Rule of 40

Over the last couple of weeks, I've been planning a class for Pavilion's CCO School with my friend and Toast executive, Emmanuelle Scala. My responsibility is to write the content for class number one. It's a significant responsibility, as the content in my class forms the foundation for everything that will follow. It hasn't been particularly easy to narrow down the key points.

Customer Success can look and feel quite different from organization to organization. The way Customer Success is approached upmarket with high ACV customers is very different from how the challenge is tackled downmarket. From product-led strategies to people-heavy enterprise playbooks, there is no one-size-fits-all approach.

Furthermore, most of the "how-to's" in Customer Success fail to acknowledge the stage of company growth the company is in. It’s a missed consideration in most organizations and truly one of the reasons I think a lot of Customer Success teams found themselves on the outside looking in through many of the layoff rounds that have happened over the last few years. In my opinion, companies were just as guilty of over-indexing on the "get fit" doctrine as they were of over-indulging during the "growth at all costs" years. The whiplash is evident; this week alone, I’ve heard of three companies rehiring for a Customer Success function that they'd previously laid off.

A principle I've found myself going deep on as I prepare for the class is the Rule of Forty. Rule of Forty is one of those fancy VC compound metrics (thank you Brad Feld) most of us in seat operating in Customer Success don’t think about all that often – but we should.

Simply put, Rule of 40 states a software company's combined revenue growth rate and profit margin should equal or exceed 40%.

More specifically:

Recurring Revenue Growth Rate (%) + EBITDA Margin (%) ≥ 40%

SaaS companies above 40% are generating profit at a rate that's sustainable, whereas companies below 40% may face cash flow or liquidity issues – not good.

If you study publicly traded companies, you can see how much this impacts their value. As a general rule, the companies above 40 are also the most valuable.

Reference: https://www.meritechcapital.com/benchmarking/regression-analysis

When you break it down, you can beat the Rule of 40 in one of two ways: you can either grow really fast, or you can be very efficient; some combination of the two is what most companies strive for. Said differently, if you have really good margins, you don’t need to grow as fast. Conversely, if you’re growing super fast, you’re able to stomach some short-term inefficiencies. There was a point during my time at Motive when we grew from about 1 million in ARR to 60 million in ARR in the span of 6 months. Let me tell you, I certainly wasn’t thinking about efficiency during this period of time, I was simply trying to capture lightning in a bottle, and that was the right move.

In paying attention to Rule of 40, you really need to take stock of what your Customer Success team is ACTUALLY doing. Where they spend their time influences your margins drastically. Only CFO did a great job of highlighting this in a recent article: Is Customer Success COGS or OpEx? Understanding Gross Margins.

Simply put, if you’re mostly engaged in Support, Professional Services, Training, and addressing Bugs & Filling Product Gaps, your team is drawing down on your companies income and EBITDA Margin. Conversely, if you're Leading Expansion, Renewals, Driving Retention, Adoption, or even building closer customer relationships, you're more of a Sales & Marketing expense, and while still impacting your margin your responsibility lies more on the gross side side of the EBITDA Margin — you are part of making the revenue number bigger. There are world-class Customer Success teams that fall on both sides of the this equation. One isn’t better than the other; they just come with a different set of operating principles.

Take, for example, the Sales & Marketing Expense Customer Success team. Great, this is the in-vogue preference, and common LinkedIn banter would suggest that this would make the team immune from layoffs. But what if this team isn’t all that good at expanding accounts? In balancing Rule of 40, this team has a big responsibility to growth and if they are falling short, what does this mean for the organization? Conversely, what about the support focused team that hasn’t taken the steps to create efficiencies so that their cost to service customers isn’t through the roof? They are just as much a draw on Rule of 40 as the sales leaning team team that stinks at expansion.

When you get in tune with Rule of 40 you start to really gain clarity as to what your responsibility to the organization is. More often than not, when I talk to CEOs who have let go of their Customer Success teams, Rule of 40 was rarely on their mind, what was however, was a lack of clarity as to what Customer Success was actually doing.

Customer Success leaders, get close to your CFO, ask where you fit on the financial statement, make sure they have it right and vouch for your organization if they don’t. It’s only once you know your impact on Rule of 40 that you can really start to run your organization in a way that makes a pointed impact on your company.

More about CCO School with Pavilion:

CCO School starts March 5th and is an 8-week program to help you transform your Customer Success department from reactive firefighting to strategic value creation acknowledged at the board level and so much more. This school is designed for executive-level CS professionals aiming to enhance their skills and broaden their influence. It also caters to sales leaders aspiring to extend their impact beyond acquisition to encompass the entire customer journey.

The school is led by Emmanuelle Skala who is passionate about Customer Success and sharing her experience in helping take Toast on an epic run from $30M in ARR to over $1.2B (from Q4’23 earnings) and an IPO in 2021 (NYSE: TOST) while leading all the post sales functions from 2017 to 2023. Alongside Emmanuelle, the class is supported by some of the most successful and experienced operators in CS including Sydney Strader, Seth Wylie, Allison Tiscornia, Allison Pickins, Mike Lemire, and Sean Ilinrey.

Ready to join? CCO School is included in the Pavilion Executive membership. Join Pavilion to enroll, applications are due March 4th.