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Hosted by Financial Advisor Coach, Ray Sclafani, "Building The Billion Dollar Business" is the ultimate podcast for financial advisors seeking to elevate their practice. Each episode features deep dives into actionable advice and exclusive interviews with top professionals in the financial services industry. Tune in to unlock your potential and build a successful, enduring financial advisory practice.
Ray Sclafani (00:00.142)
Welcome to Building the Billion Dollar Business, the podcast where we dive deep into the strategies, insights and stories behind the world's most successful financial advisors and introduce content and actionable ideas to fuel your growth. Together, we'll unlock the methods, tactics and mindset shifts that set the top 1 % apart from the rest. I'm Ray Sclafani and I'll be your host. Let me take you into a boardroom conversation not in our industry,
but in Silicon Valley about a decade ago, there were a group of venture capitalists reviewing SaaS company after SaaS company. Some are growing like wildfire, but burning through cash while others are sitting on fat profit margins, but barely moving. They needed a better way to decide who was really building value. That's where this rule of 40 was born. It's a shorthand, a back of the envelope calculation. It's a simple yet powerful idea.
You add your revenue growth rate to your EBITDA margin, and if it's 40 or more, you're on solid ground. It started with software, but it didn't stay there. In fact, today, that same rule is showing up in our world, mostly in boardrooms of private equity-owned firms, RIAs with recurring revenue, enterprise ambitions, and investors at the table. If you're ignoring it, you're missing a critical measure of enterprise health.
and enterprise value creation. So let's break down what the rule of 40 is, how it works, where it falls short if used incorrectly, and how to wield it as a strategic leadership tool in your firm. Okay, here's the formula again. Revenue growth rate expressed in a percentage term, EBITDA margin also expressed in a percentage term. Those added together equals the rule of 40 score.
Ray Sclafani (02:01.678)
If the total equals or exceeds 40, the firm is considered financially healthy, creating value through either strong growth, strong profit, or a balance of both. The number itself, 40, was never magic. It was practical. A company growing at 30 % with a 10 % margin, okay, strong. A company growing at 15 % with a 25 % margin, more attractive.
You see, this is just a VC tool born out of necessity, popularized by firms like Bessemer Venture Partners as they evaluated SaaS companies. But what started in Silicon Valley as a benchmark has now crossed over into any business model with recurring revenue. And that includes RIAs. You build clients on a recurring basis. You leverage scale through people and platforms. And you're investing in growth while maintaining profit. That's why the Rule of 40 matters here.
and why more institutional buyers and PE back consolidators are using it as a filter. Why does it matter in the RIA world? Well, let me share with you the ground truth from firms we coach and the deals I see getting done. Private equity groups, strategic buyers, and even internal successors, they're no longer just asking about AUM or headcount. They want to know, are you creating intentional, sustainable, profitable growth?
One of our newer clients that just joined our community here at ClientWise, let's call them Firm A, recently came to us growing at a solid 18 % year over year. Not bad. Their EBITDA margin was 19%. Why? They had added two new offices, made two key strategic hires. One was a Chief People Officer. The other was a Chief Technology Officer. They upgraded and invested in a new tech stack.
and they hadn't refined pricing or even zeroed in on any new client acquisition. So their rule of 40 score was 37. Here's another example, firm B, they only grew at 7%, but they had a 36 % EBITDA margin. Their score was actually 43. Both firms thought they were performing well, only one had real clarity. Let me also share with you a common RIA benchmark rule.
Ray Sclafani (04:23.246)
It's called the 40-30-30 rule. I don't want to confuse these two, but in the RIA community, we've often seen 40 % of gross revenues attributing to professional staff expenses and 30 % of gross revenues to operating expenses, including support staff. I'm not a big fan of the word staff, but I'm using industry terminology. So when you see it printed in any kind of benchmarking study, you'll know exactly what it is. And then that 30 % profit margin.
So if your revenue is growing, just say 10 % and you're holding a clean 30 % margin, well, you hit the rule of 40 exactly. It looks good on paper, but here's the real problem. Roughly 70 % of growth in the RIA market is capital market driven. That's passive lift, nothing to do with strategy or business development. Here's another chunk, &A, that acquisitive growth, that inorganic growth.
So if you're using the rule of 40 and counting capital market appreciation or acquired AUM as quote growth, you're creating a false narrative. The true test is this. What's your rule of 40 when you isolate for organic growth, net new clients, new client acquisition, expansion of existing client revenue, new service offerings, pricing adjustments, real advisor productivity. When you isolate for organic growth,
the rule of 40 becomes less comfortable and much more revealing. And that's why it matters because it forces the conversation about what's driving your business and what's not. Here's how to put the rule of 40 to work. First, take the revenue growth rate. Use trailing 12 month revenue compared to the prior 12 months. For example, 10 million last year versus 11.5 million this year. Well, that's 15 % growth.
then take your EBITDA margin, use normalized EBITDA, adjusted for one-time expenses and true owner comp. So if you took a firm with 2.875 million EBITDA on 11.5 million revenue, well, that's a 25 % margin. If we add the growth rate at 15 % and 25 % on the margin, that's 40, that's a solid score. But I wouldn't stop there. I would track it quarterly.
Ray Sclafani (06:46.958)
over the rolling 12 months before and after any major leadership or investment decision, and most importantly, segment it. What's your rule of 40 for organic growth? What's your rule of 40 for legacy client base? What's your rule of 40 for next gen growth segment? What's it look like for your core team's client roster? This is where you start leading like a CEO, not just operating like a lead advisor.
And the Rule of is not just a scoreboard, it's a strategic lens. Here are four ways that leading firms are using the Rule of 40. Number one, in board meetings, they use it as a conversation starter about trade-offs, where to invest, where to pause, where to optimize. They use it in &A transactions as a way to evaluate tuck-ins or larger transactions. A high Rule of 40 is an indicator of real enterprise value.
not just surface level growth. Firms are using it in compensation design. Some are even linking team incentives to metrics tied to the rule of 40 like profitability and net new revenue per advisor. And firms are also using it in CEO development. The rule of 40 becomes a feedback tool. Am I operating like a growth minded CEO or am I stuck being the firm's most productive advisor? If you're chasing growth and ignoring margin or
optimizing for margin and starving growth, this score brings it to light. There's no hiding. This is about balance, sustainability, and leadership maturity. With each episode, I typically introduce a series of coaching questions for your next leadership meeting. Today, there are five. Number one, what's your rule of 40 score? And is it based on true organic growth or inflated by the capital markets and &A?
Number two, how has your rule of 40 score trended over the past four quarters? Number three, what specific actions are you taking to grow revenue that is not market driven? Number four, who on your team owns the responsibility to monitor and improve this score? Number five, what would need to change to raise your rule of 40 by five points?
Ray Sclafani (09:11.222)
in the next 12 months without sacrificing client experience. You want to start with these five questions and it's not about hitting some magic number. It's about building a business that endures and that someone would want to own. If this episode hit home, please share it with your team and better yet, bring your rule of 40 score into your next leadership conversation and let it spark a real discussion. And if you need any help applying this inside your firm, you know how to contact ClientWise.
Thanks for listening. Well, thanks for tuning in and that's a wrap. Until next time, this is Ray Sclafani. Keep building, growing and striving for greatness. Together, we'll redefine what's possible in the world of wealth management. Be sure to check back for our latest episode and article.