Executive Summary

The Rule of X is a smarter way to measure the performance of VC-backed companies in the growth phase (i.e. $10-20m+ annual recurring revenue). It’s based on the traditional Rule of 40, but it gives more weight to revenue growth than free cash flow margin, because growth has a compounding effect on value, while margin has a linear one.

The Rule of X states that the sum of your revenue growth rate multiplied by a factor X and your free cash flow (FCF) margin should be as high as possible. The factor X is determined by the market conditions and your cost of capital, but a conservative base assumption is 2x to 3x. This means that growth is valued at least 2x to 3x more than FCF margin.

• For example, if your cloud business is growing at 30% per year and has a 15% FCF margin, your Rule of 40 is 45%, but your Rule of X (with a 2x multiplier) is 75%. This means that your business is more valuable than a business with 15% growth and 30% FCF margin, which has the same Rule of 40 but a lower Rule of X (60%).
• Why does this matter? Because the Rule of X can help you make better decisions about how to invest in your business and optimize your valuation. If you have an efficient software company with adequate FCF margins, you can prioritize growth over profitability. Rather than starving growth for the sake of FCF, make strategic investments across product, sales, marketing and partnerships that will yield future revenue.

The Rule of X is not only theoretical, but has been validated by fundamental discounted cash flow analyses and confirmed by public market data. The Rule of X has a 1.5x stronger correlation with the forward revenue multiples of the BVP Cloud Index, than the Rule of 40. The Rule of X also explains why some of the most successful software companies have invested billions of dollars into their businesses before achieving profitability, and have been rewarded with high valuations while maintaining strong growth.

But the Rule of X is not enough to capture the full picture of a company’s potential. You also need to consider these three factors:

1. Growth endurance: How long can you sustain your revenue growth? A single year of high growth is not enough to create lasting value. You need to keep growing consistently and avoid any dips in performance.
2. Quality of growth: How efficient are you at generating revenue? Some companies spend too much to achieve high growth, but they can’t maintain it when they try to improve their margins. You need to balance your spending and your growth, and make sure you’re not sacrificing one for the other.
3. Dilution from stock-based compensation: How much are you giving away to your employees and investors? Stock-based compensation reduces your ownership and your returns. You need to align it with your growth rate and your margin improvement, and make sure you’re not overpaying or underpaying.

The Rule of X is a great tool to evaluate VC-backed companies, but it’s not the only one. You need to dig deeper and look at the underlying drivers of value.

Articles

The Rule of X

Defining the Rule of X, the proper way cloud leaders should think about the growth vs. profit tradeoff (2 January 2024)

How to Maximize Valuation | Public Company "Rule of X" Performance

Applying the Rule of X and the importance of Growth Endurance (3 February 2024)

CrowdStrike - "Rule of X" Winner!

A good Rule of X company example (22 January 2024)

AppFolio - If you invested $1,000 at IPO...

A good Rule of X company example and the importance of Growth Endurance and Stock Based Compensation (7 February 2024)