Formula
How to Calculate Rule of 40
The Rule of 40 says a healthy software company's growth rate plus its profit margin should add up to at least 40 percent.
Rule of 40 Score
Rule of 40 = Revenue Growth Rate (%) + Profit Margin (%)
Where
- Revenue Growth Rate
- = Year-over-year revenue growth as a percentage
- Profit Margin
- = EBITDA margin or free cash flow margin (varies by analyst)
What Is Rule of 40?
The Rule of 40 is a single-number screen for software businesses: add the revenue growth rate to the profit margin and the total should be 40 or more. Brad Feld published it in 2015, attributing it to a late-stage investor whose firm used it to assess healthy software companies, and describing the test as growth rate plus profit adding up to 40 percent. Feld suggested using year-over-year monthly recurring revenue growth for the growth term and EBITDA for the profit term. It is a rule of thumb, not an accounting standard, and both inputs are defined by whoever is running the calculation.
Worked Example
Suppose a company grows revenue from $40,000,000 to $56,000,000 over a year while posting a $5,600,000 operating loss. Growth rate is ($56,000,000 minus $40,000,000) divided by $40,000,000, or 40 percent. Margin is negative $5,600,000 divided by $56,000,000, or negative 10 percent. The Rule of 40 score is 40 minus 10, or 30. The company is below the line. To clear 40 without slowing growth it would need to cut the loss to roughly zero; to clear 40 while letting growth fall to 25 percent it would need a 15 percent margin, which on $50,000,000 of revenue is $7,500,000 of profit. All figures are hypothetical.
Why Rule of 40 Matters
The Rule of 40 exists because growth and profitability trade off, and a single number that combines them stops a board from praising growth while ignoring what it costs. It matters most at the point where a company is choosing between spending into a market and showing operating discipline, which is where growth equity and crossover investors underwrite. Its weakness is that both inputs are unregulated, so the score is only as honest as the definitions behind it.
Related Terms
Frequently Asked Questions
How do you calculate Rule of 40?
Rule of 40 is calculated using the formula: Rule of 40 = Revenue Growth Rate (%) + Profit Margin (%). The Rule of 40 says a healthy software company's growth rate plus its profit margin should add up to at least 40 percent.
What is a good Rule of 40?
What constitutes a "good" Rule of 40 depends on context — the fund's stage, vintage year, and strategy. Check our benchmarks and calculators for specific ranges.