The Rule of 40 in HIT: Should your Company Prioritize Profitability or Growth?March 19, 2019
Among the venture capital and growth equity community, a common rule of thumb for software companies is the “Rule of 40”. The rule simply states that a healthy software company’s net profitability + revenue growth rate should exceed 40%. This rule provides a guideline to balance the trade-off between revenue growth and profitability, a question many of our clients frequently have.
To see how the Rule of 40 applies in the healthcare IT industry, we analyzed the data from 30 publicly traded Health IT companies. In past analyses, HGP has generally found that Health IT companies tend to have lower growth as compared to their general enterprise software counterparts. Consistent with this expectation, the companies tend to cluster between 0% and 25% growth on our chart. A comparable plot of enterprise SaaS companies exhibits no such clustering and range in growth fairly evenly between 10% and 60%. While HIT companies tend to fall within a smaller growth range, the Rule of 40 still seems to apply to the industry in that this set appears to aim towards a combined 40% revenue growth and EBITDA margin. On average, Health IT companies had a combined growth and profitability of 28% and a median of 30%.
Proving the importance in balancing profitability and growth, we found that higher growth plus profitability does correlate with higher valuations. Of the 30 Health IT companies included in our analysis, 23% are expected to exceed the 40% threshold in 2019. The companies exceeding 40% had an average enterprise value of 8.35 times revenue, more than double that of companies falling below the 40% rule. This point is further validated by Bain & Company’s findings that showed general enterprise software companies exceeding the 40% rule achieve returns as much as 15% higher than the S&P 500.
The Rule of 40 is a useful guide but has limitations. From HGP’s experience, smaller companies with revenues less than $10mm are often expected to have high growth, regardless of their profitability. A slow growing company with high margins at this smaller end of the market will often not receive the high valuations as would be implied by the Rule of 40. Similarly, at the other end of the market, a large multi-billion-dollar company will often be expected to deliver a positive EPS and growth is not as important a factor for valuation. In other words, the market is less forgiving of low growth for small companies, and less forgiving of low margins for large companies. If a company falls in either extreme, the full spectrum of the Rule of 40 is not applicable.
Even for a sweet-spot growth stage company, there exists a limit to how far each variable can be pushed. Simply having a combination that results in 40% is not sufficient for a high valuation as each variable should remain within a healthy range. A very high burn rate cannot simply be offset with a high growth rate and will often still hurt valuations. Furthermore, this high burn rate reduces a company’s available strategic alternatives often forcing them into unfavorable transactions due to capital necessity.
As with our previous analyses of the impact of growth on valuation, there are numerous other factors that play into valuation and neither growth nor EBITDA can guarantee a high valuation. If you’d like to learn more about your Company’s strategic alternatives, please contact us and we’d be happy to discuss.
For a general overview of the Rule of 40 as applied to the software industry as a whole, we recommend Bain’s article on the topic here.