This article took a look at the prevailing operating model in Silicon Valley – software as a service – and the venture capital rule of thumb – the rule of 40. The rule of 40 says that your growth rate and your profit should add up to 40.
So if you’re growing revenue at 40% a year, you can have a 0% profit margin. If you’re growing at 30% a year, you should have a 10% profit margin. If you’re growing at 20%, you should have a 20% profit margin. And if you have a 50% growth rate, you can be losing 10%.
For investors, it offers a simple rule for the “reasonableness” of a startups losses. As this article explains, it can be used like a price-to-earnings multiple – a shortcut that allows investors to do a quick ‘first pass’ of a company.
But as with any good rule, it gets overused. And where venture capitalists cling too closely to this rule, there are potentially great companies that get missed.
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