Blog · Finance metrics and formulas · SaaS
The Rule of 40 adds a software company's revenue growth rate to its profit margin and asks whether the sum reaches 40%. This page gives the formula and the Excel version, works five companies, shows how the choice between EBITDA and free cash flow margin can flip the result, and covers which growth figure to use and what the score cannot tell you.
The Rule of 40 says a software company's revenue growth rate plus its profit margin should be at least 40%. A company growing revenue 25% a year with an 18% EBITDA margin scores 43 and passes; one growing 15% with a 20% margin scores 35 and does not. The score is only meaningful when you say which margin it uses, because the same company can pass on one and fail on the other.
Rule of 40 score = Revenue growth % + Profit margin %
Revenue growth % = (Revenue this year − Revenue last year) / Revenue last year × 100
Profit margin % = EBITDA (or free cash flow) / Revenue this year × 100
A score of 40 or more passes. Growth and margin trade off against each other: a company can spend its margin to grow faster, or slow down and take profit, and the rule asks whether the combination is healthy.
The rule was popularized by Brad Feld in a February 3, 2015 post, The Rule of 40% For a Healthy SaaS Company. He did not claim it as his own: he wrote that he heard it at a board meeting from a late-stage investor, who described "what his firm called the 40% rule", and he summarized it as "your growth rate + your profit should add up to 40%." Feld's own preference was EBITDA: "I prefer to use EBITDA here as the baseline and then back test with the other percentages." It has since become a common screen in SaaS board packs and investor reviews.
Four figures, all for the same entity and on the same basis:
| Column | Content |
|---|---|
| A | Company, business unit or reporting period |
| B | Revenue last year (or ARR at the start of the year) |
| C | Revenue this year (or ARR at the end of the year) |
| D | EBITDA or free cash flow for this year |
Growth and margin should cover the same twelve months. If you measure growth on ARR, say so; if you measure margin on GAAP revenue, the two halves of the score rest on different bases.
Five illustrative software companies, each scored on EBITDA margin:
| Company | Revenue growth % | EBITDA margin % | Score | Result |
|---|---|---|---|---|
| A | 42 | −5 | 37 | Below 40 |
| B | 25 | 18 | 43 | Passes |
| C | 15 | 20 | 35 | Below 40 |
| D | 60 | −15 | 45 | Passes |
| E | 12 | 30 | 42 | Passes |
Company B step by step: revenue grew from $40,000,000 to $50,000,000, so growth is (50.0 − 40.0) / 40.0 = 25%. EBITDA of $9,000,000 on $50,000,000 of revenue is an 18% margin. The score is 25 + 18 = 43. A negative margin is added as a negative number: D grows 60% at −15% and scores 45.
In Excel, with last year's revenue in B2, this year's in C2 and EBITDA in D2:
=(C2-B2)/B2*100+D2/C2*100
For company B that returns 25 + 18 = 43.
Three of five pass on EBITDA margin: B, D and E. Before trusting any of them, tie the inputs out. Both revenue figures must match the income statement for the fiscal years named, EBITDA must reconcile to operating income plus depreciation and amortization, and the margin denominator must be this year's revenue, the same figure as the end point of the growth calculation. If growth used ARR and margin used revenue, recompute one of them so both use the same basis.
Company C scores 35 on EBITDA margin. On free cash flow margin of 27%, perhaps because customers pay annually in advance, it scores 15 + 27 = 42 and passes. Four of the five companies now pass, and nothing about the business changed.
| Margin used | What it includes | Effect on the score |
|---|---|---|
| EBITDA margin | Operating profit before depreciation and amortization | Ignores capitalized software costs and working capital |
| Free cash flow margin | Operating cash flow less capital expenditure | Rewards upfront annual billing; penalizes heavy capitalization |
| Operating margin | GAAP operating income | The strictest, after depreciation and stock-based compensation |
EBITDA and free cash flow are both non-GAAP measures. The SEC staff's non-GAAP interpretations define EBITDA as "earnings before interest, taxes, depreciation and amortization" and treat free cash flow as "a liquidity measure", which is why public companies must reconcile both to GAAP figures. Use the same margin every period and print its name beside the score. EBITDA margin works the EBITDA side in full.
Pick one and keep it. GAAP revenue growth ties to the audited statements; ARR growth is closer to the run rate and moves first. Over several years, read growth as a compound annual rate rather than one year's jump.
Strip acquisitions. If company E bought a business that added $2,000,000 of revenue, that revenue is not growth the company produced. Measure growth on the same set of customers and products in both years, then show acquired revenue separately.
The Rule of 40 is a screen for the trade-off between growth and profit, not a valuation and not a plan. It says nothing about where growth came from. Two companies growing 25% can be very different: one keeps and expands its customers, the other replaces heavy churn with expensive new logos. Net revenue retention separates them, and gross retention and net retention shows how to measure both. What new growth costs is in customer acquisition cost.
The growth half of the score is made of customers who stayed, expanded, shrank or left. Covirage's tools compute growth, retention and expansion from your revenue and ARR exports, reconciled to the ledger, so the growth figure can be explained account by account; the external AI model explains the result and never does the arithmetic. See Covirage for SaaS sales teams, and customer base KPIs for SaaS sales teams for the measures behind the growth rate. For the cash cost of that growth, see burn rate and unit economics, and to compute the growth rate over several years, see CAGR in Excel.
Both are used. EBITDA margin is common in board decks; free cash flow margin is often preferred by investors because it reflects capitalized costs and working capital. State which one is used, because the same company can pass on one and fail on the other.
A score of 40 or more is the usual benchmark for a mature SaaS company. Scores well above 40 are uncommon and tend to be valued highly by investors. Below 40 is not a failure on its own; the trend and the reason matter.
Less so. Very early companies can grow fast from a small base while margins are deeply negative, so the sum swings widely. The rule is most used for companies with meaningful revenue, often from the growth stage onward.
Add the negative margin as a negative number. A company growing 60% with a -15% EBITDA margin scores 60 + (-15) = 45 and passes.