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.

Check out First Analysis’s research where in 2018 they found that growth showed a higher correlation to public market valuation that even their weighted rule of 40 metric