The Rule of 40 says a software company's revenue growth rate plus its profit margin should add up to at least 40%. Grow 60% a year and you can lose 20% of revenue. Grow 20% and you should make a 20% margin. A company that grows 45% while losing 10% scores 35 and falls short.
The founder decision it helps with is whether next year's plan should push growth or margin. The score is simple enough to compute on a napkin, and easy to flatter, so below is the calculation on one company, what it means for next year's plan, what the evidence says, and the cases where the number misleads.
The calculation on one company
A software company did €10.0M of revenue last year and €14.5M this year, with an EBITDA loss of €1.45M.
growth rate = (14.5M - 10.0M) / 10.0M = 45% margin = -1.45M / 14.5M = -10% score = 45 + (-10) = 35
It misses by five points. Now use free cash flow instead of EBITDA. Suppose capitalised development costs and equipment purchases put free cash flow at -€1.9M:
FCF margin = -1.9M / 14.5M = -13.1% score = 45 + (-13.1) = 31.9
Same company, same year, a score three points lower. Neither is wrong. What matters is that you pick one definition, state it, and use it every year. The Rule of 40 calculator works the growth rate out from two years of revenue, which is safer than typing in a remembered growth rate.
Three plans for next year
The rule is most useful when you hold it against the plans on the table. This company has €8.0M in the bank and three options for next year:
| Plan | Revenue growth | Margin | Score | Next year's revenue | Profit or loss |
|---|---|---|---|---|---|
| A: push growth | 60% | -20% | 40 | €23.2M | -€4.64M |
| B: grow and earn | 30% | 10% | 40 | €18.85M | +€1.89M |
| C: same as this year | 45% | -10% | 35 | €21.0M | -€2.10M |
Plans A and B score exactly the same. The rule is indifferent between them on purpose: Feld's own examples give growing 50% while losing 10% the same pass as growing 20% at a 20% profit.
Your bank account is not indifferent. Plan A ends the year with about €3.4M of cash while losing money at a rate of roughly €390,000 a month, which means raising again within months. Plan B ends it with close to €9.9M (treating profit as cash, for simplicity) and no need to raise. Plan C scores worse than A yet burns less than half as much.
Use the score to screen plans and the runway to choose between them. Before choosing, run each plan's monthly burn through your runway calculation and check the answer against how long a raise would take. In Plainhub you can enter each option as a draft plan with its monthly impact and see the runway it would leave before you commit to anything.
Where the rule came from
Brad Feld wrote it up in February 2015 after hearing a late-stage investor describe it at a board meeting: growth rate plus profit should add up to 40%. Two details from that post tend to get lost.
The first is scale. The investor's version was for SaaS companies "at scale", which the post puts at at least $50 million in revenue. Feld adds that his own experience lines up with it once a company reaches about $1 million of MRR, roughly $12 million a year. Our example company, at about €1.2M a month, clears Feld's MRR line but is well short of the investor's $50 million.
The second is the inputs. Feld measures growth as year-over-year MRR growth, cross-checked against total revenue so one-time services revenue does not distort it. For profit he prefers EBITDA as the baseline and back-tests with other measures, because the definitions diverge.
How many companies pass
McKinsey looked at more than 200 software companies of different sizes between 2011 and 2021 and found they exceeded the Rule of 40 only 16% of the time. In the same article, top-quartile SaaS companies traded at nearly three times the enterprise value to revenue multiples of the bottom quartile (McKinsey, August 2021).
The same study found that among 100 US public SaaS companies with more than $100 million of revenue, median growth was 22% and median free cash flow margin was 10% (May 2021). Those two medians add up to 32. Scoring below 40 is the normal case, even among public companies.
When the score means nothing
Early on, the score is noise. Take a seed-stage company that went from €50,000 to €150,000 of revenue while losing €600,000:
growth = (150k - 50k) / 50k = 200% margin = -600k / 150k = -400% score = 200 + (-400) = -200
A score of -200 tells this founder nothing. Double the revenue next year with the same loss and the score changes wildly without the business changing much. Below the scale Feld described, the numbers that decide things are the burn multiple, which asks how much cash each euro of new recurring revenue costs, and runway, which asks how long you can keep paying it. The SaaS metrics guide sets out which metrics matter at which stage.
The rule also assumes software margins. A services firm or a hardware business measured against it learns little in either direction, because its costs grow with revenue in a way the rule never assumed.
Ways companies flatter the score
- Switching the margin definition. Adjusted EBITDA with generous add-backs and GAAP operating margin can be far apart. Moving between them from one year to the next makes the trend meaningless.
- Mixing ARR growth with a revenue margin. If ARR grew 50% and recognised revenue grew 35%, pairing the 50 with a revenue-based margin takes the better half of each. Use revenue for both, or ARR-based figures for both.
- Counting one-time revenue as growth. Implementation fees and a lumpy services project lift this year's growth and depress next year's. This is the reason Feld checks growth against MRR.
- Annualising a strong quarter. Trailing twelve months moves slower and is harder to game.
What to do with a score under 40
Decompose it before you react. A score that fell from 42 to 33 because growth slowed from 50% to 35% is a sales and retention question. The same drop caused by a margin going from -8% to -17% is a cost question.
Then compare it with the plan. A company can sit below 40 on purpose in a funded investment year, as long as the plan names what brings it back: margin improving as the new hires become productive, or growth picking up from a launch. A score that is below 40, drifting down, and has nothing in the plan to turn it is the one to act on. Compute it the same way every quarter, and look at the burn multiple underneath it when it moves.