What the Rule of 40 measures
The Rule of 40 is a quick health check for software companies. Add your revenue growth rate to your profit margin. If the total is 40 or more, the business is balancing growth and profitability well.
The idea behind it is that growth and profit trade off. A company can spend heavily to grow fast and run at a loss, or grow slowly and keep a healthy margin. Either can be fine. What investors and boards want to see is that the trade is a good one, and the Rule of 40 puts both sides into one number.
How to calculate your Rule of 40 score
Use the same 12-month period for both numbers.
- Work out revenue growth: (revenue this year − revenue last year) ÷ revenue last year × 100.
- Work out profit margin: profit ÷ revenue this year × 100, using EBITDA or free cash flow.
- Add the two percentages together.
A worked example:
- Revenue last year: $2,500,000
- Revenue this year: $3,300,000
- EBITDA this year: $396,000
Growth is 32% and the EBITDA margin is 12%, so the score is 44. That passes by 4 points. At a 12% margin the company could let growth slow to 28% and still pass. At 32% growth, the margin could fall to 8% (EBITDA of $264,000) before the score dropped below 40.
The score works with losses too. A company growing 60% with a −20% margin also scores 40.
EBITDA or free cash flow?
Both are common, and the calculator lets you switch between them.
- EBITDA margin is close to operating profit and easy to pull from a profit and loss statement. It leaves out capital spending and the timing of cash.
- Free cash flow margin is operating cash flow minus capital spending, divided by revenue. It is the stricter test, because it shows the cash the business actually generates or burns.
The two can differ a lot. Annual upfront billing tends to lift free cash flow, and capitalised development costs flatter EBITDA. Say which one you used whenever you share the score, and use the same one each time you report it.
What is a good Rule of 40 score?
40 is the pass mark. A score comfortably above it suggests room to invest more in growth or to absorb a slowdown. A score in the 30s usually means one lever needs a few points. Well below 30 means growth is not paying for the losses, or profit is not making up for slow growth.
It depends on stage. Early-stage companies often grow fast from a small base, which makes the score jump around, so the rule is most useful once revenue is meaningful and growth has settled. Many companies also miss 40 in a given year for good reasons, such as a deliberate push into a new market. The trend over several years tells you more than one score.
Common mistakes
- Mixing periods. Growth from one period and margin from another gives a number that means nothing. Use the same 12 months.
- Using monthly growth. The rule uses annual growth. 3% month-on-month growth is roughly 43% a year, not 3%.
- Counting one-off revenue. Large one-off services or set-up fees can inflate growth. Many teams use recurring revenue (ARR) growth instead.
- Switching margin measures. Quoting EBITDA one quarter and free cash flow the next makes the trend unreadable.
- Reading it in isolation. Two companies with the same score can be in very different shape. Check retention, gross margin and how efficiently sales spend turns into new revenue.
How to improve your Rule of 40 score
Every point of growth and every point of margin counts the same, so look for the cheapest point first.
- Retention and expansion. Keeping and growing existing customers adds growth without the cost of winning new ones.
- Pricing. A price rise or better packaging lifts growth and margin at the same time.
- Efficient acquisition. Channels with lower acquisition cost let you keep growing while spending less.
- Cost discipline. Hosting, tooling and headcount that no longer pull their weight drag down margin.
- Billing terms. Annual upfront plans improve free cash flow, even when EBITDA stays the same.
Related tools
See how much revenue your existing customers keep with the NRR Calculator, check how efficiently sales and marketing spend becomes new revenue with the SaaS Magic Number Calculator, and work out your SaaS gross margin. If growth is the side of the score you need, our outbound lead generation service builds pipeline without a big ad budget.