The Rule of 40

Let's Chat D2C: The Rule of 40

What is the Rule of 40?

The idea is that the growth rate plus profit margin should exceed 40%. Software companies are increasingly measured against the Rule of 40, a metric that’s able to capture the trade-off between investing in growth and short-term profitability.

Young companies (think every Shopify app from 2017 until last year) typically break this mark with rapid growth, but older companies (think Gorgias, Yotpo, Recharge, Klaviyo, etc.) need to improve performance and profit margins to hit that metric. Compounding this issue is the fact that most of these companies have significant market share (last I checked, Recharge powers more than 80% of Shopify store’s subscription programs), making increasing growth rate year over year almost impossible.

It’s One Thing to Achieve it Once - It’s another to Repeatedly Do So

A Bain & Company study of 124 publicly traded software companies found that 40% outperformed the Rule of 40 in a single year, but only 25% outperformed the Rule of 40 for three or more years, and only 16% outperformed for all five years.

Continuing Growth at Scale is Challenging

Only five software companies have grown to $5 billion from $1 billion in the past 20 years.

Three Ways to Beat the Rule of 40

1) Strong Growth

Of the companies mentioned above that outperformed the Rule of 40 over five years, one-third achieved it with revenue growth above 30%. This is the stage that most ecommerce tech companies have been in over the last five years, where revenue growth is almost a given, and profitability gets pushed to the wayside.

2) Balanced, Profitable Growth

Half of the companies did so with revenue growth between 10% and 30%, where they successfully developed new products for markets adjacent to their core.

This is the stage you see companies like Okendo (launched Okendo Connect), Klaviyo (launching product reviews), Attentive (launching email), Yotpo (launched subscriptions), and more entering.

Companies can also achieve this by acquiring other companies that already have products developed (i.e., Attentive acquiring Tone and then launching Attentive Concierge with their product).

3) Profitability

18% of companies beat the Rule of 40 with organic revenue growth below 10%. This is the stage you’re starting to see companies like Shopify potentially enter, where there is a shift towards becoming more efficient and profitable as revenue growth slows. 

The Rule of 40 will force companies to take a good hard look at their business as revenue growth slows, but it will also apply pressure to the largest companies in the space, struggling to keep revenue growth above 10%, look for strategic acquisitions to help.

What I’m Thinking About This Week: The Employer-Employee Dynamic

After a crazy year of job growth in 2021 and the employee-employer scale tilted entirely in favor of employees, 2022 has been marked by mass job cuts that are just getting started and will only continue into 2023. In fact, Stripe, Lyft, Chime, and Twitter announced massive layoffs in the past week alone.

What does this mean for Employers?

We haven’t started to see the real impact of all these layoffs quite yet, as employees evaluate what they’ll do next, but I expect talent to be significantly easier for businesses to find starting in Q2 of 2023.

What does this mean for Employees?

Things are changing. It’s not all doom and gloom, but the job market will start tightening, and open positions will become increasingly competitive.

What I Expect to See

• We’ve already started to see employers exert some of their newfound influence by requiring hybrid or in-office work as they try and fight record-breaking levels of declining employee productivity. The digital nomad lifestyle will be forced to an end for some.
• Far less company hopping in 2023, as people prioritize stability and security over a potential increase in pay with an unknown business. In 2020 and 2021, I knew multiple people who had 3 or 4 different jobs in the span of that time (and someone who even had two jobs at the same time!).
• As cash tightens with companies, there will be far fewer bidding wars for talent as budgets are constrained.
• Established industry veterans who aren’t financially reliant on a steady income stream will start their own businesses.

You can track all US-based tech companies that have laid off employees this year here.

This Week's The D2Z Podcast

#34 - Health and Wellness DTC, Supply Chain and Distribution, and Social Proof

🎧 Listen Now 🎧

In this week’s episode, I sat down with Alexej Pikovsky, CEO & Co-Founder of Alphawell Brands and NUOPTIMA (formerly the Alphagreen Group), a global health and wellness e-commerce platform. Specifically, we explored the following:

💰 Building health and wellness brands online and some trends

📲 How to determine what brands to acquire or pursue

😎 The anatomy of product supply chain and distribution channels

🚀 What makes an authentic brand and creating social proof

App Highlight - Rebuy Smart Links, Shopify Tax, Tap to Pay on iPhone, and Roku Ads for Shopify.

These are the most relevant updates I’ve seen over the past week in the ecosystem.

Rebuy Smart Links

Rebuy smart links are basically an extension of Shopify permalinks (links that direct customers to Shopify checkouts with pre-loaded items). They can be used to redirect a customer to the Rebuy Smart Cart, Shopify Cart Page, a Shopify Checkout, a Recharge Checkout, or a custom landing page. You can also include a discount code to be automatically added at checkout.

One of my favorite use cases for smart links is to include them in email/SMS campaigns to increase the conversion rate on a pre-configured bundle offer.

Shopify Tax

Shopify Tax will be automatically enabled and rolled out to merchants who sell in the US and collect sales tax over the upcoming months. It significantly improves a brand's ability to know where they may be liable to collect tax and the right amount of tax. This is a massive update for Shopify as I know multiple merchants who have had legal issues and even the sale of their business falling through because of sales tax issues.

• Sales tax insights: Know where you’re liable with a state-by-state overview of tax obligations.
• Smart categorization: Helps categorize your products and automatically applies the correct tax rate.
• Calculate and collect tax: Apply the proper rate at checkout based on your customer’s address.

Tap to Pay on iPhone

With the Shopify POS app installed, merchants can now securely accept contactless payments directly from any iPhone.

If you’re not considering attending exhibitions/fairs, hosting your pop-up store, or even getting a retail space, you need to be! Tap to Pay on iPhone makes it much easier to get up and running.

The best part is that your in-person orders will flow directly into your Shopify admin and allow you to retarget these customers easily via your email/SMS flows.

Roku Ads for Shopify

Merchants can now quickly build, buy, and measure TV streaming advertising campaigns on Roku.

I’m excited about this one as merchants try and uncover acquisition opportunities outside of Facebook ads.

Book of the Week - The Ride of a Lifetime: Lessons Learned from 15 Years as CEO of the Walt Disney Company

Robert Iger walks us through his story as CEO of Disney from 2005 to 2020 and even shares stories about his negotiations with iconic leaders like Steve Jobs (Apple), George Lucas (Star Wars), and Rupert Murdoch (Fox).

While not a traditional business lectures book, there were still a few interesting takeaways for me.

Key Takeaways

• Set high standards for everything. “The way you do anything is the way you do everything.”
• You need to view new developments not as a threat but as an opportunity (i.e., iOS 14 updates presented an opportunity for our brand to compete in other channels vs. iOS 14 updates threatened to bankrupt our business as we could no longer acquire customers profitability on Facebook).
• Have a “pragmatic enthusiasm for what can be achieved.” Optimism is critically important as a leader, but it can’t be completely delusional.
• You need to give critical feedback but deliver it with empathy and respect. Not only is it the right thing to do, but the recipient will be far less defensive and take it and internalize it much more.

And above all, what resonated with me the most was his stance on dysfunctional companies. It starts at the top. When two people at the top of a company have a dysfunctional relationship, it trickles down throughout your organization.

Upcoming Events

I’ll be hosting a masterclass webinar on 12/13 with my friends at Fairing about how I use their platform to help with purchase attribution and as a zero-party data aggregator that directly impacts Electriq’s segmentation and personalization strategy. More details to come on this!

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