Rule of 40: Formula, Benchmarks, and How to Track It
What Is the Rule of 40?
The Rule of 40 is a SaaS benchmark stating that a healthy company's revenue growth rate plus its profit margin should add up to 40 or higher. Investors use the rule to judge whether a company earns its valuation by growing fast, running profitably, or balancing both. A company posting 70% growth and a negative 30% margin passes the rule at 40. A company growing 10% with a 30% margin also passes at 40. The rule treats growth and profit as substitutes rather than separate report cards, which is exactly why it shows up in nearly every SaaS board deck and investor memo.
How Do You Calculate the Rule of 40?
You calculate the Rule of 40 by adding revenue growth rate to profit margin, usually EBITDA margin, and comparing the total against 40. The formula is simple: Growth Rate % + Profit Margin % = Rule of 40 Score. Most SaaS companies use ARR growth as the growth input, since annual recurring revenue is what a recurring-revenue company actually sells, not one-time bookings or gross billings. For the margin side, EBITDA margin is the most common choice, though some boards substitute free cash flow margin. The rule only stays useful if the growth rate and the margin behind it get calculated the same way every quarter, not recomputed from whatever spreadsheet is closest to hand.
What Counts as Profit in the Rule of 40?
Profit in the Rule of 40 usually means EBITDA margin: earnings before interest, taxes, depreciation, and amortization, divided by revenue. Some investors can substitute free cash flow margin instead, since EBITDA margins can hide working-capital swings that cash does not. Others may use net profit margin for a stricter read that includes interest and taxes. Each swap can move the score by ten points or more, so a rule that mixes profit margin definitions between reporting periods stops functioning as a rule at all. A SaaS company should pick one profit margin definition and hold it constant across every board pack.
What Is a Good Rule of 40 Score?
A good Rule of 40 score clears 40, and the exact target shifts by company stage. Below 40, a company is burning cash faster than it is growing, or growing too slowly to justify thin margins, and investors read that as a warning sign. Between 40 and 60, a company is balancing growth and profitability at a rate most late-stage investors call healthy. Above 60, a company is compounding fast, running profitably, or both, and sits in the top tier of comparable SaaS companies. An early-stage company at 20% growth and a negative margin can still pass if growth is high enough, while a mature company closer to IPO is expected to clear 40 mostly on margin, not growth rate.
Why Do Growth Rate and Profit Margin Trade Off?
Growth rate and profit margin trade off because the same dollar spent on customer acquisition either shows up as faster revenue growth or stays in EBITDA as margin. A company dials spend up to chase growth or down to protect margin, but rarely gets both to rise together for long. Early-stage SaaS companies often run negative margins on purpose, spending ahead of revenue to capture market share while capital is available. Later-stage companies shift the dial toward margin as growth naturally slows and investors start pricing the company on cash flow and profitability instead of revenue growth alone. That trade-off is exactly why the rule pairs the two numbers instead of scoring either one on its own.
How Do Investors Use the Rule of 40?
Investors use the Rule of 40 as a quick screen for comparing SaaS companies of different sizes and growth stages against one number. Venture capitalist Brad Feld is widely credited with popularizing the rule as a board-level heuristic, and it has since become standard in growth-equity and private-equity SaaS diligence. A company presenting a Rule of 40 score in a board pack is answering the investor's real question directly: is this company creating value through growth, through profitability, or both. The rule does not replace a full look at recurring revenue quality, retention, or cash runway, but it sets the frame investors reach for first, which is why the number needs to hold up under a closer look.
How Do You Track the Rule of 40 Without Spreadsheet Disagreements?
You should track the Rule of 40 from one source instead of stitching together growth rate from the billing tool, EBITDA margin from QuickBooks, and rounding the rest by hand for the board deck. When each input comes from a different system, the rule produces a different score every quarter depending on who ran the numbers last, and that gap is what turns a board discussion into an argument about the spreadsheet instead of the business. DealARR calculates the Rule of 40 from the same live deal book that feeds every other report, applying one growth-rate formula and one profit margin formula across every period, so the number on the dashboard is the number in the board pack. DealARR connects to Stripe, QuickBooks, and HubSpot, and draws on 96 SaaS metrics to keep the rule consistent alongside ARR movement, churn, and revenue recognition. Start your free trial and let DealARR calculate your Rule of 40 from your live deal book. 30-day free trial, up to 5 users, no credit card.
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