As we closed out the prior year and got started on the year ahead we’ve made a switch in our financial strategy. Growth has traditionally been the core focus of our business (not just revenue growth, but the growth of our teams). A core focus on growth is key in the earlier stages of startups to prove product-market fit, but once the company reaches a more mature stage it’s important to sustain growth and reach profitability.
I see too many companies focus all of their energies on growth in an effort to chase valuations. I will say this strategy works only up to a certain point. Once valuations are attained and capital has been raised the company has a fiduciary responsibility to return this capital to its investors. This is where we turn to a beautiful metric called the rule of 40.
The rule of 40 is a great health measurement that accurately depicts the companies ability to properly balance the trade-off between short-term investments in growth and long-term profitability. Good to great tech companies have the ability to consistently outperform the rule of 40 and capture what most believe to be the “upper-echelon” of exit multiples. To calculate the rule of 40 you add your revenue growth rate with your profit margin and if it’s greater than 40 you are in great shape. For example, Company A has a year-over-year growth rate of 30% and a profit margin of 25%. This means that Company A has a 55 on the rule of 40 (30%+25%). It is a super simple calculation, but it is so powerful to understand and manage venture-backed tech companies with.