The Rule of 40 has provided a benchmark for high-tech and software executives and investors in assessing profitability and growth for more than a decade. The Rule of 40 score follows a simple formula that provides insight into the health of the company: Growth rate + profit/EBITDA margin.
A company may get to 40% in a variety of ways, whether it’s 20% growth and 20% profitability, or 0% growth and 40% EBITDA margin. That 40% baseline is something that software companies and investors are interested in.
An analysis of 75 high-tech and software companies in the S&P 500 found that those above the Rule of 40 line outperform their peers: On average, they deliver 1,300 basis points faster revenue growth, a 283% higher P/E ratio, and a 116% higher gross margin.
As investors have placed more emphasis on growth as a driver for valuation, the growth side has become more heavily weighted into the equation, requiring high-tech and software companies of all maturity levels to find solutions that drive growth. We suggest these areas to help continue driving the growth side of the Rule of 40 equation and to better monitor SaaS performance.
Recurring revenue streams have a substantially higher impact—sometimes up to 8x—on valuation than traditional product or license sales. In addition to providing more predictable revenue, subscription-based models offer benefits that customers have not only come to love but also expect.
More companies are being born in the cloud, but there are still many at some stage of migrating to a SaaS or a subscription model, and many PE firms are driving their portfolio companies to move toward recurring revenue streams.
Corporations also are embracing this model—albeit slower—because their focus on near-term financial results and shareholder expectations and limiting disruptions to existing customers can make it more difficult to navigate the organizational, operational, financial, and technical changes necessary to make the shift.
This shift is also not limited to just software. We are increasingly seeing hardware and product companies—such as storage devices and routers—adopting subscription models, capitalizing on the software and solutions in the “box” versus the box itself as the revenue stream.
SaaS transformation is a multi-year journey that involves organization-wide change. In our work with companies that have successfully made the transition to a SaaS model, we have found it important to use an established SaaS transformation framework that guides the many aspects of change that must come together to enable success and accelerate the pace of change to realize the financial benefits—from adapting sales and go-to-market strategies, to retooling back-office capabilities, to updating financial planning.
Growth in today’s marketplace comes from both from having great products and also superior sales, services, and support processes that shape a positive customer experience. This requires sufficient focus on three areas:
Whereas past efforts emphasized making the sale, driving growth today depends on retaining, renewing, and expanding the customer relationship. This requires purposeful and proactive design of an experience that engages the customer throughout the lifecycle to drive renewal.
Specifically, engagement should promote customer success—helping the customer achieve business goals using the platform. Customer success is a proactive motion that emphasizes ways to deploy the solution effectively, increase user adoption, and realize value.
Shifting customers to new products, platforms, and delivery models requires thought, from both a system and data standpoint but also from a change management and experience standpoint. For established companies, the transition to a new subscription model will likely be gradual—with traditional and new models running in parallel.
Companies will need a purposeful plan for migrating each customer in order to maintain a positive experience while balancing the effort and impact necessary to migrate specific customers. Understanding the lifetime value of specific customers or cohorts is an important input in determining the appropriate strategy for migrating customers from legacy platforms and/or products, particularly when evaluating high-customized customer instances.
Software and high-tech firms are in the unique position of being a benchmark for consumer experience—meaning the market tends to hold this sector to the highest standards.
Moving to a model of continuous customer engagement and service, however, will require more customer and partner touchpoints than ever. This will quickly strain resources if not planned carefully. Organizations need to harness the pandemic-driven digital momentum to drive growth and lifetime value without adding cost. As you plan for engaging customers across the lifecycle, consider ways to use digital automation during selling, implementation, and ongoing support and services.
Leveraging customer usage insights to tailor engagement during different points in their journey is critical to an enriched experience. Offering try-buy options, providing contextual self-help with sophisticated search, and fostering a thriving digital community can aid your sales, services, and operations functions, enabling them to maintain high engagement without substantial increases in resources.
One practical way to accelerate growth is through acquisition, which can expedite the move to a new model—for example, acquiring established SaaS capabilities rather than trying to develop them from scratch.
Few sectors have proven as resilient and relevant through the pandemic as high-tech and software, with greater deal value than any other industry in 2020. And our research indicates that the appetite has not diminished. In our report, High-Tech M&A Defies the Odds, 70% of respondents said they plan to acquire as many as two high-tech or software acquisitions over the coming 24 months, while 27% intend to make three or four such acquisitions.
Software acquisitions tend to move at a particularly fast pace. In our research, 77% of respondents said they expected post-close integration on their most recent deal to take a year or less. Having a well-defined strategy and integration plan is critical to realizing full potential. Capitalizing on the full potential of acquisitions requires both operational integration as well as having a strategy for product and platform rationalization that factors in market analysis, customer analysis, and a deep understanding of the underlying technologies.
Planning isn’t where it ends, but it does set the foundation for effectively executing on all aspects of the integration and go-forward strategy.
Artificial intelligence (AI) and machine learning are poised to be differentiators in this sector, delivering an inside-out look at large volumes of historical data to enable timely decisions and actions.
Revenue and growth potential can be hard to predict with confidence—particularly in an evolving market and an environment where customer behaviors have been forever changed by the pandemic. Large-scale engineering, statistics, and machine learning tools can analyze billions of transactional, product, service, and channel data points in order to predict areas such as behavior, growth from new customers, retention rates from individual customers, spending level by customer, or lifetime value by customer segment.
Such analysis can benchmark white space opportunities and pinpoint targets for both corrective action (e.g., revenue leakage from too much focus on unprofitable customers), and surface areas of greatest growth potential (e.g., new revenue streams or via cross-selling).
To illustrate what’s possible, one software company recently wanted to answer several key questions: What is our cross-selling opportunity? How much opportunity to we have to upgrade existing customers? How great is our risk of customer churn? Which of these areas is the fastest/best way to grow revenue in the short term? Data science models and machine learning enabled us to provide answers in just weeks. Our analysis revealed $1.1 billion cross-selling opportunity in the first two years, $52 million in upgrade potential from existing customers, and $71 million in churn risk that the company could then act to mitigate.
Achieving rapid growth hinges on continuous product innovation and effective partnering within the organization. But the talent and skills on which today’s software organizations rely to drive growth is increasingly scarce—and the shortage has grown throughout the pandemic as demand for digital capabilities increased.
Retaining top talent in a hot job market is critical. Companies are emphasizing a differentiated employee experience, monitoring employee fulfillment, adding new flexible work arrangements, and taking important steps towards inclusion and diversity.
In today’s software market, contingent labor and outsourcing have become as much growth drivers as they are cost-saving mechanisms. Shifting the mentality from cost-savings to growth emphasizes the need to have a well-defined mechanism to optimize this talent source. We see opportunities for high-tech companies from mid-size to the largest technology companies in the world to optimize profitability and enable new growth areas by strategically using contingent workers and outsourcing.
The Rule of 40 remains top of mind, and for good reason. It keeps the focus squarely on value creation and profitable performance. But as the industry evolves and companies mature, guiding growth becomes more challenging. Applying the principles above not only will elevate your growth potential; it will help create a solid foundation for growing the right way.