The Rule of Negative 40

As you start to truly scale your software startup, you’ll probably start to hear investors talk about the Rule of 40.

Simply put, you take you growth rate and subtract your EBITDA margin. If it’s above 40%, you’re in good shape. If it’s below 40%, you should start figuring out how to cut costs.

For example, if you’re at $5m in revenue and growing 100% (expecting to hit $10m in revenue next year) but losing $6m in the process (negative 60% EBITDA margin), you’re okay. Lose any more than that, and you’ve got to dial back on spending. Here’s a recent post with some great charts looking at how public SaaS companies conform to the Rule of 40 from the smart folks at Volition Capital: 

The Rule of 40 is wrong for fast growing companies

My guess is the Rule of 40 comes from the fact that a mature software company should expect 20% EBITDA margins and likely will be growing 10% (which would equal 30% combined number for the Rule of 40), and because investors always want to push you, that becomes 40.

However, as long as you are burning money to drive growth, the Rule of Negative 40 is a much better metric.

Here’s why:

For every dollar of additional revenue, you are adding, at a minimum, 6x that in additional company enterprise value, given the low end of SaaS valuations. If you go from $10m in revenue to $20m in revenue, your valuation, theoretically, goes up from $60m to $120m. You should be willing to spend up to $60m to add that $10m in revenue. With the Rule of Negative 40, you’d be willing to have a -140% EBITDA margin to support 100% growth, or in this case, burn $14m. That’s still over a 3x return on the $14m investment ($60m gain in value for $14m of spend).

There’s one caveat:

The rest of your P&L needs to be at the right ratios.

If you’re overspending on G&A (office space, free lunch, HR, execs, etc) or your gross margin isn’t 75-80% or anything else is structurally unsound, the theory goes out the door because you aren’t able to cut your way to 20% EBITDA margins if you wanted to stop growth but improve margin.

I’ve put together a quick spreadsheet to demonstrate this, if you want to make a copy and play around:

Note, there are obviously plenty of other factors that play into why you might want to be more conservative with your burn relative to your growth, including, most importantly, your ability to raise the capital needed to fund that growth.

Would love to hear your thoughts on the new Rule of Negative 40!

Why You Need to Have a Billion Dollar Idea to Raise Venture Capital

I remember in the early days of Beyond Pricing, I always hated when a VC would focus on how we could become a unicorn.

We had a great idea, the market needed it, and we were growing! Heck, we probably had product market fit! Why wouldn’t you invest us!

Turns out, there’s some pretty basic math behind why a venture capitalist needs to hear a plausible story about how, in ten year’s time, your company could be worth $1 billion.

Venture Capital is an Asset Class

The first thing to recognize is that a venture capital fund, to those who invest in it (LPs), is just one of many other funds or other places to invest. These LPs can be university endowments, family offices, wealthy individuals. But they are all measuring the venture fund based on its returns compared to other places they could put their money. A very common benchmark is what you could make by just putting your money in an S&P 500 index fund. While that varies from year-to-year, the long-term averages is around 8% annual return.

So if you’re going to invest in a venture fund, which is inherently more risky than the S&P, you’re going to hope to get a decent premium to that 8%. By most standards, a decent VC annual return is 10% after fees, or 12% before the standard 2% annual fee VCs charge LPs. Moreover, the average fund will last 10 years. A little bit of simple math shows that the total amount of cash returned to the investors after 10 years needs to be over 3x the invested capital to hit that annual return target (1.12^10=3.1x). So a $100m fund needs to return $300m to make its investors a small premium over the S&P to account for A LOT more risk.

There’s been a lot written about VC math here and here but you can see both in the examples in those posts and in this spreadsheet which you can download and play around with, there’s almost no reasonable way to get to 3x without at least one $1 billion company in your portfolio as a seed investor. And if a fund can’t get to 3x, the investors were likely better putting their money in the S&P.

(Note: all of these analyses are oversimplified back of the envelopes and don’t model out the full impact of dilution and many other things that move the needle slightly one way or another)

With a fund with 20 companies (which is fairly typical), you would need two companies to sell for $300m, three for $100m, and four for $50m (along with some smaller exists or returns of capital, though that doesn’t affect the outcome much). Nearly 50% of your portfolio would need to sell for $50m or more. The actual average is closer to 10%.

A more likely (and still unlikely given the low percentage of VC funds that actually hit a 3x return) scenario if you’re lucky is to have a single unicorn, one that sells for $100m, and two that sell for $50m. In that scenario, over 75% of your returns are from the unicorn (which matches the general power law in venture capital)

So How Do You Show You Could Be Worth $1 Billion?

This is where TAM (total addressable market) comes in and why it matters. Basically, you’re trying to show, if everyone bought your product, how much revenue would that be. Then make some sort of assumption about what a reasonable market share would be (reasonable being the operative word; you should know what market share the most successful company in your space has and don’t assume anything more than that or risk losing credibility).

For instance, for Beyond Pricing we showed that globally, vacation rentals do about $180 billion annual in revenue. We charged 1% of revenue for our product. So our addressable (for our first product) was $1.8 billion. Given our first-move advantage, the tendency for vertical software products to achieve much higher market share than horizontal products, and the lack of well-funded competitors, we thought 10% market share was (justifiably) reasonable (and probably low). That would come out to a path to $180m in annual revenue.

You basically need to answer the question the VC has around what they need to believe for you to get to a certain amount of revenue. If they believe that’s doable, you’re in business!

The final question is, what amount of revenue equals a billion dollar company. I’ve written a bit about that before, but the key is knowing what the typical price-to-sales ratio is for your industry. In software, depending on your growth rate, that’s typically 6-10x revenue. If you’re building a venture-backed, billion dollar company, you’re probably growing on the fast end, so a 10x revenue multiple is reasonable, meaning you need to show a believable path to $100m in revenue.

That’s the magic number you’ll often hear a VC ask you.

What if there’s not a clear path to $100m in revenue?

If you can’t show that path, you probably have a really nice business but shouldn’t take on venture capital. There’s plenty of other ways to fund your business, but, as you can see from the math, venture capital just doesn’t make sense.

A Back of the Envelope Guide to Estimating Any Software Company’s Revenue (+ Growth)

As I was building Beyond Pricing, very early on we wanted to focus on building a company based on the right ratios.

One of the best ratios I came across was the revenue per employee.

This is a great measure of how efficient you are. Both Tom Tunguz and Jason Lemkin have written great posts about this.

The main takeaway is you should target $200k revenue per employee.

Fast growing companies who are burning capital might dip down to $100k revenue per employee, but anything below that is likely not going anywhere fast and will soon run out of money.

So how do you estimate a software company’s revenue? Multiply employees by $100-200k.

Typically, the more mature the company, the closer to $200k they will be. This isn’t always the case (we definitely bucked that trend at Beyond Pricing).

Let’s look at a couple examples, using LinkedIn.

Braze has around 500 employees. They’ve been around a while, so are likely closer to $200k per employee, which would mean $100m ARR.

Source: LinkedIn

And look at that. That’s exactly what they’re at:

Looker as around 900 employees. We’d expect them to have around $180m ARR if they were at $200k revenue per employee.

About a year ago, based on employee growth rates, they had around 650 employees. Back then, they claimed to have $100m ARR. That puts them right around $150k revenue per employee, right in the middle of our range. If we use that number to update our estimate, they’d be at $135m ARR, right around the $140m Cowen estimates.

One final example with a disclosure that I know the founders but don’t actually know their revenue. Clubhouse recently raised a Series B and has around 50 employees. I’m going to guess their ARR is right around $5m.

This is further supported by a couple posts about average ARR for different rounds (here and here). tldr; Series A: $1-2m, Series B: ~$5m. I’ll let Kurt and team confirm or deny 🙂

As far as growth, in general, I’ve found revenue growth to typical be 50-100% higher than the employee growth shown on LinkedIn. For instance, looker had employee growth of around 40% according to Linkedin from 2018-2019 but they reported 70% ARR growth. This more or less matches what I saw at Beyond Pricing as well.

By the way, this is often what analysts at venture capital and private equity firms are looking at. So don’t be surprised when your employee growth rate is above 50% (meaning you’re likely 2x-ing or more) and your employee count is approaching 50 to get those calls from Series B investors. I know we did!

A final note: this is only for US-based software companies. They don’t really apply in other countries where labor is much cheaper or other industries, where average wages are much lower.