The rule of 40 says a healthy software company's revenue growth rate plus its profit margin should add up to at least 40%. A company growing 50% a year can lose 10% of revenue and still pass; one growing 15% needs a 25% margin.
It is a way to judge growth and profitability together, so a fast-growing, loss-making company and a slower, profitable one can be compared on one number.
The rule of 40 formula
Rule of 40 score = revenue growth rate (%) + profit margin (%)
revenue growth rate = (revenue this year − revenue last year)
/ revenue last year × 100
profit margin = profit / revenue × 100
(EBITDA or free cash flow)A score of 40 or more passes. The rule doesn't fix which growth or which profit to use, so the convention you pick matters:
- Growth: year-over-year revenue growth is most common. ARR growth works for subscription businesses if you use it consistently.
- Profit: Brad Feld's February 2015 post, which popularized the rule, used EBITDA margin. Many investors use free cash flow margin instead, since it is closer to cash and harder to adjust.
Rule of 40 calculations: three companies
| Company A | Company B | Company C | |
|---|---|---|---|
| Revenue last year | $10.0M | $6.0M | $20.0M |
| Revenue this year | $13.5M | $10.2M | $24.0M |
| Growth | 35% | 70% | 20% |
| EBITDA this year | $1.08M | −$2.55M | −$2.4M |
| EBITDA margin | 8% | −25% | −10% |
| Rule of 40 score | 43 | 45 | 10 |
- Company A grows at a moderate rate and makes a small profit: it passes.
- Company B loses a quarter of its revenue, but growth of 70% carries it over the line. Investors usually accept that trade while growth is that fast.
- Company C is in the hardest spot: growth has slowed to 20% and it still loses money. To pass, it needs margin of +20% at this growth, a 30-point swing, or a big return to growth.
How to use your score
The rule of 40 works best as a guide to trade-offs. If you are above 40, you have room to spend more for growth or to take margin, depending on what the market rewards. If you are below 40, the score tells you how far you have to move, and the two levers show you how: every point of growth you add is worth the same as a point of margin.
Track the score every quarter on a trailing twelve-month basis, so one big quarter doesn't swing it.
Common rule of 40 mistakes
- Mixing periods. Annual growth plus a single quarter's margin, or a quarter's growth annualized, gives a score that means nothing.
- Using adjusted EBITDA that excludes real costs. Leaving out stock-based compensation or one-off items flatters the margin. Say what was adjusted.
- Mixing bookings growth with accounting margin. Use revenue or ARR growth with a margin on the same basis.
- Applying it to a company with tiny revenue. Going from $200,000 to $600,000 is 200% growth and tells you little about the business at scale.
- Changing the definition when the score drops. Pick EBITDA or free cash flow once and keep it.
Related metrics
- Burn multiple: how much cash each dollar of new ARR costs, a sharper test for loss-making growth.
- Burn rate: the monthly cash behind a negative margin.
- Annual recurring revenue: the growth half of the score for subscription companies.
- SaaS magic number: whether sales and marketing spend is producing that growth.
Get the inputs automatically
The two halves come from two systems. For growth, the Stripe weekly MRR report posts MRR every Monday; a year of those cards gives you ARR growth. For margin, QuickBooks monthly P&L summary posts last month's revenue, costs and net income on the 5th. Ask your agent to combine the trailing twelve months of each into one score and post it as a metric card once a quarter, so the trend builds up on its own.
Questions
Who came up with the rule of 40?
Brad Feld wrote it up in a February 2015 blog post, crediting a late-stage investor he had heard describe it at a board meeting. It spread from there through SaaS investors and public market analysts.
Which profit margin should I use?
Feld's post used EBITDA margin. Many investors now prefer free cash flow margin because it is harder to adjust. Either works if you name it and keep it the same every quarter.
Does the rule of 40 apply to early-stage startups?
Not very usefully. A company growing from a tiny base posts huge growth rates and deep losses that both swing from quarter to quarter. The rule is most telling once revenue is large enough that growth and margin are stable.
Is a score of exactly 40 good?
The rule treats 40 or more as healthy. What matters more is the direction: a score sliding from 45 to 30 over a year says growth is slowing faster than margins improve.