The X rule and how cloud leaders need to think about growth versus profit

As interest rates have returned to historical norms, the world is back to cost of capital and free cash flow generation. Businesses work hard to adhere to traditional heuristics such as the Rule of 40 (ie, the idea that the sum of revenue growth and profit margin must equal 40%+, a metric that Bessemer helped popularize ). Executives of both private and public cloud companies often believe that free cash flow (FCF) margins are just as important as (if not more important than) growth and that the trade-off is 1:1. Many financial executives love the Rule of 40 for its clarity, but assigning equal weight to growth and profitability for late-stage businesses is misguided and has led to bad business decisions.

Our point of view

Growth should remain the top priority for businesses with sufficient FCF margins. While the focus on efficiency is valid, the traditional rule of 40 math is completely wrong as you approach break even and become free cash flow positive.

The world has become too much of an FCF margin mindset versus a growth mindset, which is counterproductive to growing effective businesses. Long-term models show that even in tight markets, growth should be valued at least ~2x to 3x FCF margin.

Why;

While an increase in margin has a linear impact on value, an increase in growth rate can have a compound impact on value. We show the detailed math below, and it’s borne out by the public market valuation correlations when you check the relative importance of growth versus FCF margin. The actual ratio fluctuates wildly in the short term — ranging from ~2x to ~9x over the last few years — but over the long term, the ratio typically works out to 2x to 3x more value for growth versus profitability.

We recommend that even the most conservative financial planners can safely use a ~2x leverage ratio for late-stage private equity. Public companies with lower cost of capital can use ~2x to 3x multiple (provided growth is efficient).