Rule of 40
Growth MetricsThe Rule of 40 is the most-quoted SaaS heuristic for assessing whether a company is balancing growth and profitability healthily. It states that the sum of revenue growth rate and profit margin should be 40% or more.
The rule emerged from venture capital around 2015 and has since become standard board-level discipline. Its appeal is brutal simplicity: a single number that captures the trade-off between investing for growth and producing profit, with a clear pass/fail line at 40.
Contents
Key takeaways
- Rule of 40 = Revenue Growth Rate (%) + Profit Margin (%). Sum should be 40 or higher. Above 50 is best-in-class; above 60 is exceptional.
- Most SaaS companies use EBITDA margin or free-cash-flow margin for the profit term. Consistency matters more than which margin you pick; pick one and stick with it.
- The metric is forgiving when you trade growth for profitability. 50% growth at minus 10% margin scores 40, the same as 20% growth at 20% margin. Both are healthy; neither is.
What is the Rule of 40?
The Rule of 40 says a SaaS company is in healthy shape when its revenue growth rate plus its profit margin sums to 40% or more. The intuition: a company can be high-growth and unprofitable, or low-growth and very profitable, and both can be acceptable as long as the trade-off scores above 40.
The rule was originally articulated for public SaaS companies with stable revenue bases, but is now applied at every stage from Series B onward. At earlier stages, growth dominates the equation and profit margin is usually negative; the rule still informs which losses are tolerable.
How do you calculate the Rule of 40?
The formula:
Rule of 40 = Revenue Growth Rate (%) + Profit Margin (%)
Worked examples:
- A SaaS company growing revenue 60% year-over-year with EBITDA margin of minus 15% scores 60 + (−15) = 45. Passes.
- A SaaS company growing 25% with EBITDA margin of 10% scores 25 + 10 = 35. Fails the rule, suggests overspending or undergrowing.
- A SaaS company growing 15% with EBITDA margin of 30% scores 15 + 30 = 45. Passes; a more profitability-led trade-off.
Which profit margin you use changes the result. The three common variants:
- EBITDA margin: most common, captures operating profitability before financing.
- Free cash flow margin: stricter, accounts for working capital and capex.
- Operating margin: less common, includes stock-based compensation effects that can distort growth-stage SaaS.
Most public SaaS companies report against EBITDA margin. Pick one variant and use it consistently.
Rule of 40 benchmarks and limitations
Where companies score:
- Top decile public SaaS: 60 to 90+ Rule of 40. Snowflake, ServiceNow, and similar have historically posted 60+.
- Median public SaaS: 30 to 40. The line is blurrier than headline framing suggests.
- Below 20: the company is undergrown and unprofitable. Either growth needs to accelerate or losses need to come down sharply.
Known limitations:
- 1.The rule penalizes very large companies. A 50,000-employee SaaS at 15% growth and 25% margin scores the same 40 as a Series B at 60% growth at minus 20% margin. Both are healthy at their stage but the trade-offs are different.
- 2.It does not adjust for capital structure. A heavily debt-funded company at high margin scores well even if interest payments are unsustainable.
- 3.It does not capture quality of growth. A 50% growth rate driven by one large deal that won't recur is treated identically to organic growth that compounds.
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Frequently asked questions
Is the Rule of 40 still relevant for early-stage SaaS?
Yes, with caveats. Pre-Series B companies almost always score below 40 because growth is high but margins are deeply negative. The rule's value at early stage is as a forward target: investors look for a credible path to a 40+ score within 18 to 24 months.
Should I use revenue growth or ARR growth in the Rule of 40?
Both are acceptable; pick one and document. ARR growth is preferred for SaaS because it strips out timing noise from non-recurring revenue. Revenue growth is what shows up in public filings and is more comparable across companies.
Can a SaaS company succeed below the Rule of 40?
Some do, but they trade higher capital requirements for the same growth and face tougher fundraising rounds. The market gives the most generous valuations to companies above 40; below 40 the pressure to either accelerate growth or improve profitability rises with every quarter.