I'd never heard of this rule, so I can't say it was planned but I've just done the maths on our startup (http://macropod.com) and we're exactly on 40%.
I certainly didn't use this equation, but our monthly expenditure is controlled quite heavily by our growth rate. So maybe there's something in that....I think I'll go work out whether this hold true for various growth rates using our method...
FWIW:
- I have a spreadsheet which maps out our revenue and expenses over the past 2 years.
- It estimates our future growth
- It combines that with our bank balance and our expenses to work out an "optimum burn rate".
- We use this number as a guide to how much we should be spending.
The "optimum burn rate" is the spend that will see us use as much of our cash as possible without us dropping below a certain threshold (which at the moment 3x our monthly burn).
I would guess he is suggesting that less than 40% means you are over-spending or under-performing and more than 40% means you are under-spending (eg. you should invest more in growth).
The way I read it, it was more like a rough guideline rather than a strict rule... but when you put something forth as a guideline, it does not sound as crisp and presentable. I mean, there is no basis put forward, simply said someone uses that figure when they want to get a rough idea bout a company. I imagine once something passes that filter, they would do a more thorough analysis.
You could apply the 40% rule to personal finances as well. If your income/salary is increasing 20% a year, put 20% into savings. If your income is increasing 5% a year, put 35% into savings.
I disagree, in personal finances you aren't afforded the same kind of burn rates because there isn't an investor model for individuals. If my salary has increased 100% YoY for the last 3 years, I would be in a troubling amount of debt.
This applies in reverse as well, if you take a salary cut you likely aren't going to be able to save more money as a result.
For personal finances I think its better to tease out a baseline amount for expenses and save everything above that, re-calibrating occasionally as required.
This is exactly what people do when they go to school: they take on huge amounts of debt in order to make their income grow by >100% YoY for a few years.
Very few incoming college students know enough about finance or exactly what different choices will payout to make smart trade-offs in this area, but this reasoning is pretty common with MBA and Law School students. Occasionally it even works; I've known a few young lawyers who ended law school with $200K in debt, but it was paid off within 4 years and their income was roughly 8x what it was before law school.
On writing my response I realized school was probably the one time where this sort of strategy would be appropriate for an individual. At the same time, school is a much higher risk proposition (in many cases) and involves much more time and debt than the 40% guideline accounts for.
You also have to keep in mind that most people who finish law school don't get big law jobs that allow them to pay off loans quickly. The same holds true for MBAs and most PhDs. About the only advanced degree that has some level of income guarantee (for now) is a MD. So while school can fit the 40% rule, it rarely does.
Not sure why this won't still work in theory.
100% YoY increase:
Salary Year 1: $100 - you are allowed to go $60 into debt
Salary Year 2: $200 - you are allowed a further $120
Salary Year 3: $400 - you are allowed a further $240
Salary Year 4: $800 - your total debts are still around half a year's salary, which is only modestly troubling - banks would most likely be happy to service your debt at a competitive rate.
If you recognise your period of fast increasing salary is over, you are now advised to save $320 - which pays off much of your debt.
In practice, there are some other problems which you partially recognise - depending only on salary doesn't give you a diverse portfolio of investment; salary is more likely to suffer an unexpected shock than business income; expenses are difficult to reduce.
This is a good analogy if the debt is invested in your personal financial growth somehow, for instance through education or perhaps actual investments, but a terrible analogy for the kind of deficit-spending most people do, like on cars and high living expenses.
A loan is typically the textbook definition of an investment..
Banks give a student X dollars, after college the student pays X + i. The bank takes some risk and receives more money than they started with. I'm not sure how it wouldn't be an investment.
That's a though question as there are always exceptions to the rule but generally I would be cautious in investing (money) in a company that is growing slower than its sector would allow for. However I would happy to invest time in such companies, but that's because I'm a consultant :-)
The only way Tarsnap could have growth rate + profit margin equal to 40% is if it was losing money. Given that Tarsnap is bootstrapped, that's not an option for me.
>Given that Tarsnap is bootstrapped, that's not an option for me.
Indeed. I think the advice is for VC funded companies. Whole different ballgame. In the ideal case, VC funding lets you grow faster and ultimately make more money. Whereas bootstrapped companies are constrained by the requirement to make at least some money from the getgo.
On the flipside, this constraint of bootstrapping ensures that we actually do make money. Whereas in the less than ideal case for VC the outcome is zero for the founder.
(Bootstrapping can result in zero too, but you usually find this out faster than in a startup.)
There are tradeoffs to either method. I prefer the bootstrapped way. But you can apply that rule to a bootstrapped business to some extent: if your budget allows it, then it can make sense to trim margins if your growth rate is high and you can increase growth by spending.
I wondered that as well as I'm in the same situation, but then I wondered if it works as a target if it means we should be spending more on staff and reinvestment to grow even more? But that'd mean the %age gets even higher so.. maybe not ;-)
I also don't really understand why having a higher margin is useful in a declining business. It's either a lost cause or one should be reinvesting in reversing the growth problem, no..?
In a declining business, either you want to extract as much as possible before the market disappears, or you want to invest in turning the decline into growth.
Either can be valid answers. Consider a business that is in decline because the market it is serving is disappearing. In that case this guideline tells you that if you try to invest money into getting it back into growth, and you fail, then you should instead focus on minimizing cost and maximizing price to extract as much value as possible (to e.g. reinvest in another business).
Alternatively if you find investing more leads the growth rates to increase accordingly to keep matching this guideline, it indicates that you have untapped market potential that is worth exploiting in order to put you in a position to extract far higher earnings (in absolute terms) down the road.
You can reformulate it pretty much as: Invest in growth when growth is cheap, and extract profit when it is not.
Not necessarily. Might just be a shrinking target audience, but if you can keep a good margin there's no reason not to keep serving a non-growth market.
This literally means that you can lose as much money as you want as long as you grow at a stupid-fast rate. It doesn't matter what you're building or whether anyone wants to pay for it, as long as you get what the monkeys call a "hockey-stick curve".
You're OK even if you literally win at losing. Good to know.
If you've got a hockey-stick curve for revenue and you're losing money, that's not necessarily a problem (within reason). At some point you can start spending less on user acquisition/marketing and you'll go from losing money/growing fast to profitable/growing slower.
I've noticed that a lot of startups delay making any revenue, and that this might not be for bad reasons, because plenty of companies start to really suffer once they start making revenues (but fall short of what they "should" be seeing and how has they "should" be growing) not because there is anything wrong with them as businesses, but because their ADD investors lose faith and interest.
So now it makes sense that companies would delay revenue until they have enough of a free-tier footprint that they can control revenue growth for a few years and ensure exponential growth (this may involve intentionally tamping down early-year revenue in order to have a sharp upward trend).
That makes sense. If your company doesn't have revenue, it could be worth 200 billion dollars! Once your company has actual revenue, it's pretty obvious it's worth whatever it's worth.
It's advantageous to remain in the mystery-land of hype and unrealistic expectations as long as you can keep drumming up easy investor money.
When I was in school the professor said something about interest rates and opportunity costs that was more algebraic than arithmetic; but I guess that is all academic.
I certainly didn't use this equation, but our monthly expenditure is controlled quite heavily by our growth rate. So maybe there's something in that....I think I'll go work out whether this hold true for various growth rates using our method...
FWIW:
- I have a spreadsheet which maps out our revenue and expenses over the past 2 years.
- It estimates our future growth
- It combines that with our bank balance and our expenses to work out an "optimum burn rate".
- We use this number as a guide to how much we should be spending.
The "optimum burn rate" is the spend that will see us use as much of our cash as possible without us dropping below a certain threshold (which at the moment 3x our monthly burn).