The Rule of 40 states that the sum of a software company's growth and profitability should exceed 40%. Thierry Depeyrot discusses how companies can achieve this goal by combining data-driven analytics with well-informed performance benchmarks.
Read the Bain Brief: Hacking Software's Rule of 40
Read the transcript below.
THIERRY DEPEYROT: Software companies are increasingly measured against the Rule of 40, which states that growth and profitability should exceed 40%. That's not actually such a high bar.
In 2017, we assessed that over 40% of software companies exceeded the Rule of 40, but the challenge is to do it consistently and sustainably over the years. We observed that roughly a quarter of the companies have exceeded the rule of 40 for over periods of three, four, or even five years. In this group of overachievers, we observed that growth is really an important dimension.
Slightly over a quarter of software companies which have exceeded this Rule of 40 over a sustained period of time have done it with more than 30% growth. Half of them have done it with 10% to 30% growth and high levels of profitability.
The remaining group is more mature—operating under 10% growth, but at high levels of profitability to deliver over the Rule of 40. So, in essence, the Rule of 40 is a good way to assess the performance of any software company or business unit.
If you want to apply it, we observed that there are two important angles which you want to take on. The first one is focused on growth and what you can realistically achieve in a given market. We often see that companies are too optimistic in terms of what they can find. The other dimension is on the profitability side, where you want to use well-informed benchmarks to be able to assess where you have operational opportunity to take cost out, but also where you might need to invest more.
Looking at these two dimensions, we see that companies which have a data-driven conversation tend to come to better outcomes by choosing targets which are both ambitious and more achievable.
Software companies need to balance growth and profitability to create lasting value.