The Rule of 40 in SaaS Explained

In the world of Software-as-a-Service (SaaS), balancing growth and profitability is the eternal struggle. Early-stage startups often burn cash to grow at all costs, while mature companies focus on efficiency and margins. But how do investors, founders, and boards know if a company is striking the right balance? Enter the Rule of 40.

What you’ll learn

In this comprehensive guide, you will learn:

1. The exact formula for calculating the Rule of 40.
2. Why this metric has become the gold standard for SaaS valuation.
3. How to benchmark your company against public and private peers.
4. Actionable strategies to improve your score without sacrificing long-term health.
5. Nuances for bootstrapped vs. VC-backed companies.

The Formula Deconstructed

The math is deceptively simple:

Rule of 40 Score = Revenue Growth Rate (%) + Profit Margin (%)

However, the devil is in the details. Which growth rate? Which profit margin?

1. Revenue Growth Rate

Typically, this is your year-over-year (YoY) ARR growth. For quarterly reporting, you might use trailing twelve months (TTM) revenue growth.

• Example: If you had $1M ARR last year and $1.5M ARR today, your growth rate is 50%.

2. Profit Margin

This is where definitions vary.

• EBITDA Margin: Earnings Before Interest, Taxes, Depreciation, and Amortization. This is the standard for private equity and mature firms.
• Free Cash Flow (FCF) Margin: Operating cash flow minus capital expenditures. This is often "truer" for businesses with high working capital needs.
• Net Income Margin: Rarely used in high-growth SaaS due to non-cash expenses like stock-based compensation.

For most Seed to Series B startups, Burn Rate (negative margin) is the proxy. If you are burning cash, your margin is negative.

• Example: If you generate $1.5M revenue but spend $2M, your margin is -33%.

Calculation Example

Let's combine them.

• Growth: 50%
• Margin: -33%
• Score: 50 - 33 = 17% (Fails the Rule of 40)

Now imagine a different company:

• Growth: 30%
• Margin: 15%
• Score: 30 + 15 = 45% (Passes the Rule of 40)

Despite growing slower, the second company is considered "healthier" by this metric because it is doing so efficiently.

Why Investors Obsess Over It

The Rule of 40 was popularized by venture capitalists (including Brad Feld) as a quick heuristic to filter investment opportunities. It solves the problem of comparing apples to oranges—high-growth cash burners vs. slower-growth cash generators.

The Valuation Premium

Data from thousands of SaaS companies shows a strong correlation between Rule of 40 scores and revenue multiples.

• Score < 20: Often trade at 1-3x revenue.
• Score 20-40: Trade at 4-7x revenue.
• Score > 40: Can command 8-15x revenue or more.

If you are looking to exit, hitting the Rule of 40 is arguably the single most effective way to bump your valuation bracket.

Strategies to Improve Your Score

Improving your score requires pulling one of two levers, or ideally both.

Lever 1: Accelerate Growth (The "Growth at all Costs" Trap)

Increasing the 'Top Line' is the most obvious path.

• Expand Channels: If you rely on outbound, layer in paid search or content.
• Upsell Existing Customers: Net Revenue Retention (NRR) carries a double benefit—it increases growth without the high CAC of new logos.
• Pricing: Raising prices is the fastest way to increase growth and margin simultaneously.

Warning: Pushing growth often degrades margin. If you spend $2 to acquire $1 of ARR (metrics degradation), your Rule of 40 score might actually drop even as growth spikes.

Lever 2: Optimize Margins (The "Efficiency" Path)

In the 2024-2025 "efficient growth" era, this is favored.

• Cut Churn: Churn is a leaky bucket. Fixing it improves LTV and reduces the need for replacement leads.
• Automate Onboarding: Move from high-touch implementation to product-led growth (PLG) or automated email flows.
• Rationalize Headcount: Ensure every hire maps to revenue. Revenue-per-employee is a key sub-metric here.

Examples

Let's look at two hypothetical companies to see the Rule of 40 in action.

Example A: "RocketShip SaaS" (Series B)

• ARR: $5M
• YoY Growth: 80%
• EBITDA Margin: -50% (Burning $2.5M/year)
• Calculation: 80 + (-50) = 30
• Verdict: Despite impressive growth, the burn is too high. Investors might worry about the path to profitability. They fail the Rule of 40.

Example B: "SteadyState CRM" (Bootstrapped)

• ARR: $2M
• YoY Growth: 20%
• EBITDA Margin: 25% (Profiting $500k/year)
• Calculation: 20 + 25 = 45
• Verdict: This company is a cash cow. It passes the Rule of 40 with flying colors and is an attractive target for Private Equity or strategic acquisition.

Checklist: Are You Ready for Diligence?

If you are preparing for a fundraise or exit, use this checklist to ensure your Rule of 40 calculation stands up to scrutiny:

• [ ] Standardize Revenue Recognition: Ensure you are using recognized ARR, not bookings.
• [ ] Define Margin Clearly: Decide if you are using EBITDA or FCF and stick to it. Be prepared to explain why.
• [ ] Segment by Product: If you have multiple lines, calculate the score for each.
• [ ] Trend Analysis: Don't just show one snapshot. Show the last 4 quarters to demonstrate a trend toward 40.
• [ ] Exclude One-Offs: Remove non-recurring revenue (consulting, setup fees) from the growth calculation to show true SaaS momentum.

FAQ

Q: Does the Rule of 40 apply to early-stage startups? A: Generally, no. Below $1M ARR, the data is too noisy. Focus on finding Product-Market Fit (PMF) and initial traction. The Rule becomes useful after $1M ARR.

Q: Is it better to have high growth or high margin? A: In the current market (2025), balanced efficient growth is preferred. However, purely historically, high growth (>50%) was often rewarded more than high margin, provided the unit economics (LTV:CAC) were sound.

Q: Can I exceed 40? A: Yes! Top-tier public companies like Snowflake or Datadog have historically posted scores of 60, 70, or even 80. These are the "outliers" that define the upper bound of valuation.

Q: What if I'm at 38? A: You're fine. 40 is a heuristic, not a law of physics. Being consistently at 38 is better than hitting 45 once and crashing to 10 the next quarter.

Q: Does services revenue count? A: Ideally, no. Investors value recurring software revenue. If you include low-margin services revenue, it might artificially inflate growth but drag down your blended margin.

Q: How often should I track this? A: Quarterly is standard for board reporting. Monthly is good for internal operational checks.

Related Resources

To dive deeper into the metrics that drive valuation, check out these related guides:

• AI Valuation Bubble - How AI is distorting traditional multiples.
• Micro-SaaS Valuation - Valuation dynamics for smaller sub-$1M ARR firms.
• Exit Strategy - How to time your exit for maximum value.
• Valuation Guide - The complete handbook for 2025.
• Growth Metrics - Which metrics actually move the needle?
• Free Valuation Calculator - Calculate your own numbers instantly.