Rule of 40
The Rule of 40 states that a healthy SaaS company's combined revenue growth rate and profit margin should equal or exceed 40%. If you're growing 30% year-over-year, you need at least 10% profit margin. Growing 50%? You can afford -10% margins. It's the investor shorthand for 'sustainable growth.'
Company A: 35% YoY growth, 10% EBITDA margin = 45 (passes). Company B: 20% growth, 15% margin = 35 (fails). Company C: 60% growth, -15% margin = 45 (passes, but composition matters — hypergrowth can justify losses). At $100M ARR, Company A's balanced profile is often valued higher than Company C's growth-at-all-costs approach.
The Rule of 40 is the metric that separates "growing at all costs" from "growing intelligently." VCs love it because it forces a trade-off conversation: you can either grow fast or be profitable, but the sum needs to hit 40.
Here's what nobody tells you: the Rule of 40 is forgiving at scale but brutal at early stage. A $5M ARR company burning cash on growth gets a pass. A $50M company with the same profile gets questions. And the composition matters — a 25% growth + 15% margin company is valued very differently than a 40% growth + 0% margin company, even though both hit 40.
The real insight? Use it internally before investors ask. If you're at 25, you either need to accelerate growth or cut costs. Knowing your number forces the strategic conversation.
Define ItOther Definitions
“The Rule of 40 is a principle that a software company's combined revenue growth rate and profit margin should equal or exceed 40%. Companies that achieve this balance are generally considered healthy and sustainable.”
“A widely used benchmark in cloud computing that states a healthy SaaS company should have a combined growth rate and profit margin of 40% or more. It helps investors quickly assess the health and efficiency of SaaS businesses.”
“Software companies with above-average growth and profitability (Rule of 40+ performers) are valued at a significant premium, with analysis showing they achieve 2x the enterprise value multiples of their peers.”
The Rule of 40 creates a simple framework: Revenue Growth Rate (%) + Profit Margin (%) ≥ 40%. For SaaS, profit margin typically means EBITDA margin or free cash flow margin.
Bain and Bessemer both frame this as a health check — companies above 40 are balancing growth and efficiency, while those below are either growing too slowly for their burn rate or not profitable enough for their growth. McKinsey's research adds the valuation angle: Rule of 40+ companies command premium multiples.
The practical application: early-stage companies (under $10M ARR) often prioritize growth over profitability, targeting 50%+ growth even with negative margins. At scale ($50M+ ARR), the mix shifts toward profitability as growth naturally decelerates. The companies that maintain 40+ at scale are the ones that trade at 10x+ revenue multiples.
MistakesCommon Mistakes
Using inconsistent margin definitions (mixing EBITDA, operating, and FCF margins)
Applying Rule of 40 too strictly to early-stage companies (< $10M ARR)
Ignoring the composition — 40% growth + 0% margin ≠ 20% growth + 20% margin in investor eyes
Not adjusting for one-time costs or revenue spikes that distort the calculation
Treating it as a target rather than a health check — some stages justify Rule of 30
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