes increasingly challenging. Competitive market spaces with healthy profitability often attract strong competition, particularly from well-funded incumbents in adjacent spaces (such as broader enterprise resource planning platforms that encroach on point solutions).
Converting late adopters to innovative offerings becomes more arduous and expensive with longer selling cycles.
Many former Rule of 40 winners have stumbled upon the peak of the S-curve, facing stalled adoption. The most successful companies anticipate and strategically maneuver to adapt and expand their products and services to adjacent markets. By leveraging their leadership in one market, they can accelerate adoption among the early majority in others.
Motive, a high-growth leader in telematics and fleet management, is considered a Rule of 40 stalwart, growing to over 100,000 customers in its first decade of operations. Formerly known as KeepTruckin, Motive rightfully foresaw the limitations of expanding solely within the trucking industry and redefined its sandbox as the much broader physical asset and equipment supply chain across most industrial sectors. The company’s most recent funding round (a Series F with $150 million in new capital) reflects a healthy investor response to a more expansive growth vision that has already borne success in new verticals such as agriculture and oil & gas.
2. Mastering the cross-sell fallacy
The primary strategic pitfall we often encounter across the hundreds of SaaS platforms we evaluate is the fallacy of the “synergy cross-sell.” With the prevalence of buy-and-build strategies to expand SaaS platforms, numerous companies pin their future growth on leveraging existing customers and upselling them with newly acquired products. Yet, for every long-term Rule of 40 winner (with Oracle as the long-standing Hall of Famer for growth through acquisition), we observe many platform expansions that struggle to fulfill their investment thesis. This is because a “superficial” combination across products, despite being rebranded under a single company logo and sold by a unified commercial organization, often fails to create genuine customer value.
At Stax, we evaluate true cross-sell potential under only two measurable and identifiable scenarios. The first is the commonality of the buyer. Trust, track record, and a “perceived or real switching cost” can be utilized to sell an additional product or module to fulfill the supplementary requirements of a common buyer. In this scenario, an acquisition typically offers a faster and higher return than new internal product development options.
Second, when buyers are different and the combined modules span a broader set of customer needs, the integrated offering must not only deliver tangible benefits across the expanded buyer base but also anchor to a leading platform within a key workflow. Think Adobe, Workday, and Salesforce. The ability to cross-sell based on the integration of features and functions into the anchor becomes the dominant selling point.
ZoomInfo, another long-standing Rule of 40 winner, holds the position as the leading provider of prospecting intelligence for commercial (sales and marketing) organizations of all sizes. Initially focusing on accurate business and contact information for millions of businesses, sold primarily to sales leaders, its value proposition has evolved into a multiplatform revenue operations solution spanning a company’s entire go-to-market strategy. The key lies in fully integrating acquired functionality to create additional benefits for new buyers. When ZoomInfo obtained account-based marketing (ABM) capabilities (including tracking website visits via IP addresses to identify purchase intent), it seamlessly integrated ABM functionality into business-profiling data and analytics. This integration enabled users to effortlessly create priority lead triggers based on purchase intent or build tailored lists for audience-specific campaigns. What ZoomInfo got right was a heightened value proposition across both sales and marketing leaders while effectively monetizing ABM through a more holistic, integrated offering that stands out from competitors.
3. The innovation-driven, productivity-led operating model
Efficiently managing top-line growth requires balancing investments for growth while simultaneously demonstrating EBITDA expansion. The Rule of 40 weeds out companies unable to drive higher operating profitability through efficient scaling and flexibility during periods of slower or fluctuating demand. High growth is often not linear. Leading companies establish lean, flexible operating models that can rapidly adjust the cost base for consistent EBITDA achievement under all demand conditions.
In this vein, we also observe a new breed of Rule of 40 SaaS leaders that are beginning to deploy generative AI (GenAI) across functions, particularly within development operations. These innovators have moved beyond the hype cycle and are now scaling successful pilots into industrialized methods. The benefits—enhancing developer productivity by an estimated 20% to 50%, while significantly improving productivity for both low-code and high-code tasks—are significant 2 . The most impactful benefit may be more intangible: developer satisfaction. By automating manual, mundane, and repetitive coding tasks through GenAI, developers become more productive and challenged, fostering greater innovation for the continual release of great products.
Consistently meeting the Rule of 40 is undoubtedly challenging but achievable. Winners take many shapes but share a commonality in combining strategic vision with expansion driven by real innovation.
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