Rule of 40 (%)

Valuation

Industry:

SaaS

Aliases:

Growth-Profitability Balance

SaaS 40% Rule

Back to Metric Dictionary

Short Definition

The Rule of 40 (%) is a key metric for SaaS companies, combining revenue growth rate and profit margin (like Free Cash Flow or EBITDA margin). A score of 40% or higher indicates a healthy balance between growth and profitability. This benchmark helps evaluate capital efficiency and guides strategic decisions.

Short Definition

Why it matters for Investors

One number, two engines: Captures the trade-off between growth and profitability.
Capital efficiency lens: Rewards growth that converts to cash, penalizes “bought” growth.
Comparable across stages: Works as a directional benchmark from scale-up to public.

Why it matters for Investors

One number, two engines: Captures the trade-off between growth and profitability.
Capital efficiency lens: Rewards growth that converts to cash, penalizes “bought” growth.
Comparable across stages: Works as a directional benchmark from scale-up to public.

Why it matters for Investors

One number, two engines: Captures the trade-off between growth and profitability.
Capital efficiency lens: Rewards growth that converts to cash, penalizes “bought” growth.
Comparable across stages: Works as a directional benchmark from scale-up to public.

Formula

Practical considerations:

Lock your policy: Specify which growth (Revenue vs ARR) and which margin (FCF vs EBITDA vs Operating).
Use TTM/rolling periods: Smooth seasonality and billing cyclicality.
Same currency & basis: If using constant-currency growth or “Adjusted” margins, label and reconcile.
Negative is allowed: A profitable slow grower or a fast grower with losses can still hit ≥40%.
Segment views: New-logo vs expansion growth, or by product/region, to see what drives the score.

Formula

Practical considerations:

Lock your policy: Specify which growth (Revenue vs ARR) and which margin (FCF vs EBITDA vs Operating).
Use TTM/rolling periods: Smooth seasonality and billing cyclicality.
Same currency & basis: If using constant-currency growth or “Adjusted” margins, label and reconcile.
Negative is allowed: A profitable slow grower or a fast grower with losses can still hit ≥40%.
Segment views: New-logo vs expansion growth, or by product/region, to see what drives the score.

Formula

Practical considerations:

Lock your policy: Specify which growth (Revenue vs ARR) and which margin (FCF vs EBITDA vs Operating).
Use TTM/rolling periods: Smooth seasonality and billing cyclicality.
Same currency & basis: If using constant-currency growth or “Adjusted” margins, label and reconcile.
Negative is allowed: A profitable slow grower or a fast grower with losses can still hit ≥40%.
Segment views: New-logo vs expansion growth, or by product/region, to see what drives the score.

Worked Example

Metric	Value (%)	Notes
Revenue (FY2024)	$50,000,000	Total recognized revenue this year.
Revenue (FY2023)	$37,000,000	Total recognized revenue last year.
YoY Revenue Growth	35%	((50 − 37) ÷ 37) × 100 = 35%.
EBITDA Margin	10%	EBITDA ÷ Revenue = (5,000,000 ÷ 50,000,000) × 100.
Rule of 40 (%)	45%	35% (growth) + 10% (margin) = 45%.

Notes

Revenue Growth (35%) represents the annual percentage increase in revenue compared to the previous year.
EBITDA Margin (10%) reflects operating profitability before non-cash and financing costs.
Rule of 40 (45%) combines these two measures to show the company’s total growth-plus-profitability performance.
The calculation is additive; if either growth or margin changes, the combined percentage adjusts accordingly.
The chosen profit metric (EBITDA Margin here) must remain consistent across periods for accurate trend analysis.
Use the same time frame (typically YoY) for both components.
If profit margins are negative, the total still reflects the combined performance correctly (e.g., 50% growth − 20% margin = 30%).

Worked Example

Metric	Value (%)	Notes
Revenue (FY2024)	$50,000,000	Total recognized revenue this year.
Revenue (FY2023)	$37,000,000	Total recognized revenue last year.
YoY Revenue Growth	35%	((50 − 37) ÷ 37) × 100 = 35%.
EBITDA Margin	10%	EBITDA ÷ Revenue = (5,000,000 ÷ 50,000,000) × 100.
Rule of 40 (%)	45%	35% (growth) + 10% (margin) = 45%.

Notes

Revenue Growth (35%) represents the annual percentage increase in revenue compared to the previous year.
EBITDA Margin (10%) reflects operating profitability before non-cash and financing costs.
Rule of 40 (45%) combines these two measures to show the company’s total growth-plus-profitability performance.
The calculation is additive; if either growth or margin changes, the combined percentage adjusts accordingly.
The chosen profit metric (EBITDA Margin here) must remain consistent across periods for accurate trend analysis.
Use the same time frame (typically YoY) for both components.
If profit margins are negative, the total still reflects the combined performance correctly (e.g., 50% growth − 20% margin = 30%).

Worked Example

Metric	Value (%)	Notes
Revenue (FY2024)	$50,000,000	Total recognized revenue this year.
Revenue (FY2023)	$37,000,000	Total recognized revenue last year.
YoY Revenue Growth	35%	((50 − 37) ÷ 37) × 100 = 35%.
EBITDA Margin	10%	EBITDA ÷ Revenue = (5,000,000 ÷ 50,000,000) × 100.
Rule of 40 (%)	45%	35% (growth) + 10% (margin) = 45%.

Notes

Revenue Growth (35%) represents the annual percentage increase in revenue compared to the previous year.
EBITDA Margin (10%) reflects operating profitability before non-cash and financing costs.
Rule of 40 (45%) combines these two measures to show the company’s total growth-plus-profitability performance.
The calculation is additive; if either growth or margin changes, the combined percentage adjusts accordingly.
The chosen profit metric (EBITDA Margin here) must remain consistent across periods for accurate trend analysis.
Use the same time frame (typically YoY) for both components.
If profit margins are negative, the total still reflects the combined performance correctly (e.g., 50% growth − 20% margin = 30%).

Best Practices

Publish the recipe: Growth definition, margin definition, period basis, and any adjustments.
Show the parts: Report both growth and margin next to the Rule of 40 score.
Trend it: Present quarterly and TTM time series; call out one-offs.
Bridge drivers: Price/mix/volume for growth; gross margin & OpEx for profitability.
Segment: New vs existing customers, products, or regions to see where efficiency comes from.

Best Practices

Publish the recipe: Growth definition, margin definition, period basis, and any adjustments.
Show the parts: Report both growth and margin next to the Rule of 40 score.
Trend it: Present quarterly and TTM time series; call out one-offs.
Bridge drivers: Price/mix/volume for growth; gross margin & OpEx for profitability.
Segment: New vs existing customers, products, or regions to see where efficiency comes from.

Best Practices

Publish the recipe: Growth definition, margin definition, period basis, and any adjustments.
Show the parts: Report both growth and margin next to the Rule of 40 score.
Trend it: Present quarterly and TTM time series; call out one-offs.
Bridge drivers: Price/mix/volume for growth; gross margin & OpEx for profitability.
Segment: New vs existing customers, products, or regions to see where efficiency comes from.

FAQs

Why “40”? Where does it come from?
It’s an industry rule of thumb — SaaS companies historically valued higher when Growth % + Profit % ≥ 40%. It signals good unit economics and capital discipline.
What profit metric should I use?
EBITDA Margin for private SaaS; Free Cash Flow Margin for public or later-stage. Be consistent.
Can negative-profit companies still pass?
Yes, if revenue growth is strong enough. Example: −10% margin + 60% growth = 50% Rule of 40 — still good.
Does faster growth always justify losses?
Not forever. The Rule of 40 shows when it stops making sense — if growth slows and losses stay high, efficiency breaks down.
Can non-SaaS companies use it?
Yes, but it’s most meaningful for subscription or recurring-revenue models where growth and profit are tightly linked.

FAQs

Why “40”? Where does it come from?
It’s an industry rule of thumb — SaaS companies historically valued higher when Growth % + Profit % ≥ 40%. It signals good unit economics and capital discipline.
What profit metric should I use?
EBITDA Margin for private SaaS; Free Cash Flow Margin for public or later-stage. Be consistent.
Can negative-profit companies still pass?
Yes, if revenue growth is strong enough. Example: −10% margin + 60% growth = 50% Rule of 40 — still good.
Does faster growth always justify losses?
Not forever. The Rule of 40 shows when it stops making sense — if growth slows and losses stay high, efficiency breaks down.
Can non-SaaS companies use it?
Yes, but it’s most meaningful for subscription or recurring-revenue models where growth and profit are tightly linked.

FAQs

Why “40”? Where does it come from?
It’s an industry rule of thumb — SaaS companies historically valued higher when Growth % + Profit % ≥ 40%. It signals good unit economics and capital discipline.
What profit metric should I use?
EBITDA Margin for private SaaS; Free Cash Flow Margin for public or later-stage. Be consistent.
Can negative-profit companies still pass?
Yes, if revenue growth is strong enough. Example: −10% margin + 60% growth = 50% Rule of 40 — still good.
Does faster growth always justify losses?
Not forever. The Rule of 40 shows when it stops making sense — if growth slows and losses stay high, efficiency breaks down.
Can non-SaaS companies use it?
Yes, but it’s most meaningful for subscription or recurring-revenue models where growth and profit are tightly linked.