Business owners often face a crossroads. Should I invest to create growth? Or should I keep expenses in check and generate profits? It is usually hard to have both.
This question gets compounded in an M&A opportunity – Will my valuation be penalized because I invested for growth, rather than profits? How can I keep running my business-as-usual when I want to maximize the valuation?
The Rule of 40
In the technology sector, there is a handy equation that helps assess a company and considers both growth and profits – called the Rule of 40.
Simply stated: Revenue Growth % PLUS EBITDA Margin % should be 40 or more.
An example: Revenue growth over last year is 20% and the adjusted EBITDA margin is 25%. That equals 45, which is more than 40.
Looking more closely, you can see that a high investment in expenses like sales and marketing should generate higher revenue growth, though profits may be lower. This is particularly true of start-ups and younger companies. If the revenue growth isn’t that good, then perhaps rethink where the investment is made. Conversely, keeping expenses low and foregoing those investments should yield a higher bottom line. This could be the case of more mature companies with well established market relationships and product lines.
This rule can be applied to a variety of companies, both startups and mature, because it considers both growth and profitability. Most analysts will do this measurement over multiple years and also apply it to the forecast. While the number 40 is a recognized benchmark in the software sector, other benchmarks can apply to other sectors such as manufacturing, processing, services, and distribution.
If you are considering an M&A transaction, be sure to talk to a professional and discuss the balance between growth and profitability.