Finance
Rule of 40
A SaaS health benchmark stating that the sum of revenue growth rate and profit margin (typically EBITDA or free cash flow margin) should be ≥40%.
In plain English
Grow 30% with 10% profit margin = 40, you're on the rule. Grow 60% with -20% margin = 40, also on the rule. Mature SaaS businesses ride the trade-off; healthy ones stay above the line.
Example
Company A: 50% YoY revenue growth, -15% FCF margin. Rule of 40 = 35%. Below the line. Company B: 25% growth, 20% FCF margin. Rule of 40 = 45%. Above the line. Both could be priced similarly if investors weight growth quality.
Formula
Rule of 40 = Revenue Growth Rate (%) + Profit Margin (%) ≥ 40
Why it matters
Public market and late-stage private investors compare SaaS companies against this benchmark almost universally. Below 40 = at-risk valuation multiple; above 40 = premium. It's a single number that captures the growth-vs-efficiency trade-off.
Common mistakes
- Using gross margin instead of operating/FCF margin — gross margin is too high for the benchmark
- Applying Rule of 40 below Series B — early-stage growth swamps the margin half of the formula
- Cutting growth to hit the rule via efficiency only — usually destroys long-term value