The Rule of 40 is a heuristic: a healthy software company's growth rate plus its profit margin should be at least 40%. It gives growth-focused and profit-focused companies a common yardstick, and it shows up in board decks, investor screens and public-company comparisons.
The formula
Rule of 40 score = revenue growth rate + profit margin
- Growth rate: year-over-year growth in revenue or ARR, as a percentage.
- Profit margin: EBITDA margin or free cash flow margin, as a percentage (negative when losing money).
Examples
| Company | Growth | FCF margin | Score |
|---|---|---|---|
| A | 70% | −35% | 35 |
| B | 30% | 12% | 42 |
| C | 45% | −5% | 40 |
Company A is growing fastest but burning heavily; Company B is slower and profitable; both sit near the line, which is the point of the measure.
Choices to fix in writing
- Revenue or ARR growth. ARR growth is a better leading indicator for subscription businesses; GAAP revenue growth is easier to audit.
- EBITDA or free cash flow margin. Free cash flow captures working capital and capital expenditures, including the effect of annual prepayments.
- Trailing twelve months or a single quarter annualized. Trailing periods are steadier.
- Adjustments. If you adjust EBITDA (stock comp, one-time items), list the adjustments.
Using it well
- Track the trend: moving from 25 to 35 over four quarters says more than any single score.
- Show the components: growth and margin each tell a story the sum hides.
- Compare against companies at a similar stage and scale.
Where it fits with other metrics
The burn multiple asks how efficiently cash turns into growth; the Rule of 40 asks whether the balance of growth and profitability is healthy. Together they cover most of the capital-efficiency conversation with a board or a later-stage investor.
Calculating it from your books
- Pull trailing twelve months revenue (or ending ARR) for the current and prior-year periods.
- Growth rate = current ÷ prior − 1.
- Pull operating cash flow and capital expenditures for the same twelve months.
- Free cash flow margin = (operating cash flow − capital expenditures) ÷ trailing revenue.
- Add the two percentages.
Because annual prepayments land as cash before revenue, a company that shifts customers to annual billing can lift its free cash flow margin without changing the underlying business. Note billing-term changes next to the score.
A quarterly table for the board
| Quarter | ARR growth | FCF margin | Score |
|---|---|---|---|
| Q1 | 62% | −30% | 32 |
| Q2 | 58% | −24% | 34 |
| Q3 | 55% | −17% | 38 |
The direction is the message: growth slowing gently while efficiency improves faster.
We calculate the score each quarter from the same statements and ARR data as the rest of the finance pack, with the definitions on the page.
Sources
- SEC, Commission Guidance on Management's Discussion and Analysis (key performance indicators and metrics), Release 33-10751 (PDF)
- FASB Accounting Standards Codification, Topic 230, Statement of Cash Flows
Questions founders ask
Which margin should we use?
EBITDA margin and free cash flow margin are both common. Free cash flow margin is harder to adjust, so many investors prefer it. Pick one, label it and keep it.
Does the Rule of 40 apply to early-stage startups?
Less so. Very early companies often grow fast with deep losses. The rule is most used for companies with established revenue, often in the later venture stages and beyond.
