The Rule of 100
A few years ago, I came across the Rule of 40 – the principle that for a software company, it’s revenue growth rate and profit margin should exceed 40%. Here is what it means in practice:
- If a business is growing at 100%, it can have a profit margin of -60%
- If a business is growing at 60%, the profit margin can be -20%
- If a business is growing at 20%, the profit margin should be +20%
Bain has more on the Rule of 40:
The Rule of 40…has gained momentum as a high-level gauge of performance for software businesses in recent years, especially in the realms of venture capital and growth equity. Increasingly, software industry executives are embracing the Rule of 40 as an important metric to help measure the trade-offs of balancing growth and profitability.
Software companies that can balance growth and profitability to outperform the Rule of 40 have valuations (measured by the ratio of enterprise value to revenue) double that of companies that fall “below the line,” and they achieve returns as much as 15% higher than the S&P 500. Companies whose growth slows and that fail to improve profitability often find themselves the target of activist investors and private equity acquirers.
I was thinking recently about proficorns, the profits generated and the trade-offs between profits and growth. What is a good-sized proficorn? Since proficorns do not have external investors, there is no benchmark valuation being set. How can proficorn entrepreneur’s benchmark themselves?
While my approach is not scientific or backed up by a study of proficorns, I came up with two key metrics:
- Profits (EBIDTA): this is important because it can measure the cash being generated each year. Profits are the oxygen for a proficorn’s growth, since there is no external capital. Profits help the entrepreneur invest in new areas, expand geographies or even acquire other businesses. Profit after tax (PAT) can have many other accounting elements factored in, so EBIDTA is a better metric to use. For our purposes, we can measure EBIDTA in millions of dollars. If the entrepreneur chooses, one-off investments / gains / write-offs can be excluded from this number.
- EBIDTA Growth percentage: Stagnation can be the death knell for a business. So, growth is important, especially in tech. Measuring growth in EBIDTA gives a glimpse into the future health of the business.
So, take these two numbers (EBIDTA in millions of dollars and EBIDTA percentage growth) and multiply them. The first goal for an entrepreneur should be to get the result to be more than 100 – for the business to have a healthy valuation (let’s say, $100 million or more). Thus, if a business is generating $5 million EBIDTA, it must have a growth rate of 20% or more to get a valuation of $100 million or more. If the business is generating $10 million in EBIDTA, growth can be lower at 10% to achieve the same benchmark valuation.
Admittedly, this is not backed by deep analysis – it is just a simple rule of 100 to guide entrepreneurs towards the magic marker of crossing $100 million in valuation. In today’s world, growth is being valued even more highly. But in my thinking, growth cannot come at the cost of profits. The Rule of 100 can help proficorn entrepreneurs balance the two – ensure the right mix of cash generation to invest in the future, and maintain a steady growth trajectory.
Tomorrow: Part 63