In SaaS, companies are constantly balancing two critical goals: growth and profitability. But how do investors, founders, and analysts know whether a SaaS business is managing this balance effectively?
Enter the Rule of 40 — a simple yet powerful financial metric that combines revenue growth and profit margin into a single number. It helps stakeholders understand if a SaaS company is healthy, scalable, and efficient.
Whether you’re an early-stage founder, a venture capitalist, or a SaaS CFO, understanding the Rule of 40 can give you clarity on business performance.
Table of Contents
What is the Rule of 40 in SaaS?
The Rule of 40 is a financial benchmark used to assess the performance of SaaS companies. It states that:
Revenue Growth Rate + Profit Margin = 40% or more
In essence, a SaaS business should aim for a combined total of 40% when you add the year-over-year (YoY) revenue growth to the EBITDA margin, operating margin, or free cash flow margin.
For example, if a company is growing revenue by 50% but has a -10% profit margin, it still satisfies the Rule of 40:
50% (Growth) + (-10%) (Profit) = 40%
It’s commonly used by:
- Investors to evaluate performance and capital efficiency
- SaaS founders and CFOs to benchmark financial health
- Analysts to compare SaaS companies at different stages
Why the Rule of 40 Matters
SaaS businesses often require significant upfront investment in product development and customer acquisition. The Rule of 40 offers a simple way to evaluate how efficiently a company is balancing:
- Growth – How fast is the company expanding revenue?
- Profitability – Is the business generating or burning cash?
Key Benefits:
- Balances burn-heavy growth with disciplined operations
- Helps compare young high-growth startups with mature SaaS firms
- Aids in VC/investor funding decisions
- Encourages long-term sustainable strategies
Meeting or exceeding the Rule of 40 often signals a business that could scale efficiently without constantly needing new capital.
How to Calculate the Rule of 40
The formula is straightforward:
Rule of 40 Score = Revenue Growth Rate (%) + Profit Margin (%)
Step-by-Step:
- Calculate Revenue Growth Rate:
(CurrentPeriodRevenue−PriorPeriodRevenue)/PriorPeriodRevenue×100(Current Period Revenue – Prior Period Revenue) / Prior Period Revenue × 100(CurrentPeriodRevenue−PriorPeriodRevenue)/PriorPeriodRevenue×100 - Choose a Profitability Metric (commonly used options):
- EBITDA margin
- Operating margin
- Free cash flow margin
- Add the Two Numbers:
If the result is 40% or more, the business is considered efficient by Rule of 40 standards.
Example Formula:
If your revenue grew 30% YoY and your EBITDA margin is 15%, then:
Rule of 40 Score = 30% + 15% = 45%
Example of How to Use the Rule of 40
Let’s take two hypothetical SaaS companies:
Company A
- Revenue Growth: 60%
- EBITDA Margin: -25%
- Rule of 40 Score = 60 – 25 = 35% (below threshold)
Company B
- Revenue Growth: 25%
- EBITDA Margin: 20%
- Rule of 40 Score = 25 + 20 = 45% (efficient and sustainable)
Despite Company A growing faster, Company B is likely a better-balanced business in terms of long-term scalability and profitability.
Also. read: Top 5 Solutions for your SaaS Business Model
When the Rule of 40 Applies and When It Doesn’t
The Rule of 40 Applies When:
- You’re analyzing mid-to-late-stage SaaS companies
- There’s enough revenue data to calculate margins accurately
- You need a quick benchmark for SaaS financial health
- Comparing public or mature private SaaS firms
It Doesn’t Apply Well When:
- The company is pre-revenue or very early-stage
- Profitability metrics are skewed due to one-time costs
- You’re evaluating non-SaaS or hardware-based business models
- The focus is strictly on growth at all costs (e.g., in new markets)
In short, it’s most useful when applied to companies beyond product-market fit and in serious scaling mode.
FAQs
1. Is the Rule of 40 a good metric?
Yes, it’s a strong high-level efficiency indicator for SaaS companies. However, it’s best used in combination with other financial metrics like CAC, LTV, and gross margin.
2. Who uses the Rule of 40?
The Rule of 40 is widely used by venture capitalists, SaaS founders, CFOs, and public market investors to gauge performance and capital efficiency.
3. Are there any limitations or criticisms of the Rule of 40?
Yes. Critics argue it can oversimplify complex business dynamics, ignore cash flow realities, or encourage short-term cost-cutting just to meet the benchmark. Also, early-stage startups often don’t meet the threshold, but that doesn’t mean they lack potential.
4. What profit metric should I use with the Rule of 40?
While EBITDA margin is the most commonly used, some analysts prefer Operating Margin or Free Cash Flow Margin depending on the company’s stage and reporting standards. Choose the one most aligned with your company’s financial structure.
5. Does the Rule of 40 apply to non-SaaS businesses?
Not directly. The Rule of 40 is specifically designed for SaaS companies due to their recurring revenue model and unique cost structures. However, some adapted versions exist for subscription-based or high-growth tech companies.
6. Can a company have a negative Rule of 40 score?
Yes. If both your revenue growth and profit margin are negative (e.g., -10% growth and -30% margin), your score would be -40%, indicating serious financial inefficiency or instability.
7. Is it better to have higher growth or higher profit in the Rule of 40?
That depends on your stage. Startups may prioritize growth, even at the expense of profits, while mature companies are expected to show stronger profitability. The key is achieving a balance that results in a 40%+ score.
8. How does the Rule of 40 compare to other SaaS metrics like CAC or LTV?
The Rule of 40 gives a macro-level view of financial efficiency, while CAC (Customer Acquisition Cost) and LTV (Lifetime Value) provide more granular insights into customer economics. All three are complementary in assessing SaaS health.
