The Rule of 40 is a powerful financial benchmark that helps evaluate the health and performance of businesses, particularly in the software and technology sectors. As Brad Feld, a prominent venture capitalist, explained when he popularized this concept in 2015, the rule states that a company's combined growth rate and profit margin should equal or exceed 40%.
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Growth Rate (%) + Profit Margin (%) ≥ 40%
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What makes this formula so valuable is its elegant simplicity. While other metrics might have you drowning in spreadsheets, the Rule of 40 gives you a quick pulse check on your company's health by balancing two critical but often competing business objectives: growth and profitability.
The Rule of 40 emerged from venture capital and private equity communities around 2015. Brad Feld is widely credited with popularizing the concept through his blog post "The Rule of 40% For a Healthy SaaS Company," where he described it as a quick heuristic used by growth equity investors.
The rule gained significant traction during the mid-2010s as investors sought better ways to evaluate SaaS businesses, which often prioritized growth over immediate profitability. Traditional valuation metrics like P/E ratios weren't as applicable to these high-growth, often unprofitable companies.
By 2017-2018, the Rule of 40 had become a standard benchmark discussed in earnings calls, investor presentations, and board meetings across the technology sector, with companies like Salesforce, Adobe, and Microsoft referencing their performance against this metric.
In practical terms, here's how the Rule of 40 calculation works:
Determine Your Revenue Growth Rate: Calculate either your Monthly Recurring Revenue (MRR) or Annual Recurring Revenue (ARR) growth percentage for a specific period.
Calculate Your Profit Margin: Most commonly measured using EBITDA margin (Earnings Before Interest, Taxes, Depreciation, and Amortization divided by total revenue).
Add the Two Figures: If your revenue growth rate is 25% and your EBITDA margin is 15%, your Rule of 40 score is 40%—indicating you've hit the benchmark.
This creates a flexible framework that allows for different combinations:
Growing at 50%? You can sustain a 10% loss
Growing at 40%? You should be breaking even
Growing at 20%? You need a 20% profit margin
The significance of the Rule of 40 varies across different stages of business development:
McKinsey's comprehensive research on the Rule of 40 provides valuable insights into its significance and challenges:
Despite its importance, only about one-third of SaaS companies reach the Rule of 40, with businesses exceeding this benchmark merely 16% of the time.
Companies that do meet or surpass the Rule of 40 are rewarded with significantly higher enterprise value to revenue multiples, with top-quartile companies generating nearly triple the multiples of bottom-quartile firms.
The study identified four key metrics highly correlated with enterprise value to revenue multiples: annual recurring revenue (ARR) growth, net retention rate, last 12 months median payback period, and free cash flow percentage.
Top-performing companies excel in setting realistic growth targets, prioritizing net retention (often achieving rates of 120% or more), optimizing go-to-market spend, and rapidly building new business lines.
Let's examine three common scenarios for achieving the Rule of 40:
This "growth at manageable loss" approach is typical for companies disrupting markets or establishing category leadership.
Companies like Slack, Zoom (in their early years), and many B2B SaaS platforms have successfully employed this strategy. The critical factor is having a clear path to future profitability—negative margins must be an investment choice, not a structural business model flaw.
This "profitable stability" approach is common among mature market leaders or companies in stable markets.
Microsoft (post-2014), Adobe (after transitioning to SaaS), and mature enterprise software companies often exemplify this approach, generating substantial cash while continuing steady growth.
The "balanced harmony" approach represents the ideal middle ground many businesses aspire to achieve.
Companies like Salesforce in recent years, HubSpot, and Veeva Systems have achieved this balanced approach, continuing to invest in growth initiatives while maintaining strong operational efficiency.
Despite its conceptual simplicity, the Rule of 40 can be challenging to achieve for several reasons:
Investment timing misalignment: Companies making significant investments in future growth often see costs now while benefits materialize later. During these investment periods, they may temporarily fall below the threshold.
Scale inefficiencies: Early-stage companies frequently lack economies of scale necessary for profitability, while maintaining high growth becomes increasingly difficult at larger revenue bases.
Changing market conditions: Economic downturns, competitive pressures, or market saturation can suddenly impact both growth and profitability.
Structural business model issues: Some business models inherently struggle with the Rule of 40 due to high customer acquisition costs, low retention rates, or insufficient margin structures.
Leadership capabilities: Many founding teams excel at either growth execution or operational efficiency, but not both. The balanced approach requires a well-rounded leadership team.
Consider a company ramping up sales capacity by adding new sales representatives. These new hires create immediate costs (salaries, training, enablement) while typically taking 6-12 months to reach full productivity. During this ramp-up period, the company may fall below the threshold despite making strategically sound investments.
The dominant venture-backed startup mentality has undergone significant evolution:
Dotcom Era (1995-2001): "Growth at all costs" defined this period. Companies prioritized user acquisition and market share with minimal concern for unit economics or profitability.
Post-Dotcom Crash (2002-2008): A sobering period where investors demanded clearer paths to profitability and sustainable business models.
Post-Financial Crisis (2009-2015): A renewed focus on growth emerged, but with greater attention to unit economics and concepts like "payback period" and "customer lifetime value."
SaaS Maturity Era (2016-2021): The Rule of 40 gained prominence, establishing the balanced growth framework. Companies recognized that neither extreme growth nor extreme profitability alone created optimal outcomes.
Post-2022 Reality Check: Rising interest rates and market corrections prompted renewed focus on efficient growth, sustainable unit economics, and reasonable paths to profitability.
Businesses that consistently achieve the Rule of 40 experience several advantages when seeking exits:
Higher valuations: Research consistently shows Rule of 40 companies command premium multiples—often 30-50% higher than peers falling below the threshold.
Broader buyer interest: These companies appeal to both strategic acquirers (seeking growth) and financial buyers (seeking profits), creating competitive dynamics that drive valuations higher.
Greater negotiating leverage: Companies demonstrating both growth and profitability face less pressure to sell, allowing founders to negotiate from positions of strength.
Smoother due diligence: Businesses meeting the Rule of 40 typically maintain stronger operational fundamentals, leading to fewer surprises during buyer due diligence.
Better post-acquisition performance: Acquirers recognize that Rule of 40 companies typically integrate more successfully and deliver on financial projections, reducing perceived acquisition risk.
While SaaS companies below the Rule of 40 might receive valuations of 4-6x revenue, those exceeding the threshold often command multiples of 8-15x revenue or higher. For a $10M revenue business, this difference could represent tens of millions in additional exit value.
While the Rule of 40 is valuable, several alternative metrics can provide a more comprehensive view of a company's health:
This measures sales efficiency by dividing new ARR by sales and marketing spend from the previous quarter. A Magic Number above 1 is generally considered good.
This measures how long it takes to recover the cost of acquiring a new customer. A shorter payback period is better.
This shows the percentage of recurring revenue retained from existing customers over time, including expansions, contractions, and churn. An NRR over 100% indicates growth from the existing customer base.
Similar to NRR, but excludes expansions. It focuses solely on how well a company retains its existing revenue base.
This compares the long-term value of a customer to the cost of acquiring them. A higher ratio indicates better unit economics.
This measures a company's ability to grow recurring revenue using its sales efficiency, calculated by dividing new and expansion MRR by churned and contraction MRR.
The Burn Multiple metric looks at how much cash a company is burning to generate each dollar of ARR growth. A lower burn multiple is better.
Wise resource allocation is essential for long-term success. Invest in research and development, customer care, and marketing while maintaining profitability. Effective management of internal financing ensures sufficient funding for innovation without undermining financial stability.
Identify your most profitable segments and concentrate efforts there to exponentially boost growth and profitability. This targeted approach can yield better results than trying to grow across all business areas simultaneously.
Foster an environment of continuous innovation through innovation labs or a creative corporate culture. The objective is to continuously develop novel ideas and business lines that ensure your company remains competitive and relevant.
Are your growth and profitability metrics harmonized with the aspirations set by the Rule of 40? Consider these steps:
Assess Current Metrics: Conduct a thorough analysis of current revenue growth rates and profit margins.
Identify Core Revenue Drivers: Focus resources on the most profitable segments.
Innovate Relentlessly: Foster an environment of continuous innovation to stay ahead.
Adapt Financial Goals: Modify goals based on the business lifecycle, with milestones like $1 million MRR triggering shifts in strategy.
Monitor Alternative Metrics: Track complementary metrics like CAC payback period, NRR, and Magic Number to get a comprehensive view of performance.
Develop a Clear Path: Create a multi-year plan to reach or exceed the Rule of 40, with specific initiatives targeted at both growth and profitability.
The Rule of 40 has emerged as one of the most valuable frameworks for evaluating business performance because it acknowledges a fundamental truth: exceptional businesses deliver both growth and profitability. While the specific balance and timing may vary based on company stage, industry, and strategic objectives, the principle of responsible, sustainable growth transcends these differences.
For founders and executives navigating strategic decisions, the Rule of 40 provides a helpful lens for evaluating tradeoffs. When considering a new market expansion, product launch, or efficiency initiative, asking "How will this impact our Rule of 40 performance over the next 24 months?" can help clarify the true value of the opportunity.
For investors and acquirers, the metric offers a simple but powerful initial screen for identifying companies that have found that elusive balance between expanding their business and operating it efficiently.
As business environments become increasingly complex and competitive, frameworks that cut through the noise to highlight fundamental performance become invaluable. The Rule of 40, with its elegant simplicity and focus on what truly matters, has rightfully earned its place as a cornerstone metric for modern business evaluation.
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