The Future of Valuation: Moving Beyond the Rule of 40

　　Challenging the Rule of 40

　　In the world of venture capital, there has been an ongoing debate about the most effective method for valuing a startup. Bessemer Venture Partners, a firm that played a key role in popularizing the current standard, now believes it is time for a significant change.

　　The subject of discussion is the renowned Rule of 40, one of the venture industry's most widely used valuation metrics. It was historically applied to cloud companies and gained popularity in 2015 through blog posts by Brad Feld and Fred Wilson. The Rule of 40 is straightforward: when you combine a company's revenue growth rate and its profit margin, the two figures should add up to a number greater than 40. This formula serves as a convenient way to ensure that a company strikes a healthy balance between ambitious goals and operational efficiency.

　　"The fundamental concept of the Rule of 40 is the idea that growth and profitability are equally important, and companies should consider the inherent trade-off between growth rates and cash flow," explains Bessemer Ventures partner Byron Deeter, whose firm has previously relied on the Rule of 40 as a key benchmark in assessing the efficiency (and value) of cloud startups.

　　Introducing the Rule of X

　　However, Deeter believes it is time to move on. He is challenging the Rule of 40 with his own metric, the Rule of X. The key difference between the two lies in their respective philosophies: the Rule of 40 posits that cash flow and growth are of equal importance, while the Rule of X emphasizes the significance of growth in the current economic climate characterized by high interest rates and corporate cost-cutting.

　　"People can cut too far, companies aren't ambitious enough, and growth rates hunker down at a time when tech markets are evolving fast, and innovation and opportunities are still abundant," he says.

　　The Nuances of Valuation

　　Valuation is not an exact science. Instead, it is a complex intersection of art, mathematics, narrative, and faith, which is why investors often rely on the most effective rules and conventions they can find. For years, the Rule of 40 has been one of the most popular and trusted methods.

　　Deeter acknowledges that the Rule of 40 remains useful, particularly for early-stage companies. However, he argues that late-stage companies are better off focusing on their growth potential. Therefore, the problem lies not with the rule itself but with its overly broad application.

　　The Rule of 40 is a snapshot of the present, while the Rule of X is a vision of the future. In the current market, the Rule of 40 is seen as bearish, while the Rule of X is bullish. The Rule of 40 is not inherently flawed; it is the rigid adherence to it that creates problems. Sometimes, a good and clear rule can be overused.

　　The Significance of the Rule of X

　　"The problem is that it's a blunt instrument, that the hammer is being applied across the board right now," Deeter explains. "It's being applied to all stages incorrectly, and that's where I think it's a meaningful disservice."

　　Deeter's stance represents a dissenting opinion. A quick Google search reveals that the Rule of 40 is widely referenced on company and firm websites and featured in reports by consulting firms like McKinsey. However, Deeter's contrarianism on a seemingly technical valuation metric reminded me of a book I've been reading in installments, James Grant's Money of the Mind: How the 1980s Got That Way. The book chronicles the history of debt in the United States, but it also explores how conventional wisdom and norms in financial markets change when someone proves to be right—and makes money in the process. My favorite quote from the book so far: "In investment banking, heresy paid better than orthodoxy."

　　When I share this quote with Deeter, I ask him how much of a heresy the Rule of X truly is.

　　"I think it's significant," he says. "But I really believe all businesses, whether they're grocery stores or tech businesses, should be valued as a sum of their future free cash flows and not the current dollars out."

　　Venture Deals and Other News

　　In other news, a federal judge recently blocked JetBlue's proposed $3.8 billion acquisition of Spirit Airlines. The judge agreed with the Justice Department's assertion that the merger would be anticompetitive, marking another setback for potential megadeals. Recently, regulatory pressure also led to the breakup of Adobe and Figma's massive $20 billion deal. The current exit environment is challenging, and regulatory scrutiny is not making things any easier.