Rule of 40
DEFINITION
The Rule of 40 is a guideline for software and subscription businesses that says revenue growth rate plus profit margin should add up to at least 40 percent. It balances the trade-off between growing fast and being profitable in a single number.
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The Rule of 40 is a rule of thumb for software and subscription businesses that says a company's revenue growth rate plus its profit margin should add up to at least 40 percent. It captures the trade-off between growth and profitability in a single number, so a fast-growing company can run at a loss and still pass, while a slower grower is expected to be more profitable.
The Rule of 40 exists because growth and profitability pull against each other. Spending to grow quickly usually depresses margins, while protecting margins usually slows growth. The rule combines the two into one figure and sets a threshold: growth rate plus profit margin at or above 40 percent is treated as healthy. A company growing 60 percent a year can lose the equivalent of 20 percent of revenue and still clear the bar, because 60 minus 20 is 40. A company growing 10 percent is expected to post around a 30 percent profit margin to reach the same 40. The profit-margin input is not fixed by a standard; different users plug in EBITDA margin, free cash flow margin, or operating margin, which means two Rule of 40 figures are only comparable if they use the same inputs. It is a directional screen, most often applied to companies at meaningful scale rather than very early-stage ones. Its revenue side starts with accurate recurring-revenue tracking, which for a subscription business is typically managed by a billing platform such as Recurly.
Why the Rule of 40 matters for subscription businesses
For a subscription business, the Rule of 40 is a fast way to sanity-check whether growth is coming at a reasonable cost. It resists two easy traps: praising growth that burns cash unsustainably, and praising profitability that comes from starving growth. Investors use it to compare software companies on a common footing and to flag ones that are either overspending or underinvesting. Operators use it internally to frame decisions about how hard to push on acquisition versus how much to hold back for margin. Because it is one number, it travels well in board decks and diligence, but its simplicity is also its limit: it compresses a lot of nuance and depends heavily on which margin definition is used.
For an operator, the Rule of 40 depends on trustworthy revenue and growth data, which starts with accurate recurring-revenue tracking. Clean billing and revenue data from a subscription platform such as Recurly make it possible to calculate growth and, in turn, the Rule of 40 from real numbers rather than estimates.
How to use the Rule of 40
Pick a consistent definition of both inputs and keep it stable over time.
Choose the growth measure, usually year-over-year revenue or ARR growth, and the profit-margin measure, such as EBITDA, free cash flow, or operating margin, and state which you used whenever you report the figure.
Read the result as a screen, not a verdict, since passing does not prove a business is healthy and falling just short is not automatically a problem, especially for companies below the scale where the rule was intended to apply.
Track the trend across periods and pair it with the underlying growth and margin figures, since the same total can come from very different mixes of the two.
How to calculate the Rule of 40
The Rule of 40 adds two rates and compares the sum to 40 percent:
Rule of 40 = Revenue growth rate (percent) + Profit margin (percent)
A company passes when Revenue growth rate + Profit margin is greater than or equal to 40 percent
To calculate it:
Find the revenue growth rate, usually year over year, as a percentage.
Find the profit margin over the same period, as a percentage, using a stated measure such as EBITDA, free cash flow, or operating margin.
Add the two. If the sum is at least 40 percent, the company passes the Rule of 40.
Worked example (illustrative):
Revenue growth rate, year over year: 35 percent
Profit margin, EBITDA basis: 10 percent
Rule of 40 = 35 percent + 10 percent = 45 percent, which clears the 40 percent threshold.
A second business growing 15 percent with a 5 percent margin sums to 20 percent, which falls below the bar. These are hypothetical figures used to show the arithmetic. The 40 percent figure is the rule's own definitional threshold, not a benchmark, and where a specific company or peer group actually lands will vary and should be checked against current data rather than assumed.
Benefits and examples
The Rule of 40 gives a quick, comparable read on growth quality.
It balances growth and profitability in one figure, so neither is celebrated in isolation.
It gives investors a common screen for comparing software companies.
It frames internal trade-offs between spending to grow and protecting margin.
Example: two subscription businesses each score 40 on the Rule of 40. The first grows 45 percent at a negative 5 percent margin; the second grows 15 percent at a 25 percent margin. Same score, very different profiles, which is why the underlying inputs matter as much as the total.
Frequently asked questions
What is the Rule of 40? It is a guideline for software and subscription companies that says revenue growth rate plus profit margin should be at least 40 percent. It balances how fast a company grows against how profitable it is.
How do I calculate the Rule of 40? Add the revenue growth rate to the profit margin over the same period, both as percentages. If the total is 40 percent or more, the company passes. State which margin measure you used, because it changes the result.
Which profit margin should I use for the Rule of 40? There is no single required measure. People use EBITDA margin, free cash flow margin, or operating margin. The important thing is to be consistent and to say which one you used so figures can be compared.
Does passing the Rule of 40 mean a company is healthy? Not on its own. It is a directional screen, not a verdict. The same score can come from very different mixes of growth and margin, so look at the underlying inputs too.
Does the Rule of 40 apply to early-stage startups? It is most useful for companies at meaningful scale. Very early-stage companies often grow far above 40 percent while deeply unprofitable, so the rule is less informative for them.
