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SaaS EBITDA Margins and The Rule of 40

Updated: Mar 25

When “growth at any cost” was the name of the game in tech, founders could breeze by without calculating and comparing their startup’s EBITDA margin.


Top-down picture of a football field with a man in a brown shirt and dark jeans holding a briefcase next to the 30-yard line. The 40-yard line is in view to the right, visually representing The Rule of 40 -- a calculation that uses EBITDA margin and revenue growth rate to link a SaaS startup's growth and profitability..

EBITDA — earnings before interest, taxes, depreciation, and amortization — is a profitability measure that excludes costs that can obscure the true performance of a business. An EBITDA margin is the ratio of EBITDA to revenue; it shows how operating expenses are eating into a company’s profits.


In today’s increasingly competitive and uncertain markets, where only the strongest SaaS startups survive, EBITDA margins not only provide insight into a business’ operational health and profitability, but they also influence investor transactions and corresponding startup valuations.



Stripping out expenses that don’t affect daily business operations makes it easier to compare the profitability of a growing SaaS startup against similar companies and industry averages. That is, in part, why EBITDA margins have become so important. Startup leaders can track EBITDA margins over time to steer the business along a path to profitability and monitor its overall financial health.


For potential investors or buyers, EBITDA margins offer a reliable gauge for evaluating businesses with less bias. Without interest payments, tax disparities, and other paper expenses, companies can be analyzed on a level playing field.


A startup with a higher EBITDA margin is generally considered lower-risk and financially stable, with fewer operating expenses and strong earnings. Margins that are stable or increasing over time further signal that the business is a solid investment.


Let’s take a deeper look at how to compare and analyze EBITDA margins for a SaaS startup.


What is a good EBITDA margin percentage?

High EBITDA percentages indicate a company can pay its operating costs and still have money to funnel back into the business.


What is considered good? How high should you aim?


Your EBITDA margin should be in line with the SaaS industry average; the industry average is a good baseline goal but set your aspirational target higher. An EBITDA margin falling below the industry average suggests your business has cash flow and profitability challenges.


For example, a 50% EBITDA margin in most industries is considered exceptionally good. If your EBITDA margin is 10%, your SaaS startup’s operations may not be sustainable.


SaaS industry EBITDA margin averages

In recent years, the EBITDA margin of publicly traded companies on the Nasdaq has hovered around 30%. The average EBITDA margin of more than 300 software (systems and applications) companies in the U.S at the start of 2023 was 29%.



If your startup has an EBITDA margin of 30% or higher, you’re tracking to SaaS industry averages and doing great.


 

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Macroeconomic changes affecting capital markets have taken a toll on growth and profitability within the SaaS industry. Growth slowed for most SaaS businesses last year, and software companies responded by implementing aggressive cost-cutting measures to manage cash burn and improve profitability.


With the broader industry pumping the brakes, slashing costs, and shedding top talent, a unique opportunity has arisen for young SaaS startups to scale revenue growth and accelerate future profits.


How do you know how fast you can grow in this environment without jeopardizing your startup’s health?


The Rule of 40

As SaaS startups mature and scale, successful business owners find a sustainable balance between growth and profitability. The Rule of 40, often used by investors to analyze the health of a SaaS business, links growth and profitability to provide insight into a company’s cost-effectiveness and operating performance.


The Rule of 40 says:

A company’s revenue growth rate plus its profit margin for the same time period should exceed 40%.


Rule of 40 Calculation

The Rule of 40 = YoY Revenue Growth + EBITDA Margin



Example:

SaaSy Startup Co. has an EBITDA margin of -5% and an annual growth rate of 55%. Even though the company isn’t profitable, it’s growing quickly enough to hit 50% with its Rule of 40 calculation, well over the 40% threshold.


Though SaaSy Startup Co. might be challenged to raise a favorable equity round in today’s trepidatious, profit-focused investor environment, its founders can continue to accelerate revenue growth and delay the raise using non-dilutive financing, while keeping a careful watch over expenses and margins.


What EBITDA margins and the Rule of 40 say about your SaaS business

What EBITDA margins and the Rule of 40 say about your SaaS business

Arguably more applicable to late-stage SaaS startups and investors, any growing SaaS business can use the Rule of 40 as a North Star on the path to profitability and success. Not only is it a simple key performance indicator to calculate, but it also influences SaaS startup valuations — and what founders can walk away with when they exit.


If a company’s calculation exceeds 40%, it’s probably in a strong position for long-term growth and profitability. Startups above the 40% target are more attractive to investors and have more leverage to negotiate a higher valuation.

 

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A Rule of 40 number that’s less than 40% could indicate that the business is growing too slowly or burning through cash too quickly — or both. Digging deeper into cash burn rate, revenue growth, churn, expenses, and other levers can help business leaders adjust their strategies to improve margins.


Startups earlier in their life cycles often see more volatility in their Rule of 40 numbers as they grow at the expense of profitability and before reaching economies of scale. This calculation is still valuable to SaaS entrepreneurs, because it adds financial rigor to pivotal decision-making as the business grows.


Though the SaaS business model typically features lower operating costs and higher margins, it’s common for earlier-stage SaaS startups to run lower margins as the business builds. When growth eventually slows down, a healthy SaaS business should exhibit an increase in cash flow and EBITDA margin.


Ultimately, the Rule of 40 helps quantify the tradeoff a business makes between growth and profit.


If you’re leading a young startup that’s still maturing, it’s helpful to calculate and monitor your company’s EBITDA margin and Rule of 40 number over time to see whether they’re increasing, decreasing, or remaining relatively stable.


Through this practice you can find the right balance to grow your startup quickly and sustainably.

 

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