It seems like whenever we go through a shift in the economy, the fundamentals of finance become increasingly important. During the near-zero interest rate environment we had for more than a decade, growth was rewarded in an outsized way. 10x and 20x revenue multiples were common for startups. Because the risk-free rate of return was near zero, there was no real opportunity cost in investing in something risky. That drove up the value of companies that were investing in big growth. Today, this has changed quite a bit. There is an opportunity cost to investing in something that might not generate cash for a while. So, a lot of the attention has shifted from growth to profitability. Investors want to see cash get generated more quickly. The Rule of 40 (ensuring that a company's operating margin % + its growth rate exceeds 40%) has become a common way of categorizing top-tier startups in this environment. Boards are pushing company leaders to get to Rule of 40 as quickly as possible. Given so many companies are coming out of the grow-at-all-costs approach, the easy thing to do is to pull back on investments, project a conservative growth rate, and drive down costs to make the company's operating margin high enough that it gets the company to 40+ in the next year or two.

This is a potentially short-sighted approach, especially for earlier-stage companies with small revenue. Returning to the fundamentals of finance, we know that the value of a financial asset is the present value of the cash that you can take out of it over its lifetime. Forecasting these cash flows is done using a discounted cash flow model. Revenue multiples and the Rule of 40 are crude proxies for understanding the present value of future cash flows. The danger of the Rule of 40 for smaller companies that aren't generating significant cash flows is that they underinvest in growth to achieve a higher operating margin at a point in time but never get to a point where the company generates high amounts of actual cash.

The Rule of 40 measures a point in time calculated using the % growth rate and the % profit. But companies are not valued on what they're doing right now. And they're not valued on their growth rate. And they're not valued on their profit margins. They're valued on real amounts of cash generated in the future. Rule of 40 can be a useful metric for investors to gauge the health of a business. But that has to be tempered with an understanding of the investments the company is making today to drive future real cash flows.

One good way to manage this is to classify revenue and cost projections into two buckets. 1/ Core: revenue that will be generated from investments made in the past, and 2/ New: revenue that will be generated from new investments. Leaders need to really understand the future cash flows associated with their core business and whether or not that will produce adequate cash flows relative to expectations. That provides the input needed to throttle investments in new initiatives. The core should get more profitable and the new stuff should drive lots of new revenue. Blending the two and optimizing to a short-term metric runs the risk of severing the company’s execution plan from what’s best for investors over the long term.