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 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, we can instead use this calculation with the trailing-12-month growth rate and compare it with the trailing 12 months’ profit margin from the previous year. By doing both calculations (both trailing 12 months and the year over year), you get a read on whether your Rule of 40% is accelerating or slowing down. Ideally, you want to see your current month year-over-year percentage higher than the trailing 12 months’ percentage.

Within limits, outside investors will highly value a business with low (or, in certain cases, negative) profit margins if those are accompanied by high growth rates—as long as they still add up to at least 40% when combined. Similarly, high profit margins with lower growth rates will also be valued—again, as long as they add up to 40%.

But if you’re looking to maximize value, err on the side of faster growth and lower margins.

Does The Rule Apply To Advisory Firms?
Turns out that the 40% rule applies very well to our industry, too. But we arrive at the figure in a different way.

SaaS firms tend to grow much faster than advisory firms but have lower profit margins (at least in the early years). Advisories generally grow rather slowly but often have very high profit margins. Either way, the 40% number works for both industries.

You can apply the rule as a guide when making strategic decisions about structuring your business.

Strategically Using The Rule Of 40%
I recently reviewed the latest benchmarking data from Schwab and Fidelity, and here’s what they show for advisory firms with at least $250 million in assets under management:

• Net organic growth in AUM (which excludes market movement and acquisitions) has averaged approximately 5.5% compounded per year for the last five years ended in 2020.
• Revenue growth has averaged approximately 7.5% compounded per year for the five years ended 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.
• The average advisory firm with more than $250 million in assets under management has averaged 37.5% on the “Rule of 40%” scale (that is, a 30% profit margin plus 7.5% annual growth).

Here are a couple of observations about those numbers.

1. It’s not quite apples to apples, because the data I’m using combines five-year average growth rates with 2020’s profit margins, but it should be directionally correct.
2. The average advisory firm is quite profitable but growing slowly.

The Mix Of Growth And Profit Margin
The key question now is: What is the right mix of the growth rate and profit margin for your business?

To answer that, there are several things to consider.

• If you’re optimizing for current income and not too concerned about having a big liquidity event (such as a sale) in the future, then the 30% (or more) profit margin and an annual organic growth rate of 5% to 7.5% should work fine.
• If you have a high profit margin (40% or more) with little to negative revenue growth, you’ve got a wasting asset. You won’t attract top talent and you should consider selling or regrouping to get back on a growth track.
• If you’re happy with your current income but want to build long-term equity value for a possible sale of your firm, then you should make a conscious decision to trade a lower profit margin for higher growth. Shoot for at least double-digit organic growth, and if you want to get aggressive, complement the organic growth rate with a merger and acquisition strategy. But don’t let your operating margin drop below 15% if possible as that leaves little cushion during an extended bear market.
• If you think you’ll sell the business someday, start making it salable today. Even if your business isn’t for sale, it must be salable. That means you have clean and updated monthly financials, you’re tracking metrics, you have a solid team, you have a consistent record of organic growth, you have a nice mix of clients from an age standpoint, etc.

The Rule of 40% is a solid way to think about the mix between the growth and profitability of your business. The key is to get clear on your business strategy, specifically by asking, “What are you trying to accomplish?” That will inform the strategy you develop to drive your arrival at a number that’s 40% (or more).

What is your Rule of 40% number?

Steve Sanduski, CFP, is a financial advisor business coach and the co-founder of ROL Advisor, a discovery process technology system. He’s also a New York Times best-selling author and host of the Between Now and Success podcast.