Add your revenue growth rate to your profit margin. If the sum is 40 or higher, you're healthy. A quick way to check if a SaaS company is balancing growth and profitability correctly.
Imagine you have a lemonade stand. You can either:
The Rule of 40 says: it's okay to pick either one, as long as the two together add up to 40.
Growing super fast (50%) but losing money (-10%)? That's 50 + (-10) = 40. ✓
Growing slowly (10%) but making good profit (30%)? That's 10 + 30 = 40. ✓
It's like saying: "You can run fast OR carry heavy bags, but the total effort should reach a certain level."
The Rule of 40 became popular around 2015 as a quick health check for software-as-a-service (SaaS) companies. It was championed by VCs like Brad Feld and became an industry standard.
Why 40? Historically, top-performing SaaS companies clustered around this number. It became a benchmark separating "good" from "struggling."
Company A: Growing 60% YoY, losing 15% margin → 60 + (-15) = 45 ✓
Company B: Growing 20% YoY, 25% profit margin → 20 + 25 = 45 ✓
Both pass! Different strategies, same health score.
The beauty: It doesn't force companies into one mold. Hypergrowth startups burning cash and mature profitable companies can both score well — as long as they're executing their strategy effectively.
What's "good"?
The Rule of 40 seems simple, but there's no universal agreement on what goes into it.
Growth rate options:
Profit margin options:
A company might score 45 using EBITDA margin but only 32 using FCF margin (if they have high capex or stock-based compensation).
The FCF variant: Many investors prefer Revenue Growth + FCF Margin because:
Common pitfalls:
The lifecycle curve: Rule of 40 scores typically follow a pattern:
The score stays similar, but the mix shifts from growth to profitability over time.
The valuation connection: Rule of 40 scores correlate strongly with EV/Revenue multiples. Research from Battery Ventures shows:
Growth vs. profitability — which matters more?
In high-interest-rate environments (2022-present), investors increasingly prefer profitability. But research suggests:
The "Rule of X" variant: Some analysts weight growth more heavily:
This reflects the empirical reality that markets reward growth more than profitability (when above certain thresholds).
Strategic implications:
The efficiency frontier: Best-in-class companies operate on the "efficient frontier" where they maximize growth for a given level of burn, or minimize burn for a given growth rate. Rule of 40 helps identify companies off this frontier.
Slowing growth + stable losses = Deteriorating Rule of 40 → Execution issues
Stable growth + increasing losses = Often indicates pricing power erosion or GTM inefficiency
The fundamental critique: Rule of 40 is a heuristic, not a law. It conflates two different things:
Adding them together is mathematically... questionable. It works as a rough filter but obscures important nuances.
What Rule of 40 misses:
The ZIRP distortion (2010-2021): Zero interest rates created perverse incentives:
The 2022+ correction: Higher rates exposed companies that couldn't flip to profitability. Many "Rule of 40" companies saw:
Emerging alternatives:
The durability question: Experts now ask: "What's your Rule of 40 at steady state?" This acknowledges that early-stage Rule of 40 with heavy losses is meaningful only if there's a credible path to profitable Rule of 40.
What practitioners argue about:
The meta-insight: Rule of 40 endures not because it's analytically rigorous, but because it's memorable, easy to calculate, and "good enough" for initial screening. Its real value is forcing the growth-vs-profitability conversation — the specific number 40 is somewhat arbitrary.