There’s an ongoing debate in the VC world about the best way to value a startup. And Bessemer Venture Partners, a firm that was key in popularizing the current standard, now says it’s time for a big change.
At issue is the so-called Rule of 40, one of venture’s most-loved valuation metrics. It’s historically been applied to cloud companies and was popularized in 2015 through blog posts by Brad Feld and Fred Wilson. The Rule of 40 is simple—if you add up a company’s revenue growth rate and its profit margin, the two figures should combine to a number that’s greater than 40. The formula is a handy way of ensuring that a company has a healthy balance of ambitions and efficiency.
“The core concept of the Rule of 40 is this idea that growth and profitability are equal, and that companies should think about that inherent trade-off between growth rates and cash flow,” says Bessemer Ventures partner Byron Deeter, whose firm has previously used the Rule of 40 as a key yardstick in how it assesses the efficiency (and value) of cloud startups.
But Deeter says it’s time to move on. He’s rebelling against the Rule of 40 with his own metric, the Rule of X. The key difference between the two is this—the Rule of 40 says that cash flow and growth are equal. But in the current economic environment of high interest rates and corporate cost-cutting, Deeter believes that growth isn’t being prioritized enough.
”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 said.
Valuation isn’t an exact science. Valuation, instead, is the odd intersection of art, math, narrative, and faith—and that’s why investors so frequently rely on the best rules and conventions they can find. And for years, the Rule of 40 has been one of the best-loved of these methods.
And the Rule of 40 remains useful, especially for earlier stage companies, Deeter says. A late stage company, he argues, is better off focusing on its growth potential. So the problem isn’t the rule itself, just that it’s too broadly applied.
If the Rule of 40 is about the present, the Rule of X is about the future. In this market, the Rule of 40 is bearish, while the Rule of X is bullish. The Rule of 40 isn’t a problem, it’s rigid adherence to it that’s problematic. It’s that a good, clear rule can sometimes be used too much.
“The problem is that it’s a blunt instrument, that the hammer is being applied across the board right now,” Deeter told me. “It’s being applied to all stages incorrectly, and that’s where I think it’s a meaningful disservice.”
It’s a dissident take. Even a quick Google shows that the Rule of 40 appears on company and firm websites, and is featured in reports by consulting firms like McKinsey. But Deeter’s operating on a longtime tradition. His contrarianism on something as in-the-weeds as a valuation metric made me think about a book I’ve been episodically reading, James Grant’s Money of the Mind: How the 1980s Got That Way. It’s a history of debt in the U.S., yes. But the book also chronicles how conventional wisdom and norms in financial markets change when someone’s right—and makes money in the process. My favorite quote in the book so far: “In investment banking, heresy paid better than orthodoxy.”
I tell Deeter about this, and I ask him how much of a heresy the Rule of X really 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.”
Elsewhere…A federal judge yesterday 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, and the decision marks another loss for would-be megadeals. Recently, pressure from regulators also saw the breakup of Adobe and Figma’s monster $20 billion deal. It’s a tough exit environment right now, and regulatory scrutiny isn’t making things any easier.
See you tomorrow,
Allie Garfinkle
Twitter:@agarfinks
Email: alexandra.garfinkle@fortune.com
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Joe Abrams curated the deals section of today’s newsletter.
VENTURE DEALS
- Quantinuum, a Broomfield, Colo.-based developer and provider of quantum computing technology, raised $300 million in funding. JPMorgan Chase led the round and was joined by Mitsui, Honeywell, Amgen, and others.
- INERATEC, a Karlsruhe, Germany-based provider of synthetic e-fuels for cars, raised $129 million in Series B funding. Piva Capital led the round and was joined by Copec WIND Ventures, RockCreekHG Ventures, TDK Ventures, Emerald, and Samsung Ventures.
- Onera Health, an Eindhoven, Netherlands-based provider of sleep testing technology, raised €30 million ($32 million) in Series C funding. EQT Life Sciences and Gimv led the round and was joined by existing investors Innovation Industries, Invest-NL, and others.
- Sakana AI, a Tokyo, Japan-based AI research company, raised $30 million in seed funding. Lux Capital led the round and was joined by Khosla Ventures, Sony, NTT, KDDI, and others.
- Vicarius, a New York City-based developer of software designed to autonomously remediate security vulnerabilities in software, raised $30 million in Series B funding. Bright Pixel led the round and was joined by AllegisCyber Capital, AlleyCorp, Strait, and others.
- Prismatic, a Sioux Falls, S.D.-based platform designed to help B2B teams integrate other apps and software their customers use, raised $22 million in Series B funding from Five Elms Capital.
- Xyte, a Tel Aviv, Israel and Mountain View, Calif.-based platform designed to help manufacturers commercialize their hardware into a service, raised $20 million in Series A funding. Intel Capital led the round and was joined by Samsung Next and existing investors S Capital and Mindset Ventures.
- Digital Infrastructure Inc, a Brooklyn, N.Y.-based platform where drivers can share vehicle data and earn rewards, raised $11.5 million in Series A funding. CoinFund led the round and was joined by Slow Ventures, Consensys Mesh, and others.
- The Realest, a Los Angeles, Calif.-based memorabilia marketplace and provider of authentication services, raised $4.6 million in seed funding. KB Partners led the round and was joined by BAM Ventures, NFX, Slow Ventures, FLÜS Investment Group, and others.
- NEXT Life Sciences, a San Luis Obispo, Calif.-based developer of a non hormonal male contraceptive, raised $2.5 million in seed funding. The Family led the round and was joined by Transform VC and others.
PRIVATE EQUITY
- IBS Software, backed by Apax Partners, agreed to acquire Above Property Services, a Naples, Fla.-based provider of hotel and travel technology, for $90 million.
- Aquiline Capital Partners acquired a majority stake in Pharma Force Group, a Wayne, Penn.-based pharmacy solutions provider to hospitals and health clinics. Financial terms were not disclosed.
- CORE Industrial Partners acquired a majority stake in Aviation Concepts, a Sunrise, Fla.-based components provider to the commercial aviation industry. Financial terms were not disclosed.
- Firmament acquired a majority stake in Navitrans, a Kortrijk, Belgium-based provider of transportation management software and warehouse management software for transport service providers. Financial terms were not disclosed.
- General Atlantic agreed to acquire Actis, a London, U.K.-based private equity firm investing in infrastructure. Financial terms were not disclosed.
- H.I.G. Capital acquired Patriot Pickle, a Wayne, N.J.-based manufacturer and distributor of pickles, from Swander Pace Capital. Financial terms were not disclosed.
- L Catterton acquired a minority stake in Sploot Veterinary Care, a Denver, Colo.-based veterinary care platform. Financial terms were not disclosed.
- MPearlRock acquired nutpods, a Bellevue, Wash.-based producer of plant-based coffee creamer. Financial terms were not disclosed.
- Oakley Capital agreed to acquire a majority stake in Steer Automotive Group, an Aylesbury, U.K.-based provider of car collision repair services. Financial terms were not disclosed.
- RTC Aerospace, backed by Stellex Capital Management, acquired Vanderhorst BrothersIndustries, a Simi Valley, Calif.-based manufacturer of precision components to the aerospace, defense, and space industries. Financial terms were not disclosed.
- Snyk, backed by Amity Equity Partners and Coatue Management, acquired Helios, a Tel Aviv, Israel-based security platform designed to analyze software vulnerabilities. Financial terms were not disclosed.
- Summit Partners acquired a minority stake in DocuSketch, a Lakeland, Fla.-based documentation, scoping, sketching, and estimating services provider for the property restoration industry. Financial terms were not disclosed.
EXITS
- CIVC Partners acquired Datavail Corp., a Broomfield, Colo.-based provider of data management and analysis services, from a group of investors led by Catalyst Investors. Financial terms were not disclosed.
- TRC Companies acquired Locana, a Denver, Colo.-based provider of location and mapping technology, from Transom Capital and Angeleno Group. Financial terms were not disclosed.
OTHER
-Restaurant Brands International (NYSE: QSR) agreed to acquireCarrols Restaurant Group(Nasdaq: TAST), a Syracuse, N.Y.-based owner and operator of restaurant chains, for approximately $1 billion.
FUNDS + FUNDS OF FUNDS
- Thomvest Ventures, a San Francisco-based venture capital firm, raised $250 million in funding for a new fund focused on the financial and real estate technology, cybersecurity, cloud, and AI infrastructure sectors.
PEOPLE
- Cathay Capital, a New York City-based private equity firm, hired Rene Sauerteig as an operating partner. Formerly, he was with Benevis.
- Greycroft, a New York City-based venture capital firm, hired Adam Boutin as a partner. Formerly, he was with Capital One Ventures.
- Thomvest Ventures, a San Francisco-based venture capital firm, promoted Umesh Padval and Nima Wedlake to managing director.
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