What is the Rule of 40? SaaS Growth Formula...

The Rule of 40 states that a healthy SaaS company's combined growth rate and profit margin should equal or exceed 40%—the benchmark that reveals whether you're building sustainable value or just burning capital. This elegant formula (Revenue Growth % + Profit Margin % ≥ 40) captures the essential trade-off in SaaS: you can grow fast while losing money, be profitable while growing slowly, or achieve some combination—but the sum should reach 40%. A company growing 50% annually with -10% profit margin hits exactly 40; so does one growing 20% with 20% margins. According to a 2024 Bessemer Venture Partners analysis, public SaaS companies exceeding the Rule of 40 trade at 40-50% higher revenue multiples than those below it. The metric has become the standard yardstick for SaaS health because it acknowledges that early-stage companies should prioritize growth while mature companies should generate profits—without letting either grow at any cost. During 2020-2021, many companies abandoned the Rule of 40 in pursuit of growth at all costs; the 2022-2024 market correction brutally reminded founders and investors why efficiency matters. Today, exceeding the Rule of 40 signals to investors that you understand the balance between growth and efficiency, and you're building a business that can ultimately generate returns. This comprehensive guide covers Rule of 40 calculation methodology, the variations used by different investors, benchmarks by company stage and market conditions, strategies for improving your score, and how the metric should inform strategic decisions. Whether you're fundraising, planning budgets, or evaluating your company's health, the Rule of 40 provides a single number that captures sustainable SaaS performance.

Understanding the Rule of 40

The Rule of 40 combines growth and profitability into a single metric that measures overall business health. Understanding its logic and limitations helps apply it appropriately.

Definition and Core Logic

Rule of 40 = Revenue Growth Rate % + Profit Margin %. A score of 40+ is considered healthy. The logic: SaaS companies can choose to invest in growth (sacrificing near-term profits) or harvest profits (accepting slower growth). The Rule of 40 says the combination should total at least 40%. Example combinations that hit 40: 60% growth + -20% profit margin = 40 (growth-focused). 40% growth + 0% profit margin = 40 (break-even growth). 20% growth + 20% profit margin = 40 (balanced). 10% growth + 30% profit margin = 40 (profit-focused). All are "healthy" by Rule of 40 standards, but each represents a different strategic choice about how to allocate the underlying business performance.

Why 40%? The Historical Context

The "40" threshold emerged from venture capitalist Brad Feld's analysis in 2015, based on patterns observed across many SaaS companies. It roughly correlates with the minimum performance required for venture-scale returns. Companies below 40 struggle to achieve the returns investors expect; those well above 40 represent exceptional businesses. The threshold isn't magic—some use 30 for earlier-stage companies, others argue 50 is the true elite threshold. The value is in having a consistent benchmark. The number has proven durable because it captures the fundamental SaaS trade-off: recurring revenue economics enable fast growth at the cost of profitability, but you shouldn't sacrifice too much of either.

The Growth vs. Profitability Trade-Off

The Rule of 40 encapsulates the core strategic choice in SaaS: invest in growth or harvest profits. Growth investment: spend on sales, marketing, R&D to acquire customers and build product. This typically reduces current profitability but builds future revenue. Profit generation: spend less, grow slower, but generate cash now. The Rule of 40 says: whichever path you choose, the combined result should be strong. A company with 80% growth and -30% margins (Rule of 40 = 50) is doing something right, as is one with 15% growth and 35% margins (Rule of 40 = 50). A company with 20% growth and -5% margins (Rule of 40 = 15) is doing neither—not growing fast enough to justify losses, not profitable enough to be sustainable.

Limitations and Context

The Rule of 40 has important limitations: Stage sensitivity (very early companies may reasonably be below 40 while building product-market fit), market conditions (during capital-abundant periods, growth is priced higher; during tight markets, profitability matters more), business model differences (different SaaS models have different achievable ranges), and short-term gaming (you can hit 40 through unsustainable cuts or one-time revenue boosts). Use Rule of 40 as one input, not the only measure. A company at 45 through sustainable performance is healthier than one at 45 through aggressive cost-cutting that damages long-term growth capacity.

Rule of 40 Logic

The metric acknowledges that growth and profitability are trade-offs—you can excel at either or balance both, but the combination should reflect strong underlying business performance.

Calculating the Rule of 40

Rule of 40 calculation requires choosing appropriate metrics for both growth and profitability. Different variations exist, so consistency matters for comparison.

Basic Rule of 40 Formula

Rule of 40 = Year-over-Year Revenue Growth Rate % + Profit Margin %. Example: $50M ARR growing to $65M ARR = 30% growth. Operating margin = -5%. Rule of 40 = 30% + (-5%) = 25. This company is below 40. Alternative example: $100M ARR growing to $120M ARR = 20% growth. Operating margin = 25%. Rule of 40 = 20% + 25% = 45. This company exceeds the threshold. The calculation is simple, but the choice of inputs matters significantly.

Choosing the Growth Metric

Common growth metric choices: ARR YoY Growth (most standard): year-over-year growth in Annual Recurring Revenue. Focuses on subscription business. Revenue YoY Growth: total revenue including services. More comprehensive but can be distorted by one-time revenue. Forward Growth: expected growth based on pipeline and trends. Used for forward-looking analysis. Monthly Growth Annualized: useful for early-stage companies without full-year history. Most investors and analysts use ARR YoY growth for public companies and recurring revenue-focused analysis. Be consistent in your choice and explicit about which metric you're using.

Choosing the Profitability Metric

Common profitability metric choices: EBITDA Margin: earnings before interest, taxes, depreciation, and amortization. Most commonly used for Rule of 40. Operating Margin: EBITDA minus depreciation and amortization. More conservative. FCF Margin: free cash flow / revenue. Captures actual cash generation. Net Income Margin: bottom-line profitability. Rarely used for SaaS Rule of 40. EBITDA margin is standard for Rule of 40 calculations because it focuses on operating performance without the distortion of financing and accounting choices. FCF margin is increasingly used as investors focus on cash generation.

Calculation Variations

Different organizations use variations: Standard: YoY ARR Growth + EBITDA Margin. Bessemer Variation: YoY Revenue Growth + FCF Margin. Emphasizes cash generation. SaaS Capital Variation: uses gross margin-adjusted figures. Adjusts for profitability at gross margin level. Forward-Looking: uses projected growth + current margin. For planning purposes. Document which variation you use and apply consistently. When comparing to benchmarks, ensure you're using matching methodologies.

Calculation Consistency

The standard formula uses ARR YoY growth + EBITDA margin, but variations exist—always document your methodology and use consistent inputs for trend analysis.

Rule of 40 Benchmarks

Rule of 40 benchmarks vary by company stage, market conditions, and strategic context. Understanding appropriate targets helps set realistic goals.

Overall SaaS Benchmarks

Rule of 40 performance across SaaS: Elite: 60+ (rare, indicates exceptional performance on both growth and profitability). Excellent: 50-60 (strong performance, premium valuations). Good: 40-50 (meeting the benchmark, healthy business). Developing: 30-40 (below benchmark but potentially acceptable at certain stages). Concerning: below 30 (neither growing fast nor profitable—needs attention). Median public SaaS companies hover around 30-35, meaning the typical public SaaS company doesn't actually meet the Rule of 40. The benchmark is aspirational—companies that achieve it are above average.

Benchmarks by Company Stage

Rule of 40 expectations vary by stage: Seed/Series A: Rule of 40 often below threshold (<30) as companies invest heavily before revenue scales. Investors accept this with strong growth trajectory. Series B: Target approaching 40 or clearly on path. Should demonstrate that efficiency is achievable as you scale. Series C+: Should meet or exceed 40. Scale should enable profitability without sacrificing growth. Late stage/Pre-IPO: Expect 40+. Companies preparing for public markets need to demonstrate Rule of 40 capability. Public: Median ~30-35, but premium multiples go to companies at 40+. Investors adjust expectations by stage—a Series A company at 25 might be fine with 100%+ growth, while a Series C company at 25 faces serious questions.

Market Condition Impact

Rule of 40 importance varies with market conditions: Bull markets (2020-2021): growth weighted heavily, companies prioritized growth even at Rule of 40 sacrifice. Bear markets (2022-2024): profitability became crucial, Rule of 40 suddenly mattered for valuations. Normalized markets: balanced consideration of growth and profitability. During bull markets, a company with 80% growth and -40% margin (Rule of 40 = 40) might be valued higher than one with 30% growth and 15% margin (Rule of 40 = 45). During bear markets, the opposite occurs. The metric's importance cycles with market sentiment.

Valuation Correlation

Rule of 40 correlates with valuation multiples: Companies above 40: typically trade at 8-15x revenue (varies by market). Companies at 30-40: typically trade at 5-8x revenue. Companies below 30: typically trade at 3-5x revenue. The premium for exceeding Rule of 40 is substantial—studies consistently show 40-60% higher multiples for companies above the threshold versus those below. This makes Rule of 40 improvement one of the highest-leverage activities for valuation enhancement.

Benchmark Reality

Median public SaaS companies score 30-35—the Rule of 40 is an aspirational benchmark that top-performing companies achieve, not an industry average.

Strategic Implications

The Rule of 40 should inform strategic decisions about growth investment, profitability targets, and resource allocation.

Growth vs. Profitability Decisions

Use Rule of 40 to frame investment decisions: If Rule of 40 > 50: you have room to invest more in growth (accept lower margins) or harvest profits (accept slower growth). If Rule of 40 = 40-50: healthy range, maintain balance or strategically shift based on market conditions. If Rule of 40 = 30-40: need improvement, either accelerate growth or cut costs. If Rule of 40 < 30: serious attention needed, likely need both growth improvement and cost reduction. The metric helps answer "should we invest more in growth?" If you're at 55, you can afford to push growth even if it costs margin; if you're at 35, you need efficiency before you can afford more investment.

Budget and Planning Applications

Incorporate Rule of 40 into planning: Budget constraints: ensure proposed spending maintains target Rule of 40 score. Scenario planning: model how different investment levels affect Rule of 40. Hiring decisions: evaluate whether additional headcount improves or degrades Rule of 40. Investment prioritization: prioritize initiatives that improve Rule of 40 through either growth or efficiency. Example: if you're at 38 and considering a major growth investment that would add 10% growth but cost 5% margin, the net effect is +5 to Rule of 40 (to 43)—likely worthwhile. If it adds 5% growth at 10% margin cost, net effect is -5 (to 33)—probably not worth it.

Fundraising Positioning

Rule of 40 matters for fundraising: Investor screening: many growth investors require Rule of 40 achievement or clear path to it. Valuation justification: Rule of 40 performance supports premium valuation asks. Strategic narrative: explains your growth/profitability balance and why it's appropriate for your stage. Comparables: enables comparison to similar-stage peers. When preparing for fundraising, understand your Rule of 40 score and be ready to explain it. If below 40, articulate the path to improvement. If above 40, position for premium valuation.

When to Prioritize Each Component

Different situations favor different priorities: Prioritize growth when: market opportunity is large and time-limited, unit economics are strong, and capital is available. Accept lower margins to capture market. Prioritize profitability when: growth is slowing naturally, capital markets are tight, or unit economics need improvement. Capture value from existing customer base. Balance both when: market is mature but still growing, or company is transitioning from hypergrowth to sustainable growth phase. The right choice depends on market conditions, competitive dynamics, and your specific unit economics.

Strategic Framework

Rule of 40 helps frame the growth vs. profitability trade-off—if you're above 50, you have room to invest; if you're below 40, you need improvement on one or both dimensions.

Improving Your Rule of 40 Score

Improving Rule of 40 requires either accelerating growth, improving profitability, or both. The right approach depends on where you're starting.

Growth Improvement Strategies

Accelerate the growth component: Expansion revenue (grow existing customer revenue through upsells and cross-sells—often more efficient than new acquisition), product-led growth (self-serve acquisition reduces CAC and accelerates growth), pricing optimization (price increases directly improve growth rate and often profitability too), and new market entry (geographic or segment expansion can accelerate growth). Growth improvement is powerful because it's unbounded—you can theoretically grow very fast. But growth at any cost isn't the answer; growth that damages unit economics doesn't help.

Profitability Improvement Strategies

Improve the margin component: Gross margin optimization (infrastructure efficiency, support automation, pricing improvements), sales efficiency (better targeting, higher productivity, channel leverage), marketing efficiency (CAC reduction through better targeting and organic growth), and G&A optimization (scaling support functions efficiently). Profitability improvement is bounded—you can't exceed 100% margin—but often provides faster Rule of 40 improvement than growth acceleration. A company at 20% growth and -10% margin might reach 40 faster by getting to 20% margin than by accelerating to 50% growth.

Combined Improvement Approaches

Often the best approach improves both simultaneously: Pricing optimization (increases both revenue growth rate and margin), product-led growth (accelerates growth while reducing CAC, improving margin), retention improvement (improves growth through lower churn and margin through reduced acquisition dependency), and operational excellence (enables faster execution at lower cost). Focus on improvements that move both metrics—these are the highest-leverage opportunities.

Avoiding Rule of 40 Gaming

Some approaches "improve" Rule of 40 unsustainably: Aggressive cost cuts (can improve margin but damage growth capability), one-time revenue recognition (inflates growth temporarily), delaying necessary investments (improves margin but mortgages the future), and channel stuffing (accelerates near-term growth at future expense). These tactics may hit Rule of 40 targets temporarily but damage the underlying business. Focus on sustainable improvement through genuine efficiency and growth, not accounting games.

Improvement Priority

Pricing optimization and product-led growth often improve both growth and margin simultaneously—these are the highest-leverage Rule of 40 improvement strategies.

Rule of 40 Variations and Alternatives

The Rule of 40 has spawned variations and alternative metrics. Understanding these helps choose the right benchmark for your situation.

Common Rule of 40 Variations

Investors and analysts use several variations: FCF-Based Rule of 40: uses free cash flow margin instead of EBITDA. More conservative, reflects actual cash generation. Gross Margin-Adjusted: adjusts for differences in gross margin across business models. Weighted versions: some weight growth more heavily (e.g., 1.5x growth + margin) in certain market conditions. Forward-Looking: uses projected growth and current margin trajectory. For planning. Understand which variation your investors or board use, and calculate accordingly.

Rule of X Alternatives

Other "rules" attempt to capture similar dynamics: Rule of 30: lower threshold sometimes used for earlier-stage or challenged businesses. Rule of 50: higher threshold for elite performance. Rule of 60: used to identify truly exceptional businesses. Efficiency Score: various weighted combinations of growth, margins, and other metrics. The specific threshold matters less than the concept: growth and profitability should sum to a healthy total reflecting strong underlying performance.

Alternative Efficiency Metrics

Other metrics capture similar concepts: Burn Multiple (net burn / net new ARR): measures capital efficiency of growth. Target under 1.5x. Magic Number (net new ARR / S&M spend): measures sales and marketing efficiency. Target above 0.75. SaaS Quick Ratio (new MRR / lost MRR): measures growth quality. Target above 4. Each metric captures different aspects of efficiency. Rule of 40 is a holistic measure; these alternatives focus on specific efficiency dimensions.

Choosing the Right Benchmark

Select benchmarks appropriate to your context: For fundraising: use the metric your target investors emphasize. For board reporting: use consistent methodology over time. For internal planning: use the variation most actionable for your decisions. For competitive analysis: use the variation with available peer data. Document your methodology and apply it consistently. The specific calculation matters less than using it meaningfully for decision-making.

Methodology Choice

The specific Rule of 40 variation matters less than consistency—document your methodology and apply it uniformly for meaningful trend analysis.

Frequently Asked Questions

What is a good Rule of 40 score?

Elite: 60+ (exceptional). Excellent: 50-60 (strong, premium valuations). Good: 40-50 (meeting benchmark). Developing: 30-40 (below but acceptable at certain stages). Concerning: below 30 (needs attention). Median public SaaS scores 30-35—Rule of 40 is aspirational, not average. Context matters: Series A companies at 25 with 100%+ growth might be fine, while Series C companies at 25 face serious questions. Companies exceeding 40 typically trade at 40-60% higher revenue multiples.

How do I calculate Rule of 40?

Rule of 40 = Revenue Growth Rate % + Profit Margin %. Standard inputs: ARR YoY Growth + EBITDA Margin. Example: $50M ARR growing to $65M = 30% growth; EBITDA margin = -5%. Rule of 40 = 30 + (-5) = 25. Variations exist: some use FCF margin instead of EBITDA, or total revenue instead of ARR. Document your methodology and apply consistently. A score of 40+ is considered healthy.

Why does Rule of 40 matter?

Rule of 40 captures the essential SaaS trade-off: you can grow fast while losing money, be profitable while growing slowly, or balance both—but the combination should be strong. Companies above 40 trade at 40-60% higher revenue multiples than those below. The metric signals to investors that you understand growth vs. profitability trade-offs and are building sustainable value. It became especially important after 2022 market corrections punished companies that grew at any cost.

Should growth or profitability be prioritized?

Depends on context. Prioritize growth when: market opportunity is large and time-limited, unit economics are strong, capital is available. Prioritize profitability when: growth is naturally slowing, capital markets are tight, unit economics need improvement. The Rule of 40 framework helps—if you're at 55, you can afford to trade margin for growth; if you're at 35, you likely need efficiency improvement before more investment makes sense. Market conditions also matter: bull markets weight growth; bear markets weight profitability.

How can I improve my Rule of 40 score?

Improve either component or both: Growth levers: expansion revenue, product-led growth, pricing optimization, new market entry. Profitability levers: gross margin optimization, sales and marketing efficiency, G&A rationalization. Best approaches improve both: pricing optimization increases revenue and margin; PLG accelerates growth while reducing CAC. Avoid gaming—aggressive cuts or one-time revenue may hit targets temporarily but damage underlying business health.

What Rule of 40 score do investors expect?

Expectations vary by stage: Seed/Series A—often below 40 as companies invest ahead of revenue, but should show path to improvement. Series B—target approaching 40 or clearly improving trajectory. Series C+—should meet or exceed 40; scale should enable profitability. Late stage/IPO—expect 40+; public market readiness requires demonstrated Rule of 40 capability. During bull markets, investors may accept lower scores for hypergrowth; during bear markets, profitability becomes crucial regardless of growth rate.

Key Takeaways

The Rule of 40 provides a single number that captures the essential trade-off in SaaS: you can invest in growth or generate profits, but the combination should reflect strong underlying business performance. A company growing 50% with -10% margins (Rule of 40 = 40) and one growing 20% with 20% margins (Rule of 40 = 40) are both considered healthy by this benchmark—different strategic choices, same overall performance. The metric has become the standard yardstick for SaaS health because it acknowledges stage-appropriate priorities while setting a clear threshold for what "healthy" looks like. Companies exceeding 40 command significant valuation premiums; those below face scrutiny about their path to sustainability. Use Rule of 40 to frame strategic decisions: Should we invest more in growth? Can we afford this expansion? Are we efficient enough to justify our burn rate? The answer often comes from understanding where you are relative to 40 and whether proposed changes improve or damage your score. Whether you're fundraising, planning budgets, or evaluating strategic options, the Rule of 40 provides a clear, simple framework for thinking about sustainable SaaS performance.

Tom Brennan