Rule of 40

The Rule of 40 is a SaaS health benchmark stating that a company's revenue growth rate (year-over-year percentage) plus its profit margin (typically EBITDA or free cash flow margin) should equal or exceed 40%. It provides a single composite score balancing growth and profitability, acknowledging that early-stage companies trade one for the other.

formula.sh

Rule of 40 Score = Revenue Growth Rate (%) + Profit Margin (%)

> Revenue Growth Rate: YoY ARR or revenue growth expressed as a percentage
> Profit Margin: EBITDA margin or free cash flow margin (can be negative for high-growth companies)
> Scores above 40 are considered healthy; below 40 warrants scrutiny on the growth/efficiency trade-off

example

example.sh

Your ARR grew 55% YoY and your EBITDA margin is −18% (you are investing heavily in growth).

55% + (−18%)

→ Rule of 40 Score: 37 — slightly below the threshold, acceptable at this stage

why it matters

The Rule of 40 solves a false dichotomy: investors know you cannot maximize growth and profitability simultaneously in early SaaS. The rule lets high-growth companies justify negative margins and lets profitable-but-slower companies justify their conservatism — as long as the combined score clears 40.

Public SaaS companies trading at premium valuations (15x+ ARR) almost universally score above 40 on the Rule of 40. Companies below 20 face multiple compression even when growing reasonably well. At Series B and beyond, investors will ask for this number explicitly. Build the habit of tracking it quarterly.

common mistakes

✗Using MoM or QoQ growth instead of YoY growth — the rule is designed for annual rates

✗Cherry-picking EBITDA vs. free cash flow based on which makes the score look better without disclosing the difference

✗Treating 40 as a binary pass/fail rather than a directional signal — 38 is not a crisis, 15 is

pro tips

✓Track your Rule of 40 score quarterly alongside the trend — a score improving from 28 to 36 over four quarters tells a better story than a static 38

✓Decompose the score: if your growth is slowing, you need the margin side to compensate; plan expense cuts before growth flattens

✓At early stage (pre-$1M ARR), prioritize growth over the combined score — the rule is most relevant above $5M ARR

the mrrsucks take

Your Rule of 40 score is 12. That is 28 points of explanation you owe every investor in the room. You have achieved the rare combination of slow growth and a bleeding margin — the worst of both worlds, optimized perfectly.

faq

Which profitability metric should I use — EBITDA or free cash flow?+

Both are used. EBITDA is more common in growth-stage discussions; FCF margin is preferred at scale because it captures capex and working capital reality. Be consistent and label which you are using.

Does the Rule of 40 apply to early-stage SaaS?+

It is less relevant below $3–5M ARR. At seed and early Series A, growth rate is the only number that matters. The rule becomes a key investor benchmark at Series B and beyond.

Can a company score above 40 with 10% growth?+

Yes — if your FCF margin is 35%+, you can score 45+ with modest growth. This is the profile of a bootstrapped, highly efficient business. Investors may still discount the valuation multiple versus a high-growth peer.

Rule of 40 deep dive›Capital efficiency roasts›

related metrics

./install-the-daemon

$9. 365 roasts. one public endpoint of pure shame.