40 or X? Growth or profitability?

What should you focus on as founder/ CEO?

Traditional metrics are evolving

The traditional metrics for assessing the balance between growth and profitability are evolving. Historically, the Rule of 40 has been a benchmark for evaluating the performance of cloud companies, suggesting that the sum of revenue growth rate and profit margin should exceed 40%. However, as interest rates align with historical norms, the focus has shifted towards a more nuanced understanding of this balance, particularly in relation to cost of capital and free cash flow generation.

The Rule of X

Bessemer Venture Partners has introduced a refined metric, the Rule of X, to better capture the valuation dynamics of cloud businesses in today's economic environment. This new metric acknowledges that the conventional equal weighting of growth and profitability in the Rule of 40 may not be optimal as companies approach cash flow positivity. Bessemer's analysis suggests that growth should be prioritized over free cash flow margins, with growth being valued at approximately 2x-3x more than FCF margin. This is based on the premise that while increases in margin have a linear impact on value, increases in growth rate can have a compounding effect.

The Rule of X formula, [(Growth Rate x Multiplier) + FCF margin], where the multiplier is around 2x for private companies and 2-3x for public companies, provides a more accurate reflection of a cloud business’s valuation. This approach places greater emphasis on growth, especially for businesses with sufficient free cash flow margins, challenging the previous paradigm that equally weighted growth and profitability.

Maintaining a growth mindset

Bessemer's contribution to this evolving metric underscores the importance of adapting financial analysis to changing market conditions and the unique characteristics of cloud businesses. The Rule of X encourages companies to maintain a growth mindset, with the understanding that long-term value creation in the cloud sector is not solely dependent on current profitability but significantly driven by sustainable growth.

The introduction of the Rule of X by Bessemer Venture Partners represents a significant shift in how cloud companies should approach the growth versus profit tradeoff. This metric offers a more tailored analysis for cloud businesses, emphasizing the critical role of growth in achieving long-term valuation and market success. Unfortunately, it's not as simple as the rule of 40.