Can prevailing SaaS valuations be explained by the Rule of 40 metric, and is a score of 40% the boundary for desirable performance?

Abstract: With a sample of 69 companies, we conduct a regression analysis on how prevailing valuations of Software-as-a-Service (SaaS) companies can be explained by different compositions of the Rule of 40 metric; an alternative metric that has emerged for such companies. Additionally, the study examines whether firms that outperform the Rule of 40 are valued higher, as a consequence of desirable performance, than those that do not. The Rule of 40 is used by practitioners in valuation work but its effectiveness and explanatory value have been excluded from existing academic literature, and our study attempts to fill this research gap. We propose and conclude that the Rule of 40 metric indeed has a positive correlation with a SaaS firm's valuation, thus our findings are in line with those from practitioners. Furthermore, we find that the forward-looking sales growth + free cash flow margin is the Rule of 40 composition with the highest explanatory value; supporting a majority of the precedent literature. Finally, we cannot conclude that firms that score above 40% are valued significantly higher than those that do not and hence present a contradicting conclusion to the existing literature.