In the world of startup investing, it is tempting to chase growth at all costs, but as Nassim Taleb famously said, "It is better to be conventionally wrong than unconventionally right."
This is where the Rule of 40 comes in.
It is a simple heuristic that measures the financial health of a startup by balancing its growth rate against its profitability. This balance is crucial because companies that chase growth at the expense of profitability are often the first to fail.
The Rule of 40 states that a startup's revenue growth rate plus its profit margin should equal or exceed 40.
This metric has been shown to be predictive of long-term success, as startups that meet this threshold are more likely to survive and thrive.
Let's take a look at some examples of companies that have met the Rule of 40.
1) Zoom Video Communications: Zoom, the video conferencing platform that became a household name during the COVID-19 pandemic, has a revenue growth rate of 326% and a profit margin of 24%. This gives it a Rule of 40 score of 350, indicating that it has a strong balance of growth and profitability.
2) Twilio: Twilio is a cloud communications platform that allows developers to embed messaging, voice, and video capabilities into their applications. With a revenue growth rate of 57% and a profit margin of 5%, Twilio's Rule of 40 score is 62, indicating a healthy balance of growth and profitability.
3) Crowdstrike: Crowdstrike is a cybersecurity company that provides cloud-delivered endpoint protection. With a revenue growth rate of 84% and a profit margin of -7%, Crowdstrike's Rule of 40 score is 77, which is still slightly above the threshold of 40. While the negative profit margin may raise some concerns, it is important to note that Crowdstrike is still in a high-growth phase and investing heavily in product development and sales and marketing.
4) Zscaler: Zscaler is a cloud security company that provides internet security and web security services. With a revenue growth rate of 53% and a profit margin of 6%, Zscaler's Rule of 40 score is 59, which is slightly below Twilio's score but still well above the threshold of 40.
These examples demonstrate that the Rule of 40 can be applied to companies across different sectors and industries. While there may be some variations in profit margins and growth rates, companies that meet the threshold of 40 are more likely to be financially healthy and have a better chance of long-term success.
While the Rule of 40 can be a useful tool to evaluate a company's financial health, it should not be relied upon as the sole indicator of success. As Taleb would remind us, the future is often unpredictable, and companies that seem to have a good balance of growth and profitability today may face unforeseen challenges tomorrow. We must remain vigilant and open-minded, and not be blinded by numerical thresholds and oversimplified rules of thumb.