Resources / Glossary / Rule of 40

Rule of 40.

Aka. Rule of forty · 40% rule
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What is the Rule of 40?

The Rule of 40 is a rule of thumb for evaluating software and SaaS businesses. It states that a company's revenue growth rate plus its profit margin should sum to at least 40%. A company growing 30% with a 10% margin clears it; so does one growing 50% while running a 10% loss. Both land at 40.

The logic is that growth and profitability are exchangeable up to a point. Early, fast-growing software companies legitimately sacrifice margin to capture market share, while mature ones convert slowing growth into profit. The rule says either path is acceptable as long as the combined score stays healthy — what is not acceptable is a company that is both slow-growing and unprofitable.

It is a heuristic, not a law. There is nothing magic about the number 40; it emerged as a practical benchmark for venture and growth investors assessing whether a software business is operating efficiently relative to its stage.

How to calculate the Rule of 40

The calculation is deliberately simple, but the inputs require care.

  1. Pick the growth metric. Usually year-over-year revenue growth, expressed as a percentage. Many investors prefer ARR growth for subscription businesses because it strips out one-time revenue.
  2. Pick the profitability metric. Commonly the EBITDA margin or free-cash-flow margin, expressed as a percentage of revenue. The choice matters — different margin definitions produce different scores for the same company.
  3. Add them. Growth percentage plus margin percentage. A 25% grower with a 20% EBITDA margin scores 45 and clears the bar.
  4. Interpret with stage in mind. A score above 40 signals an efficient balance; a score well below signals the company is spending without commensurate growth.

Where the rule breaks down

The rule's simplicity is also its limitation. Because growth and margin are measured differently across firms, two analysts can compute very different Rule of 40 scores for the same company depending on whether they use GAAP margin, EBITDA margin, or free-cash-flow margin, and whether they use revenue or ARR growth.

It also flatters extremes. A company growing 100% while losing 60% of revenue technically scores 40, but that profile carries very different risk from a 20%-grower at a 20% margin. The Rule of 40 is best used as a quick screen and a conversation starter — not as a standalone valuation input.

Frequently asked.

4 questions
01 Why 40 and not another number?

There is no theoretical derivation — 40 emerged as an empirical benchmark that growth investors found separated efficiently-run software businesses from inefficient ones. It is a convention that stuck because it is memorable and roughly calibrated to how the best SaaS companies operate.

Some investors raise the bar to 50 or 60 for top-tier businesses, and lower it for earlier-stage companies still investing heavily.

02 Which margin should I use in the Rule of 40?

There is no single standard. EBITDA margin and free-cash-flow margin are the most common; some use operating margin. The key is consistency — apply the same definition across every company you compare, because mixing margin definitions makes the scores meaningless.

03 Does the Rule of 40 apply outside of software?

It was built for subscription software, where recurring revenue and high gross margins make the growth-versus-profit trade-off clean. It travels poorly to capital-intensive or low-margin businesses, where the underlying economics don't support the same exchange between growth and margin.

04 Can a company game the Rule of 40?

Yes. Choosing a flattering margin definition, using ARR growth at a moment of front-loaded bookings, or pulling forward revenue can all lift the score temporarily. That is why the rule is a screen rather than a verdict — a healthy score still has to be backed by durable, recurring economics.

Related terms

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The blended cost of a company's debt and equity, weighted by their share of the capital structure — the <em>discount rate</em> used to value its future cash flows.

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Svaluation

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The value created when two combined businesses are worth more together than apart — usually from cost savings, and more speculatively from <em>revenue gains</em>.

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