One of the hot topics right now among venture-backed entrepreneurs is the trade-off between growth and cash burn. Growth is being challenged due to higher churn from tech layoffs (startups often sell to other tech companies) and uncertainty in the economy. Views on cash burn have changed dramatically due to much lower public market valuations and a higher cost of capital from alternative sources like venture debt.
In order to balance growth against cash burn (or profitability!), the Rule of 40 was created. The Rule of 40 is a score defined as the growth rate over the last 12 months plus the free cash flow (FCF) margin over the last twelve months. As a simple example, if the business grew 30% and had 10% profit margins, it’d have a score of 40 (30 + 10), and would be considered great. While a basic methodology, it gives the entrepreneur a framework for analyzing trade-offs.
Last week Kyle Porter, founder of Salesloft, shared with me a more nuanced way to think about it. Instead of growth and free cash flow margins being exactly a percentage turned into a score, there should be a multiple modifier that represents market sentiment. Sometimes growth is more highly valued, like the last few years, and sometimes less valued, like today. This can be expressed as a multiplier to the score.
While there’s no exact formula, a multiplier example right now might be 1.25 growth and .75 FCF margins. So, growth is still favored over profitability, but it’s not as dramatic as two years ago when it was closer to 2.0 (or 10.0!) for growth and 0.0 for FCF margins.
Here’s an example:
$10 million SaaS startup
40% growth rate
-10% FCF margin
Basic Rule of 40 score: 30 (40 + -10)
Growth Multiplier Rule of 40 score: 42.5 ((40*1.25) + (-10*.75))
In the basic model, this startup would have a Rule of 40 score of 30, which is good, but not great. With the growth multiplier set to 1.25x to represent growth being somewhat more important than FCF margins, the startup gets a score of 42.5, which is great.
Entrepreneurs with a venture-backed startup should decide on a target Rule of 40 score that’s appropriate for their business and consider incorporating a growth multiplier that reflects the market.
Entrepreneur
via https://www.aiupnow.com
David Cummings, Khareem Sudlow
