Rule of 40
Growth rate plus profit margin should clear 40 — the formula, why it works, and how to read your score.
What is it?
The Rule of 40 says a healthy software company's revenue growth rate plus its profit margin should sum to 40% or more. It exists because growth and profitability trade off against each other — you can buy growth by burning margin, or protect margin by slowing down — and the rule prices that trade in a single number.
Its power is that it doesn't care how you clear the bar. Growing 60% while burning 20% of revenue passes. Growing 10% at a 30% margin passes. The rule only punishes the combination that deserves it: slow growth and losses at the same time.
How to calculate?
Add your year-over-year revenue growth rate to your profit margin, both in percentage points. A company growing 25% with a 17% margin scores 42 — above the bar. The standard margin measure is free-cash-flow or EBITDA margin; pick one and keep it fixed, because switching definitions is the classic way to flatter the score.
For private SaaS, use ARR growth as the growth term and FCF margin as the profit term. Measure over a year, not a quarter — the rule describes a trajectory, and one strong quarter of either input says little.
What is a good Rule of 40 score?
Forty is the pass mark, but context sets the grade. Public SaaS medians drift in the mid-30s — most established companies actually fail the rule mildly — while top-quartile performers run at 50+. Early-stage companies should be well above 40, carried almost entirely by the growth term; a seed-stage business at 40 with zero growth is not healthy, it is stalled.
Watch the mix as much as the sum. A score of 45 built on 40 points of growth is a company investing hard; the same 45 built on 40 points of margin is a company harvesting. Neither is wrong, but they are different businesses — and a falling growth term that margin keeps compensating for is how category leaders quietly become cash cows.
Decisions to be made
The score swings on which definitions you feed it — fix them before comparing quarters or companies:
- Which margin: FCF, EBITDA or operating margin? FCF is the investor standard; EBITDA flatters companies with heavy capitalised costs.
- Which growth: total revenue or ARR? ARR is cleaner for subscription businesses but excludes services revenue.
- Trailing twelve months or annualised quarter? TTM smooths; annualised responds faster and lies more often.