Rule of 40
What is the Rule of 40?
The Rule of 40 is a SaaS financial metric that evaluates company health by combining revenue growth rate and profit margin. A company meets the Rule of 40 when its growth rate plus profit margin equals or exceeds 40%.
The metric emerged in the late 2000s as venture capitalists and SaaS investors sought a balanced framework for evaluating company performance. Before the Rule of 40, investors often focused exclusively on growth, leading companies to prioritize revenue expansion at any cost. This metric introduced a more nuanced approach: companies could achieve a passing score through high growth with low profitability, moderate growth with strong margins, or a balanced combination of both.
The Rule of 40 reflects a fundamental truth about SaaS economics. In early stages, companies typically invest heavily in growth, accepting negative or low margins. As they mature, growth naturally slows, but operational efficiency should improve, maintaining overall company health. The metric provides a single number that captures this trade-off, making it easier for boards, investors, and leadership teams to assess whether a company is performing well relative to its stage and market conditions. While not perfect, it has become one of the most widely adopted benchmarks in B2B SaaS, used in board meetings, investor pitches, and strategic planning sessions across the industry.
Key Takeaways
Balanced Growth Metric: The Rule of 40 combines growth rate and profitability into a single health indicator, allowing companies to balance aggressive expansion with sustainable economics
40% Threshold: Companies should target a combined score of 40% or higher, though exceptional performers often achieve 50-70% or more
Stage-Dependent Target: Early-stage companies typically score through high growth with negative margins, while mature companies achieve the target through profitability with slower growth
Investor Standard: Public and private SaaS investors use this metric as a primary screening tool and valuation input, with scores above 40% correlating to higher multiples
Operational Framework: The metric guides strategic decisions about investments in growth versus margin improvement, helping leadership teams allocate resources appropriately
How It Works
The Rule of 40 calculation combines two fundamental business metrics into a single performance indicator:
Formula: Revenue Growth Rate (%) + Profit Margin (%) ≥ 40%
Revenue Growth Rate is typically calculated as year-over-year percentage growth in ARR or total revenue. For quarterly reporting, many companies annualize the growth rate to maintain consistency.
Profit Margin can be measured using different profitability metrics depending on company stage and reporting standards:
- Free Cash Flow (FCF) Margin: Cash from operations minus capital expenditures, divided by revenue (most common for mature companies)
- EBITDA Margin: Earnings before interest, taxes, depreciation, and amortization, divided by revenue
- Operating Margin: Operating income divided by revenue (used by public companies)
The choice of profit metric matters significantly. A company might pass the Rule of 40 using EBITDA margin but fail using FCF margin. Most investors prefer FCF margin for private companies because it reflects actual cash generation, while public companies typically report using GAAP operating margin.
The calculation process works as follows:
Calculate trailing twelve months (TTM) revenue and compare to prior TTM period to determine growth rate
Calculate profit margin using the same TTM period
Add the two percentages together
Evaluate whether the sum meets or exceeds 40%
For example, a company growing at 60% year-over-year with a -20% FCF margin scores 40 (60 + (-20) = 40), just meeting the threshold. A more mature company growing at 20% with 25% operating margin scores 45 (20 + 25 = 45), exceeding the benchmark.
The metric's power lies in its flexibility. High-growth companies can operate at a loss while maintaining strong overall health, as long as growth is substantial enough to offset negative margins. Conversely, slower-growth companies must demonstrate operational efficiency through strong profitability to maintain a healthy score.
Key Features
Single Unified Metric: Combines growth and profitability into one number for easy comparison and communication
Stage Flexibility: Works across company maturity levels, from high-growth startups to mature public companies
Strategic Trade-off Framework: Explicitly acknowledges that companies can optimize for either growth or profitability depending on market conditions
Industry Standard Benchmark: Universally recognized in SaaS, making it useful for investor communications and competitive analysis
Board-Level Simplicity: Provides executives and boards with a quick health check without diving into detailed financial statements
Use Cases
Use Case 1: Investor Due Diligence and Valuation
Private equity firms and venture capital investors use the Rule of 40 as a primary screening metric during deal evaluation. When analyzing potential investments, investors calculate the Rule of 40 score to quickly assess whether a company demonstrates healthy unit economics. Companies scoring above 40% typically command higher valuation multiples, while those below 40% face additional scrutiny or valuation discounts. During pipeline review processes, investment committees often set Rule of 40 thresholds as minimum criteria for moving deals forward.
Use Case 2: Strategic Resource Allocation
Leadership teams use the Rule of 40 to guide decisions about investing in growth versus improving profitability. When a company scores below 40%, executives must decide whether to cut expenses to improve margins or invest more aggressively in sales and marketing to accelerate growth. For example, a company at 30% growth with 5% margins (35 total) might choose to increase CAC temporarily to reach 45% growth, accepting -5% margins to achieve a 40 score. This framework helps quantify trade-offs and align leadership around strategic priorities.
Use Case 3: Board Reporting and Performance Tracking
CFOs include the Rule of 40 in monthly or quarterly board packages as a primary KPI alongside ARR growth and burn rate. The metric provides a consistent benchmark across reporting periods, making it easy to track whether the company is improving, declining, or maintaining steady state. During market downturns, boards often increase focus on the Rule of 40, pushing companies to shift from pure growth focus toward balanced performance that protects the score while preserving cash.
Implementation Example
Here's how a typical B2B SaaS company would track and report the Rule of 40:
Quarterly Rule of 40 Calculation Dashboard
Scenario Planning Table
Scenario | Growth Rate | Operating Margin | Rule of 40 | Action Required |
|---|---|---|---|---|
Status Quo | 36% | -6% | 30% | Miss target by 10pts |
Growth Focus | 45% | -12% | 33% | Increase sales hiring 40% |
Efficiency Focus | 30% | +10% | 40% | Cut opex 15%, freeze hiring |
Balanced Path | 38% | +5% | 43% | Modest hiring, improve retention |
Investor Benchmark Comparison
According to Bessemer Venture Partners' State of the Cloud report, public SaaS companies demonstrate the following Rule of 40 distributions:
Performance Tier | Rule of 40 Range | Percentile | Revenue Multiple |
|---|---|---|---|
Exceptional | 60%+ | Top 10% | 15-25x ARR |
Strong | 40-60% | 50th-90th | 8-15x ARR |
Adequate | 20-40% | 25th-50th | 4-8x ARR |
Challenged | <20% | Bottom 25% | 2-4x ARR |
Companies consistently scoring above 40% receive premium valuations and greater strategic flexibility in capital allocation decisions.
Related Terms
ARR (Annual Recurring Revenue): The foundation metric for calculating growth rate in the Rule of 40
Net Dollar Retention: A key driver of growth rate that measures revenue expansion from existing customers
CAC Payback Period: Another efficiency metric that evaluates how long it takes to recover customer acquisition costs
Magic Number: Measures sales efficiency by comparing new ARR to prior period sales and marketing spend
Burn Rate: Monthly cash consumption that directly impacts the profitability component of Rule of 40
LTV:CAC Ratio: Compares customer lifetime value to acquisition cost, indicating long-term unit economics
ARR Growth Rate: The growth component of the Rule of 40 calculation
Gross Revenue Retention: Measures revenue retention before expansion, impacting net growth rate
Frequently Asked Questions
What is the Rule of 40?
Quick Answer: The Rule of 40 is a SaaS metric where a company's revenue growth rate plus profit margin should equal or exceed 40%, balancing growth and profitability.
The Rule of 40 provides a unified framework for evaluating SaaS company health by combining two critical metrics: how fast the company is growing and how efficiently it operates. Companies can meet the 40% threshold through various combinations—high growth with losses, moderate growth with strong margins, or balanced performance in both areas.
Why is 40% the target threshold?
Quick Answer: The 40% benchmark emerged from analysis of successful public SaaS companies, representing the minimum combined performance that typically indicates healthy long-term unit economics.
Historical analysis of public SaaS companies showed that those consistently achieving 40% or higher scores tended to deliver strong returns to shareholders, maintain sustainable business models, and command premium valuations. The threshold isn't arbitrary—it reflects the balance point where a company demonstrates it can either grow quickly enough to justify current losses or generate sufficient profitability to sustain its current growth rate. While market conditions and investor expectations shift over time, the 40% benchmark has remained remarkably consistent since the 2010s.
Should I use EBITDA margin or FCF margin in the calculation?
Quick Answer: Most investors prefer Free Cash Flow (FCF) margin because it reflects actual cash generation, though public companies often report using operating margin for consistency with GAAP reporting.
The choice of profitability metric significantly impacts your Rule of 40 score. EBITDA margin tends to be more favorable because it adds back non-cash expenses, while FCF margin accounts for actual cash movements including working capital changes and capital expenditures. Private company boards typically track both metrics, using FCF margin for operational decisions about cash runway and EBITDA margin for investor communications. Public companies must use GAAP operating margin in official disclosures, though investor presentations may reference alternative profitability measures as well.
Does the Rule of 40 apply to early-stage startups?
The Rule of 40 becomes most relevant once a company reaches approximately $10-20M in ARR and has established repeatable go-to-market motions. Before this scale, most SaaS companies operate with negative margins as they invest heavily in product-led growth, sales team development, and market positioning. Very early companies might score -50 to 0 on the Rule of 40, which is expected and acceptable at that stage. Investors instead focus on other metrics like logo retention, customer acquisition efficiency, and product-market fit indicators during seed and Series A stages.
How do I improve a below-target Rule of 40 score?
Companies scoring below 40% have three strategic paths: accelerate growth, improve profitability, or pursue a balanced approach. Growth acceleration requires investment in sales and marketing, which may further compress margins temporarily but increases the growth component. Profitability improvement involves optimizing GTM efficiency, reducing non-essential spending, and improving net dollar retention to drive growth without proportional cost increases. Most successful companies pursue the balanced path, making surgical investments in high-ROI growth initiatives while eliminating low-performing programs and improving operational efficiency across the organization.
Conclusion
The Rule of 40 has become the definitive benchmark for B2B SaaS company health, providing a single metric that balances the tension between growth and profitability. For companies at any stage, maintaining a score at or above 40% signals to investors, boards, and leadership teams that the business operates with sound unit economics and strategic discipline. The metric's elegance lies in its flexibility—it acknowledges that high-growth companies should prioritize expansion even at the cost of near-term profitability, while mature companies must demonstrate operational efficiency to offset naturally decelerating growth rates.
Different teams across the organization rely on the Rule of 40 to guide decisions. CFOs use it to set financial targets and model scenarios for board presentations. Revenue operations teams align GTM strategy to support the score, balancing investments in new customer acquisition with programs that improve retention and expansion. Sales leaders use the metric to understand how efficiency targets impact their ability to hire and scale teams. Customer success organizations recognize that improving net revenue retention simultaneously boosts growth rates and reduces relative customer acquisition costs, improving both components of the Rule of 40.
As the SaaS industry continues to mature and investors increasingly prioritize sustainable growth over growth-at-all-costs, the Rule of 40 will remain a central framework for strategic planning and performance evaluation. Companies that consistently maintain scores above 40% position themselves for premium valuations, strategic flexibility, and long-term success in competitive markets.
Last Updated: January 18, 2026
