Last updated: 2026-06-23

The Rule of 40, defined

The Rule of 40 is a benchmark for software companies that balances two goals that usually pull in opposite directions: growing quickly and earning a profit. It states that a SaaS company's revenue growth rate plus its profit margin should add up to at least 40 %. The appeal of the rule is its simplicity — it folds growth and profitability into a single number that signals whether a company is being run efficiently.

How the score is calculated

The Rule of 40 score is the sum of two percentages, both measured as a share of revenue:

Because both terms are percentages of revenue, they add directly. A company growing revenue 30 % year over year with a 15 % profit margin scores 30 % + 15 % = 45 %, comfortably above the 40 % bar. The rule deliberately treats a point of growth and a point of margin as interchangeable: a business can clear 40 % through fast growth, high profitability, or any blend of the two.

Either input can be negative. A company growing 50 % a year while running a −15 % margin still scores 50 % − 15 % = 35 %, which falls short — the heavy losses outweigh the strong growth. Conversely, a mature company growing just 10 % but earning a 35 % margin scores 45 % and passes.

Which profit margin to use

The rule does not fix a single definition of profit, and the choice matters. The two most common are:

• EBITDA margin — earnings before interest, taxes, depreciation, and amortization, as a percentage of revenue. It approximates operating cash generation.
• Free-cash-flow margin — free cash flow as a percentage of revenue. It captures cash left after capital spending.

Net income margin is used less often because depreciation schedules and one-time charges can distort it. Whichever definition is chosen, the important thing is to apply it consistently across periods and across any companies being compared, so the scores are measuring the same thing.

Worked example: three companies at 40

The table below shows three companies that all clear the Rule of 40 in different ways, plus one that does not.

The hyper-growth company justifies its losses with rapid expansion. The mature company has slowed but converts revenue into strong margins. The balanced company sits between the two. The stalled company is the warning case: it is neither growing fast nor especially profitable, so it falls well below the bar even though both numbers are positive.

How to read a score below 40

A score under 40 % is a prompt to ask which lever is weak. For an early-stage company, low or negative margins are often a deliberate choice — spending aggressively to capture a market while growth is high. The score is more concerning when neither growth nor profitability is strong: that pattern suggests the business is spending without buying proportional growth, the same inefficiency that burn-rate analysis surfaces.

Improving the score means moving one of the two terms: accelerating revenue growth or widening the margin by controlling costs. Because the two are added, a company has flexibility in how it gets there.

Limits of the rule

No single metric captures a business. The Rule of 40 is most meaningful for scaled software companies with recurring revenue and predictable economics. It is a poor fit for very early startups, where near-term losses are expected and the percentages swing wildly, and for businesses whose cost structures differ from classic SaaS. It also says nothing about the quality of growth — whether it comes from durable, retained customers or from one-time spikes.

Treat the Rule of 40 as one input among several. Pair it with net revenue retention, unit economics, and burn rate for a fuller picture. To examine how efficiently growth is being purchased, use the SaaS Magic Number Calculator alongside this score.