What is the Rule of 40?
The Rule of 40 is a benchmark for software companies: revenue growth rate plus profit margin should equal at least 40 percent. It captures a trade-off every SaaS board argues about. You can grow fast and lose money, or grow slowly and make money, but the combination should clear the bar.
The rule entered SaaS vocabulary in 2015, when investor Brad Feld wrote about it on his blog. Feld was clear that he had not invented it: he heard it from a late-stage investor at a board meeting. He also framed it as a test for companies at scale, roughly $50 million in revenue and up, which is worth remembering before you judge a seed-stage company against it.
The Rule of 40 formula
Rule of 40 score = revenue growth rate (%) + profit margin (%)
Revenue growth is year over year: (ARR now minus ARR twelve months ago) divided by ARR twelve months ago. Profit margin comes from the same twelve-month period. Both are percentages, and the margin can be negative.
| Example company | Revenue growth | Profit margin | Score | Result |
|---|
| Fast grower, burning cash | 60% | -15% | 45 | Passes |
| Balanced | 25% | 15% | 40 | Passes |
| Slow grower, profitable | 10% | 25% | 35 | Below 40 |
| Stalled and unprofitable | 8% | -10% | -2 | Well below 40 |
The examples are illustrative. Notice that a company losing money can still pass, if growth is strong enough to justify the burn.
Which profit margin should you use?
This is where most Rule of 40 debates actually start. Feld used EBITDA margin as his baseline, and back-tested it against operating income, net income and free cash flow. Today you will see three common choices:
- EBITDA margin: the original reference point, and easy to pull from a P&L.
- Free cash flow margin: reflects cash actually generated, so it is harder to flatter with accounting choices. Popular with investors.
- Operating margin: includes depreciation and amortization, useful when infrastructure is a large cost.
None is universally correct. Pick one, label it every time you report the score, and do not switch measures when a different one would look better.
When the Rule of 40 does not apply
Early-stage companies routinely score below 40 because they are deliberately trading margin for growth while they find a repeatable channel. For a company under about $10M ARR, these tell you more:
How to improve your Rule of 40 score
Every point comes from either growth or margin, and go-to-market decisions drive both.
- Fix retention before acquisition. Expansion revenue and lower churn raise growth without raising CAC.
- Tighten the ICP. Selling to accounts that look like your best customers shortens sales cycles and lowers acquisition cost.
- Cut the channels that do not convert. Spreading budget across five channels usually means none of them reaches efficiency.
- Review pricing and packaging. A price increase on the right tier is often the fastest margin gain available.
- Grow headcount slower than revenue. Automation in research, outbound personalization and reporting now makes this realistic.
If the score is below where your board expects, that is usually a go-to-market problem rather than a finance problem. A GTM strategy sprint is designed for exactly that diagnosis.
Rule of 40 FAQ
What is the Rule of 40?
The Rule of 40 says a healthy software company's revenue growth rate plus its profit margin should add up to at least 40 percent. A company growing 30 percent a year with a 10 percent margin scores 40. So does one growing 10 percent with a 30 percent margin. It is a quick way to judge whether growth is being bought at a sensible price.
How do you calculate the Rule of 40?
Add your year-over-year revenue growth rate to your profit margin, both as percentages. Rule of 40 score = revenue growth % + profit margin %. Use annual growth, for example this year's ARR versus ARR twelve months ago, and the margin from the same period.
Which profit margin should I use for the Rule of 40?
Brad Feld, who popularized the rule in 2015, used EBITDA margin as the baseline and checked it against operating income, net income and free cash flow. Many teams now use free cash flow margin because it reflects cash actually generated. Pick one, state which one you used, and keep it consistent over time.
Does the Rule of 40 apply to early-stage startups?
Not really. Feld described it as a test for SaaS companies at scale, roughly $50 million in revenue and above. Early-stage companies are usually expected to trade margin for growth, so investors look more at growth efficiency metrics such as burn multiple, CAC payback and net revenue retention.
What is a good Rule of 40 score?
A score of 40 or above passes. Scores well above 40 are rare and usually rewarded by investors. Below 40 is common and is not a crisis by itself; what matters is the direction of travel and whether the company has a credible plan to improve growth, margin, or both.
How can a SaaS company improve its Rule of 40 score?
On the growth side: improve net revenue retention through expansion and lower churn, tighten the ICP so sales cycles shorten, and cut channels that do not convert. On the margin side: reduce CAC by reallocating spend to efficient channels, raise prices or package better, and control headcount growth relative to revenue.
Below 40 and not sure why?
Share your growth, margin and channel mix. I will tell you honestly whether the gap is a go-to-market problem and where I would look first.