estate planning | insurance | investing | portfolio spotlight | real estate | retirement | technology | yOUR BUSIneSS
Understanding The Rule Of 40 %
The Rule of 40 % is a solid way to think about the mix between the growth and profitability of your business . By Steve Sanduski
IN ThE SAAS ( SOFTWARE AS A SERvIcE ) BUSINESS WORld , there ’ s something called “ The Rule of 40 %.” It says that to run a healthy business , your year-over-year monthly growth rate plus your profit margin should add up to 40 %.
For example , if your June revenue growth rate was 10 % above June one year ago , and your June profit margin was 30 %, then you hit the 40 % target . You can then play with various rates of growth and profit margins to hit ( or exceed ) the 40 % target .
For additional context , we can instead use this calculation with the trailing-12-month growth rate and compare it with the trailing 12 months ’ profit margin from the previous year . By doing both calculations ( both trailing 12 months and the year over year ), you get a read on whether your Rule of 40 % is accelerating or slowing down . Ideally , you want to see your current month year-over-year percentage higher than the trailing 12 months ’ percentage .
Within limits , outside investors will highly value a business with low ( or , in certain cases , negative ) profit margins if those are accompanied by high growth rates — as long as they still add up to at least 40 % when combined . Similarly , high profit margins with lower growth rates will also be valued — again , as long as they add up to 40 %.
But if you ’ re looking to maximize value , err on the side of faster growth and lower margins .
Does The Rule Apply To Advisory Firms ?
Turns out that the 40 % rule applies very well to our industry , too . But we arrive at the figure in a different way .
SaaS firms tend to grow much faster than advisory firms but have lower profit margins ( at least in the early years ). Advisories generally grow rather slowly but often have very high profit margins . Either way , the 40 % number works for both industries .
You can apply the rule as a guide when making strategic decisions about structuring your business .
Strategically Using The Rule Of 40 %
I recently reviewed the latest benchmarking data from Schwab and Fidelity , and here ’ s what they show for advisory firms with at least $ 250 million in assets under management :
• Net organic growth in AUM ( which excludes market movement and acquisitions ) has averaged approximately 5.5 % compounded per year for the last five years ended in 2020 .
• Revenue growth has averaged approximately 7.5 % compounded per year for the five years ended 2020 .
• Operating profit margin ( total revenue minus all expenses , including owner pay at “ replacement cost ”
september 2022 | financial advisor magazine | 27