In the SaaS business world, (Software as a Service), 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 May revenue growth rate was 10% above May one year ago, and your May 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).
Here are a couple observations on those numbers.
- It’s not quite apples to apples because the data I’m using combines 5-year average growth rates with 2020’s profit margins, but it should be directionally correct.
- The average advisory firm is quite profitable but slow growing.
The Mix Between Growth and Profit Margin
The key question now is what is the right mix between growth rate and profit margin for your business?
To answer that, here are several considerations.
- If you’re optimizing for current income and not too concerned about having a big liquidity event in the future, then the 30% (or more) profit margin and 5% to 7.5% annual organic growth rate should work fine.
- A high profit margin (40% or more) with little to negative revenue growth is a wasting asset. You won’t attract top talent and you should consider selling or regrouping and getting 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, then 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, double 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 growth and profitability of your business. The key is to get clear on your business strategy—what are you trying to accomplish—and that will inform the strategy you develop to drive your arrival at the 40% (or above) number.
What is your Rule of 40% number?