The Rule of 40 states that a healthy SaaS company’s revenue growth rate plus profit margin should equal or exceed 40%. It’s the metric investors use to quickly assess whether a company is scaling sustainably—or just burning cash to chase growth. If you want hands-on guidance interpreting your score in the context of your stage and capital strategy, a Fractional CFO for SaaS Companies can help you tie the metric to operating decisions and valuation outcomes.
This guide covers how to calculate your Rule of 40 score, what benchmarks to aim for at different company stages, and practical strategies to improve your performance on both sides of the equation.
What Is the Rule of 40 in SaaS
The Rule of 40 is a SaaS metric where a company’s revenue growth rate plus its profit margin equals or exceeds 40%. If your company is growing at 25% annually and has a 20% profit margin, your Rule of 40 score is 45%—you’re above the benchmark. This single number helps investors and founders quickly assess whether a SaaS business is scaling sustainably or just burning cash to chase growth.
The beauty of this metric is that it acknowledges a fundamental tradeoff. A company growing at 60% can afford to lose money (say, a -15% margin) and still hit 45%. Meanwhile, a slower-growing company at 15% growth would need a 25% margin to reach the same score. Both paths can work—the Rule of 40 just asks whether the combination makes sense.
Origin of the Rule of 40
Venture capitalist Brad Feld popularized this concept in the mid-2010s, and it spread quickly through VC and private equity circles. Before the Rule of 40 existed, investors struggled to compare SaaS companies at different stages. How do you evaluate a fast-growing startup burning cash against a mature company with steady profits? This metric gave everyone a common language.
How the Rule of 40 Works
The rule captures a core tension in SaaS economics: you can trade profitability for growth, or growth for profitability, but the combination still has to add up. Here’s how different companies might approach this balance:
- Growth-focused companies: Can run at a loss if revenue is expanding fast enough to offset the burn. A company growing 50% with a -10% margin still scores 40%.
- Mature companies: Typically see slower growth but compensate with stronger margins. A company growing 10% with a 35% margin also scores 45%.
- The balance: What matters is that both numbers together hit or exceed 40%, signaling the company isn’t just growing—it’s growing in a way that makes financial sense.
The Rule of 40 Formula
The formula is simple: Revenue Growth Rate (%) + Profit Margin (%) = Rule of 40 Score. Revenue growth rate measures how quickly your company’s revenue is increasing, usually calculated year-over-year. Profit margin represents the percentage of revenue you keep as profit, though the specific metric can vary depending on who’s doing the calculation.
Step-by-Step Calculation
Here’s how to calculate your score:
- Calculate your year-over-year revenue growth percentage
- Calculate your profit margin using EBITDA, operating margin, or free cash flow
- Add the two percentages together
The key is consistency. Pick one profit metric and stick with it over time so you can track meaningful trends rather than comparing apples to oranges.
Rule of 40 Calculation Example
Let’s say a SaaS company generated $5 million in revenue last year and $6.5 million this year. That’s 30% growth. If their EBITDA margin is 15%, their Rule of 40 score is 45%.
| Metric | Value |
|---|---|
| Revenue Growth Rate | 30% |
| Profit Margin (EBITDA) | 15% |
| Rule of 40 Score | 45% |
This company exceeds the benchmark, suggesting a healthy balance between expansion and profitability.
Growth Rate in the Rule of 40
In SaaS economics, “growth rate” typically refers to how quickly recurring revenue is increasing. This component represents your company’s momentum—how fast you’re acquiring new customers and expanding relationships with existing ones.
Revenue Growth vs. ARR Growth
While total revenue growth works for the calculation, Annual Recurring Revenue (ARR) growth is often preferred for subscription businesses. ARR strips out one-time fees, professional services, and other non-recurring income. For companies with significant services revenue, using ARR growth provides a clearer picture of the core, predictable revenue stream that drives SaaS valuations.
What Is a Good SaaS Growth Rate
There’s no universal “good” growth rate because expectations shift based on company stage. Early-stage startups might target triple-digit annual growth as they capture market share. Growth-stage companies typically see 30-50% as healthy. Mature SaaS businesses might consider 15-25% strong performance. The Rule of 40 accounts for these differences by allowing slower growth to be offset by higher profitability.
Profitability Metrics in the Rule of 40
Companies can choose from several profitability metrics when calculating their score. What matters most is picking one and using it consistently over time.
EBITDA Margin
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. This margin is the most common choice for Rule of 40 calculations because it removes non-cash expenses and provides a cleaner view of operational profitability. EBITDA is particularly useful when comparing companies with different capital structures or depreciation schedules.
Free Cash Flow Margin
Free cash flow margin measures actual cash generated after accounting for operating expenses and capital expenditures. Some investors prefer this metric because it reflects real cash available to the business rather than accounting profits. For companies with significant infrastructure investments, FCF margin often tells a more accurate story than EBITDA.
Operating Profit Margin
Operating profit margin includes depreciation and amortization expenses that EBITDA excludes. Companies with substantial hardware costs or infrastructure investments might prefer this metric since it captures the true cost of maintaining operations over time.
Why the Rule of 40 Matters for SaaS Valuation
The Rule of 40 directly influences how SaaS companies are valued by investors and acquirers. A strong score signals that a company has figured out how to scale efficiently—not just grow at any cost.
How Investors Use the Rule of 40
VCs, private equity firms, and strategic acquirers rely on this metric throughout their evaluation process:
- Due diligence screening: Acts as an initial filter to identify companies that may be growing unprofitably
- Benchmarking: Enables comparison across different companies within a portfolio or market segment
- Trend analysis: Tracking scores over time reveals whether a company’s balance is improving or deteriorating
Rule of 40 and EBITDA Multiples for SaaS Companies
Companies that consistently exceed the 40% threshold typically command higher valuation multiples. The logic is straightforward: these businesses have demonstrated they can grow efficiently, making them less risky investments. Research from firms like SaaS Capital has shown a correlation between Rule of 40 performance and enterprise value multiples.
What Is a Good Rule of 40 Score
Meeting or exceeding 40% generally indicates a healthy SaaS business. However, context matters. A score of 35% with a clear upward trajectory might be more attractive to investors than a static 42% that hasn’t budged in two years.
Benchmarks by Company Stage
Expectations vary significantly by maturity. Early-stage companies under $5M ARR may fall below 40% while investing heavily in product and go-to-market. Growth-stage companies between $5M and $50M ARR are expected to approach or exceed 40% consistently. Scale-stage companies above $50M ARR typically exceed 40% reliably, with many targeting 50% or higher.
Equity-Backed vs. Bootstrapped SaaS Performance
Venture-backed companies often show lower Rule of 40 scores in early years because they’re optimizing for growth over profitability—that’s what their investors want. Bootstrapped companies, lacking external capital, typically prioritize profitability earlier. This often results in stronger scores from the start, though potentially at the cost of slower market capture.
How to Balance Growth and Profitability
The Rule of 40 helps founders answer a fundamental question: where do we allocate resources? The answer depends on your market position, capital availability, and strategic goals.
When to Prioritize Growth Over Profitability
Investing heavily in growth makes sense when a large, untapped market opportunity exists and timing matters. It also makes sense when network effects create winner-take-all dynamics, or when sufficient capital is available to fund aggressive expansion without risking the company’s survival.
When to Prioritize Profitability Over Growth
Shifting focus to margins is appropriate when capital is constrained, the market is maturing, or you’re preparing for an exit. Acquirers often want to see sustainable profitability before making offers, so companies approaching a sale frequently pivot toward margin improvement.
Finding Your Optimal Balance
The right balance is unique to each company. Financial forecasting helps you model different scenarios—what happens if you increase sales headcount by 20%? What if you raise prices 10%? Working with a strategic finance partner can help you identify which levers have the greatest impact on your Rule of 40 score, including how metrics like SaaS burn rate and runway management influence the margin side of the equation.
How to Improve Your Rule of 40 Score
Improving your score means either accelerating growth, improving margins, or both. The best approach depends on where your current constraints lie.
Strategies to Accelerate Revenue Growth
- Reduce churn: Retaining existing customers is often the most efficient path to revenue growth
- Increase expansion revenue: Upselling and cross-selling to current customers improves unit economics
- Optimize sales efficiency: Shortening your CAC payback period frees capital for reinvestment
- Enter new markets: Geographic or segment expansion increases your total addressable market
Strategies to Improve SaaS Margins
- Optimize pricing: Ensure your pricing captures the value you deliver to customers
- Reduce customer acquisition costs: Improve marketing and sales efficiency to lower CAC
- Control operational expenses: Regular spending reviews help right-size teams and eliminate waste
- Improve gross margin: Reduce hosting, support, and service delivery costs
Using Financial Forecasting to Optimize Performance
Scenario modeling reveals how specific changes affect your Rule of 40 score. What’s the impact of reducing churn by 5%? How does a 10% price increase affect both growth and margins? This kind of analysis helps you focus on the highest-impact opportunities rather than guessing—and it’s where strategic fractional CFO support can help translate models into concrete operating decisions.
When SaaS Companies Should Measure the Rule of 40
The Rule of 40 isn’t particularly useful for pre-revenue startups or companies still searching for product-market fit. It becomes relevant once you have predictable recurring revenue and are focused on scaling.
The metric is especially important when preparing for fundraising or a potential exit. Investors will almost certainly evaluate your performance against this benchmark, so understanding where you stand—and why—is essential for those conversations.
Limitations of the Rule of 40
While valuable, the Rule of 40 isn’t a perfect metric. Founders are better served using it as one data point among many rather than the sole measure of business health.
Goodhart’s Law and Gaming the Metric
Goodhart’s Law warns that “when a measure becomes a target, it ceases to be a good measure.” Cutting R&D to boost short-term margins might improve your score while damaging long-term competitiveness. The goal is sustainable performance, not hitting an arbitrary number through short-sighted decisions.
When the Rule of 40 Falls Short
The metric has blind spots. Two companies with identical 40% scores can have vastly different profiles—one growing 40% with 0% margin, another growing 10% with 30% margin. The Rule of 40 also doesn’t account for revenue quality like net retention, customer concentration, or contract length. And it ignores capital efficiency entirely—how much cash was burned to achieve that score?
Rule of 40 Alternatives
Newer frameworks attempt to address some limitations of the original rule.
Rule of 50 and Rule of 60
Some investors argue the bar is too low in competitive markets. The Rule of 50 and Rule of 60 are simply higher thresholds used to identify elite performers demonstrating exceptional balance between growth and profitability.
Rule of X for SaaS Companies
The Rule of X weights growth more heavily than profitability, typically using a formula like (1.33 × Growth %) + (0.67 × Profit Margin %). This reflects the reality that investors often place a premium on growth when valuing SaaS companies, particularly at earlier stages.
Building an Exit-Ready SaaS Business with the Rule of 40
The Rule of 40 is ultimately a tool for building long-term enterprise value. Acquirers and investors use this metric as a primary indicator of company health and scalability. Founders who consistently track and optimize their score are positioning their businesses for stronger valuations and more successful exits.
Working with a strategic finance partner helps you understand where you stand, identify what’s holding you back, and chart the course to your goals—whether that’s hitting $10M in ARR or preparing for acquisition. For earlier-stage fundraising planning, it can also be useful to review Series A financial preparation for SaaS companies so your growth and margin narrative aligns with investor expectations.
