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Lord of the Operating Models
The One Operating Model to Rule-of-40 Them All
“In the Land of Silicon where the S-curves lie. One operating model to rule-of-40 them all, one model to fundraise, one model to bring them all public, and in the GAAP accounting darkness bind them.” - Lord of the Operating Models
As markets sell-off and once high-flying tech companies reassess their go-forward operating plans, many are wrestling with their operating model.
Finding the “right” model for public company life isn’t easy nor straightforward, and the Rule-of-40 forebodingly stares back at them in Board decks as an easy stop-gap solution. Don’t cave into the temptation.
Silicon Valley’s (Non-GAAP) Rule-of-40 operating model must be destroyed to truly build for the long-term.
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Rule-of-40: A Simple and Effective Model
To be clear, I have nothing against the rule-of-40 itself. It’s actually a very simple and effective model:
“The 40% rule is that your growth rate + your profit should add up to 40%. So, if you are growing at 20%, you should be generating a profit of 20%. If you are growing at 40%, you should be generating a 0% profit. If you are growing at 50%, you can lose 10%. If you are doing better than the 40% rule, that’s awesome.” - Brad Feld (source)
When applied sensibly and appropriately, rule-of-40 offers operators and investors a quick “check” on the health of a SaaS company and the “reasonableness” of their profits (or losses) vs. growth, especially during the venture capital stages of the company’s lifecycle:
“I have never seen growth and profitability so nicely tied together in a simple rule like this. I’ve always felt intuitively that it’s OK to lose money if you are growing fast, and you must make money and increasing amounts of it as your growth slows. Now there’s a formula for that instinct. And I like that very much.” - Fred Wilson (source)
In some ways, rule-of-40 is the operator’s equivalent of a valuation multiple. It’s a shortcut that packages a lot of underlying assumptions and moving parts into a simple “big picture” score to quickly “evaluate” the company and guide decisions.
The Operating Model To Rule-of-40 Them All
The simplicity and comparability that Rule-of-40 offers has arguably made this rule of thumb THE operating model in SaaS.
Most companies have some variation of rule-of-40 and you’ll inevitably here an executive say, “Our operating model is to grow 15-20% with 20-25% operating margin.” Once you notice it, you’ll see it everywhere. It’s hard to escape.
Robert Smith of PE firm Vista Equity Partners famously said, “Software companies taste like chicken. They’re selling different products, but 80% of what they do is pretty much the same.”
Do software operating models “taste like [rule-of-40] chicken” too?
Given the wide range of industries, price points, go-to market strategies, and customers served by SaaS companies, you’d expect some variation in long-term operating models, and yet, “15-20% growth and 20-25% profit” is the one operating model to rule-of-40 them all.
Maybe, instead of “taste like chicken”, we should start saying operating models “taste like hotdog”. You can have a “wagyu beef” business, but it’s going to “taste like hotdog” after it gets thrown into the rule-of-40 meat grinder with a bunch of other mystery items.
A Capital Model Masquerading as an Operating Model?
Assuming Rule-of-40 operating models have little connection to the real long-term margin and growth opportunity of the underlying business, why do so many anchor/guide to it? Here’s my hot take…
The rule-of-40 is arguably a capital model masquerading as an operating model.
Rule-of-40’s true power and allure is its ability to harness capital markets and attract investors by offering a simple heuristic to remove complexity and add familiarity to assess and value a company.
It also gives permission and cover to do things that might not make sense from a business fundamentals perspective, but is justified - daresay necessary - through the lens of access-to-capital and valuation maximization.
This is why the incentive to embrace rule-of-40 is very high, especially in an up-cycle.
If your incremental annual recurring revenue (ARR) is worth $5 on a “bottoms-up” customer lifetime value (CLTV) basis, but the market is paying (let’s say) $40 for "premium" growth ARR, there's a ton of incentive/pressure to use something closer to $40 instead of $5 in your LTV/CAC math to meaningfully up your spend and pursue growth rates that put you in “premium” grower valuation territory. And if you don’t, a well-funded upstart would gladly pursue that “uneconomical” strategy.
So when I see companies put out a rule-of-40 operating model, it’s better to view it as directional guidance on near-term spending priorities, and not representative of the “real” long-term operating model for the underlying business.
A Slave to Rule-of-40
One of the more under appreciated risks of following Rule-of-40 is decision-making gets co-opted by external market forces. Spending end up more beholden to Rule-of-40 logic than the underlying business and their specific needs.
Personally, I find this amusing, because founders are given dual-class voting power to be long-term stewards of the company, and yet, end up being slaves to copy-and-paste operational thinking:
Gross Margin: 75-80%
Sales & Marketing: 24-30%
Research & Development: 18-20%
General & Administrative: 8-10%
Operating Margin: 20-25%
For as much as founders dislike MBA thinking, their operating models are ruled by the same spreadsheet.
Your Rule-of-40 Margin Is My SBC Opportunity
Rule-of-40 should be a useful operating heuristic, but stock-based compensation (SBC) has destroyed its usefulness in public markets.
What constitutes “profit” when calculating Rule-of-40 is quite contentious, but most companies either use non-GAAP operating (or EBITDA) margin (which excludes meaningful SBC) or FCF margin (which includes meaningful SBC).
Neither choice properly represents the true economic margins of the business, and markets aren’t dumb to this (in my opinion). Operating the business on non-GAAP Rule-of-40 creates a lot more volatility and sensitivity to growth. It’s great during an up-cycle, but can get existential on a down-cycle.
When you see company guiding an operating model that’s 15-25% growth, 20%+ non-GAAP operating margin, and 15-20% SBC, they’re effectively guiding a future restructuring if they can’t outperform the targeted growth target:
Note: It’s not my intention to pick on this company. Their operating model is representative of many.
In my opinion, the non-GAAP Rule-of-40 operating model doesn’t work unless the market believes the business can grow 30-40% to support SBC costs. I suspect most companies are spending for 30-40% growth anyway, but aren’t willing to publicly commit to that growth target (and be accountable to it). This creates an air pocket where a company’s Rule-of-40 operating model is essentially guiding value destruction if it’s to be believed.
Now, if a strong growth trajectory isn’t realistic, non-GAAP operating margin needs to be closer to 30-35% with SBC meaningfully cut to achieve an “economic-reality adjusted” Rule-of-40. Basically, a restructuring needs to happen or strategic alternatives is initiated with the acquirer doing the restructuring (with selling executives benefitting from accelerated vesting termination due to change-of-control and the relief of not restructuring in public).
That said, I don’t underestimate the difficulty of breaking Silicon Valley’s “we just need to get growth back” mentality when things are going sideways. This is how companies end up making awful “transformative” acquisitions.
Destroy the (Non-GAAP) Rule-of-40 Model
If a company is serious about building for the long-term, the Rule-of-40 operating model - as currently implemented in public markets - must be destroyed.
Don’t let its simplicity deceive you. It’s capable of compelling executives into decisions that ultimately destroy long-term value and prevents them from building the enduring organization they truly desire.
Great companies and great stewards recognize the risks and consequences of blindly adopting Rule-of-40, and proactively purpose build their organization and long-term operating model to align with the actual machinations and trajectory of their business.
To find your true model, you first must destroy the model put in your hand by others.