Growth vs Profit: Using the Rule of 40 to Drive Sustainable Growth
New year, new budgets! I was sitting in a Board meeting a couple of weeks ago as the CEO was presenting the budget. They presented a high growth plan that required a lot of investment and would have led to the company burning a lot of capital. Different Board members were trying to discourage the adoption of a plan which called for — in their eyes — a crazy level of spend. Those concerns made no sense whatsoever to the CEO, saying:
“What was the point of raising the large sum of money that he’d recently taken in if we weren’t going to use it?”
It was pointed out that the valuation on the last funding round was set as a multiple of the businesses annual recurring revenue (ARR), the burn rate did not impact the valuation at all. The logical conclusion taken by the CEO was that surely to generate value, the focus should be on growing the only KPI that had any impact on the valuation, namely revenue.
I suggested that we should use the Rule of 40 (R40) as a way to evaluate the plan that he was setting out.
R40 has emerged over the past couple of years as a pretty standard metric for evaluating growth stage SaaS businesses. It states that if we add the growth rate of a growth business to the profit margin of that business and the sum is 40% or above then the company is a great SaaS business. For the uninitiated, here are some links to basic primers on the rule of 40. This metric is actually a method of balancing growth and profitability, and helping management understand when to switch their focus to profitability. Does that mean growth and profitability are equally valuable targets? I think not.
I do not understand the rule to imply that growth and EBITDA are of equal value. The markets clearly reward growth more than EBITDA. The market is basically arguing that Business A which is growing at 80% a year with negative 40% EBITDA margins is worth far more than Business B, which is of equal size, making 40% EBITDA margins but is not growing. The reason for this is simple. If we assume that both businesses can potentially reach 40% EBITDA margins in a steady state, it would be better to grow as much as possible before turning the profitability switch.
In this example, each year potential EBITDA earnings at Business A are growing at 80%! The public markets also reward growth more than profitability and indeed the correlation between R40 and enterprise value is actually lower than the correlation between growth rate and company value. So the conclusion that my CEO drew is the logical one to draw, growth is king and maybe keep an eye on your R40 as a type of sanity check.
We’ve had the fortune to work with many great CEOs who have built massive businesses but have done so without taking their businesses into the red. They have optimised growth while trying to remain approximately breakeven. There is a perception that this leads to ‘small outcomes’ but that has not been our experience. Companies like iCims, Credit Karma and Payoneer have all grown without losing much or any money and have achieved valuations greater than a billion dollars.
Here are 3 reasons why I think breakeven has proved to be a happy place for many of our companies:
1. Ownership
Growth at any cost necessarily relies on raising a ton of capital to fund growth. All of that fundraising leads to significant dilution. As a result, while the eventual total value of the business might be higher due to the growth, after dilution the actual value per share of the business ultimately owned by the founders and the employees is often lower.
We’ve seen entrepreneurs sell their business for $500M and be acclaimed as “rock stars”, which they indeed are, given how difficult it is to get to such lofty values. However, by the time they have achieved an exit they might only own 10% of the business or even less. And we’ve seen more humble entrepreneurs bootstrap their businesses to $100M exits with no venture funding or dilution. and own 80%+ of the business at exit.
The financial press describes each fundraising as if it’s a victory and an achievement when at its core it just represents the transfer of ownership from entrepreneurs and employees to investors. A focus on the value of growth may be popular among investors because it creates conditions where more companies are raising more money. However the result is that more and more entrepreneurs are arriving at the exit owning less and less of their companies
2. Financing Risk
While ‘growth at any cost’ may be an optimised strategy for a financial investor with a portfolio of companies, the increased velocity can also increase the risk of companies blowing up and going out of business. For an entrepreneur with a portfolio of one, this should be a significant factor to consider. A high burn rate means that if something goes wrong the company has limited time to react and course correct. Some people will argue that if the company can’t raise funds, it can’t be a good company; but often the issue may be both sudden and temporary. Given enough time, the company might have pivoted and recovered, but due to cash burn, the company doesn’t have the time to do so.
Companies can fail to raise money due to short term downturns in the financial markets, a lawsuit, a Google penalty, three competitors announcing funding a week before launching a new funding round, a data breach, or any number of unpredictable events. When you are breakeven you have options and time to fix things. When you are losing money, a delayed funding round can kill you. For the investor with a portfolio of companies, this might not be the end of the world but for an entrepreneur this can be a disaster.
3 ‘We can go profitable whenever we want’
If I had a penny for every time an entrepreneur has said something along these lines, I’d have a lot of pennies! And yet when entrepreneurs are faced with the real-world implications behind that sentence, a lot of them decide it’s not for them. Getting profitable means changing company culture: going to fewer conferences, flying economy, staying in cheaper hotels, downsizing and firing employees. No longer can your company afford to hire the A+ player with tons of charisma, but you need to find a ‘bargain or someone with potential’.
Lots of folks quickly discover that they don’t want to stop being the coolest company in town to work for. They don’t want to pack away the pool table and fire the masseur. It’s always hard to cut back, much harder than it is to just avoid wastage in the first place. I also believe that being profitable pushes companies to be better and more efficient. You have to make choices and be thoughtful, innovative and strategic. A high burn can cover many sins. Focusing on breakeven leads to a laser sharp focus on efficiency.
So am I saying this is the only way to go? No. But there is a perception in our industry that the only way to build a significant business is GBGH: Go Big or Go Home. We’ve got a portfolio of outstanding high growth companies that is proving that there is a different way: SLATD — Stay Lean, Achieve The Dream!
Jonathan Klahr is a partner at SGE (Susquehanna Growth Equity), an Evergreen fund that invests for the long term outside of the usual private equity fund dynamics of 5–7 year returns.
