Rule of 40
Growth rate % plus EBITDA margin % must equal or exceed 40. The single metric VCs use to balance SaaS growth against profitability efficiency.
What Is the Rule of 40?
The Rule of 40 is a performance benchmark for SaaS companies that states: a healthy software business should have a combined revenue growth rate and profit margin that equals or exceeds 40. If a company is growing ARR at 60% year-over-year with a -20% EBITDA margin, it scores 40 — passing the threshold. If it is growing at 20% with a 20% EBITDA margin, it also scores 40. The Rule of 40 acknowledges that early-stage companies can justify burning cash as long as growth is fast enough, and that mature companies can grow slowly as long as they are profitable.
The concept was popularized by Brad Feld and other VC practitioners in the mid-2010s as SaaS portfolios scaled and investors needed a single, comparable metric to evaluate companies at different growth stages without penalizing high-growth early-stage businesses or ignoring profitability at scale.
The Formula
Rule of 40 Score = Revenue Growth Rate (%) + Profit Margin (%)A score of 40 or higher is considered healthy. A score above 50 is considered excellent. Below 40 signals that neither growth nor profitability is strong enough relative to the other.
Inputs defined:
- Revenue Growth Rate: Year-over-year ARR growth percentage. If ARR was $10M last year and is $16M today, growth rate = 60%.
- Profit Margin: Typically EBITDA margin (Earnings Before Interest, Taxes, Depreciation, and Amortization as a percentage of revenue), though some practitioners use free cash flow margin for later-stage companies. The choice of margin definition must be consistent when benchmarking.
Worked Examples
Example 1 — High-growth, loss-making:
- ARR growth: 60% YoY
- EBITDA margin: -20%
- Rule of 40 Score: 60 + (-20) = 40 (passes, exactly at threshold)
Example 2 — Moderate growth, profitable:
- ARR growth: 20% YoY
- EBITDA margin: 25%
- Rule of 40 Score: 20 + 25 = 45 (passes, healthy efficiency)
Example 3 — Slow growth, marginally profitable:
- ARR growth: 15% YoY
- EBITDA margin: 10%
- Rule of 40 Score: 15 + 10 = 25 (fails — neither growth nor profit is strong enough)
Example 4 — Exceptional high-growth:
- ARR growth: 100% YoY
- EBITDA margin: -40%
- Rule of 40 Score: 100 + (-40) = 60 (strong pass — growth justifies the burn)
Why the Rule of 40 Matters for Valuation
Academic research and public market data consistently show that SaaS companies scoring above 40 on the Rule of 40 trade at significantly higher revenue multiples than those below. Analysis of public SaaS companies by firms including McKinsey and Battery Ventures has shown that businesses above the Rule of 40 command valuation multiples 2 to 3 times higher than those below it, all else equal.
This is not coincidental. A company above 40 demonstrates that it can generate substantial growth without needing infinite capital (high growth + small loss), or that it has reached a level of efficiency where it could fund growth internally (moderate growth + real profit). Both stories are fundable at premium valuations. A company below 40 often signals that it is burning cash without growing fast enough to justify the burn — the worst of both worlds.
How the Rule of 40 Changes by Stage
The Rule of 40 is most relevant and most rigidly applied at certain company stages:
Pre-Product-Market Fit (pre-$1M ARR): The Rule of 40 is largely irrelevant here. At this stage, startups should be focused entirely on growth — validating product-market fit and proving that customers want what they are building. Profitability is not expected.
$1M–$10M ARR: Growth rate still dominates. Most investors at this stage will accept deeply negative margins if growth is exceptional (80%+ YoY). A company at $5M ARR growing 120% scores well even at -60% EBITDA margin.
$10M–$50M ARR: Both inputs start mattering. Investors at Series B and growth rounds will begin scrutinizing whether the path to profitability is visible. A Rule of 40 score above 40 with a clear margin improvement trajectory is the target.
$50M+ ARR / Pre-IPO: Rule of 40 is a hard benchmark. Public market investors and growth equity funds will explicitly screen on Rule of 40. Companies below 40 face valuation compression. Companies consistently above 50 command premium multiples.
What Counts as “Profit Margin”
There is no single industry standard for the margin component. The most common choices are:
| Margin Type | When Used | Notes |
|---|---|---|
| EBITDA margin | Most common for VC benchmarking | Excludes D&A, interest, taxes — good for comparability |
| Free Cash Flow margin | Preferred for later-stage and public companies | Reflects true cash generation; harder to manipulate |
| Operating Income margin | Less common in SaaS | Includes D&A, more conservative |
| Net Income margin | Rarely used in early SaaS | Too influenced by non-operating items |
When comparing Rule of 40 scores across companies, always verify that the same margin definition is being used. A company reporting Rule of 40 using EBITDA will score higher than one using FCF margin.
Limitations of the Rule of 40
The Rule of 40 is a useful signal but an imperfect one. Key limitations include:
It does not capture cash consumption rate. A company can score 40 while burning through its runway at an unsustainable pace. Rule of 40 says nothing about burn multiple or cash efficiency.
It is not useful pre-revenue. Pre-revenue companies have no growth rate to report.
It can be gamed. Companies can cut R&D or sales spending to improve EBITDA margin and pass the Rule of 40 threshold while gutting their future growth potential.
It varies by business model. Pure SaaS companies typically have higher gross margins and thus more room to score well. Services-heavy businesses or marketplace businesses have structurally lower margins and should not be held to the same Rule of 40 benchmark without adjustment.
Key Takeaway
The Rule of 40 condenses the SaaS growth-versus-profitability tradeoff into a single number: add your year-over-year ARR growth rate to your EBITDA margin, and the result should be 40 or higher. A score above 40 signals that a company is either growing fast enough to justify its losses or profitable enough to compensate for slower growth. Public SaaS data shows that companies consistently above 40 trade at 2 to 3 times higher multiples than those below. The Rule of 40 is most actionable from $10M ARR onward — before that, growth rate is what matters most; after $50M ARR, falling below 40 is a material valuation risk.