In the SaaS (software as a service) business world, there’s something called The Rule of 40%. It says that to run a healthy business, your year-over-year (YOY) monthly growth rate plus your profit margin should add up to 40%.
For example, if your June revenue growth rate was 10% above June one year ago, and your June profit margin was 30%, then you hit the 40% target. You can then play with various rates of growth and profit margins to hit (or exceed) the 40% target.
For additional context, do the above calculation but use the trailing 12 months growth rate compared to prior year and the trailing 12 months profit margin.
By doing both calculations (the trailing 12 and the current month, YOY), you get a read on whether your Rule of 40% is accelerating or slowing down. Ideally, you want to see your current month YOY percentage higher than the trailing 12 month’s percentage.
Within limits, outside investors will highly value a business with low (or, in certain cases, negative) profit margins if they are accompanied by high growth rates that, when combined, add up to at least 40%. Similarly, high profit margins with lower growth rates that still add up to 40% will be valued highly.
But if you’re looking to maximize value, err on the side of faster growth and lower margins.
Does The Rule Of 40% Apply To Advisory Firms?
Turns out that the 40% rule applies very well to our industry too. But we arrive at 40% in a different way.
SaaS firms tend to grow much faster but have lower profit margins (at least in the early years) compared to advisory firms. Advisory firms generally grow rather slow but often have very high profit margins. Either way, the 40% number works for both industries.
You can apply the rule as a guide to making strategic decisions about structuring your business.
Strategically Using The Rule Of 40%
I reviewed the latest benchmarking data from Schwab and Fidelity and here’s what they show for advisory firms with at least $250 million in AUM.
• Net organic growth in AUM (excludes market movement and acquisitions) has averaged approximately 5.5% compounded per year for the last 5 years ending 2020.
• Revenue growth has averaged approximately 7.5% compounded per year for the 5 years ending 2020.
• Operating profit margin (total revenue minus all expenses including owner pay at “replacement cost” and excluding interest and taxes) averaged about 30% in 2020.
• Looking at the data, the average advisory firm with more than $250 million in AUM has averaged 37.5% on The Rule of 40% scale (30% profit margin plus 7.5% annual growth).