Rule of 40

How the Rule of 40 works

The rule is one addition. Written in words, the Rule of 40 score is the revenue growth rate plus the profit margin, each expressed as a percentage of revenue, and the test is whether that sum reaches 40.

Rule of 40 score = Revenue growth rate % + Profit margin %

A score of 40 or more passes the test.

Brad Feld's 2015 post, which is the reference most people cite, states the rule as growth rate plus profit adding up to 40 percent and gives three illustrations: 20 percent growth with 20 percent profit, 40 percent growth with zero profit, and 50 percent growth with a 10 percent loss. All three land on 40. Feld recommended using year-over-year monthly recurring revenue growth as the growth input and EBITDA as the profit input.

The construction encodes a specific claim: that a point of growth and a point of margin are worth the same. That is an assumption, not a finding. It is why the rule works as a screen and fails as a valuation model.

Which inputs people actually use

• Growth. Year-over-year revenue growth, year-over-year annual recurring revenue growth, year-over-year monthly recurring revenue growth, or forward growth. Feld specified MRR growth; public-market analysts typically use reported revenue growth.
• Profit. EBITDA margin, adjusted EBITDA margin, free cash flow margin, operating margin, or GAAP net margin. EBITDA and free cash flow are the two most common, and they can differ by many points for the same company.
• Period. Trailing twelve months, last reported quarter annualised, or next twelve months on consensus estimates.

Because several of these profit inputs are non-GAAP measures, a public company presenting them is subject to Regulation G and Item 10 of Regulation S-K, which require the most directly comparable GAAP measure and a reconciliation. The Rule of 40 score itself is not a reported figure; it is assembled by the reader from two disclosed ones.

Variants

• Rule of 50 and Rule of 60, applied to faster-growing companies where a 40 threshold is considered too low a bar.
• Cash-flow Rule of 40, substituting free cash flow margin for EBITDA margin, which penalises companies that capitalise costs or fund growth through working capital.
• Weighted versions, which multiply the growth term by a factor above one on the theory that growth is worth more than margin at scale. These are firm-specific conventions, not a standard.
• Burn multiple and similar efficiency ratios, used alongside the rule to check how much cash each point of growth consumed.

Worked example

Suppose three companies are being compared at the same $100,000,000 of trailing revenue.

Company A grows 55 percent and runs a negative 12 percent EBITDA margin. Score is 55 minus 12, or 43. It passes.

Company B grows 22 percent and runs a positive 20 percent EBITDA margin. Score is 22 plus 20, or 42. It passes.

Company C grows 35 percent and runs a negative 2 percent EBITDA margin. Score is 35 minus 2, or 33. It fails.

Now recompute on free cash flow margin instead of EBITDA. Company A capitalises a large share of its engineering costs and collects annually in advance, so its free cash flow margin is positive 4 percent. Its score becomes 55 plus 4, or 59. Company B carries heavy capital expenditure and its free cash flow margin is 6 percent rather than 20. Its score becomes 22 plus 6, or 28, and it now fails. Company C bills monthly, has no capitalisation, and its free cash flow margin is negative 5 percent. Its score becomes 30.

Nothing about the three businesses changed. Only the profit definition did, and the ordering moved: Company B went from passing to failing and now sits below Company C. This is the central practical point: the Rule of 40 is a comparison tool only when everyone in the comparison uses the same two inputs, computed the same way, over the same period. All figures are hypothetical.

Before quoting any score, three checks are worth running.

• Confirm the growth term and the margin term cover the same period. A trailing growth rate paired with a forward margin is not a score.
• Confirm the revenue denominator is the same in both terms. Growth is usually computed on total revenue while margin may be computed on product revenue only.
• Confirm whether the margin is GAAP or adjusted, and if adjusted, what was added back.

Where it shows up

The Rule of 40 does not appear in any legal document. It appears in the places where operating performance is argued.

In a board deck, it appears on the metrics page beside growth, net retention, and cash runway, usually as a trailing figure with a plan figure next to it. In a growth equity or crossover investment memo, it appears in the section justifying the entry multiple, because the argument that a company deserves a premium multiple is usually an argument that its combined score is high.

In public company disclosure, the inputs appear but the score usually does not. Growth comes from the income statement and the management's discussion and analysis; the margin comes either from the income statement or from a non-GAAP reconciliation table. Where a company presents adjusted EBITDA or free cash flow, Regulation G requires the most directly comparable GAAP measure and a reconciliation to it, and Item 10(e) of Regulation S-K adds, for a measure included in a Commission filing, that the GAAP measure appear with equal or greater prominence.

In a quarterly report to a limited partner, the score sometimes appears in portfolio company commentary as shorthand for whether a company is being run efficiently. The Institutional Limited Partners Association's reporting templates standardise fund-level cash flows and fees rather than portfolio operating metrics, so anything of this kind is the manager's own presentation choice.

Common mistakes

• Mixing definitions across a comparison set. A company scored on adjusted EBITDA against peers scored on free cash flow produces a ranking that reflects accounting policy, not performance.
• Treating 40 as a cliff. It is a round number chosen for memorability. A 39 and a 41 are the same company.
• Applying it to early-stage companies. At small revenue, growth rates are enormous and margins are deeply negative, so the score swings wildly and says nothing. The rule was framed for companies at scale.
• Using it on businesses it was not built for. The rule assumes recurring revenue and software-like gross margins. Applied to a hardware, services, or marketplace business with different gross margin structure, the threshold has no basis.
• Optimising the score rather than the business. Cutting sales capacity raises margin faster than it lowers growth in the short run, so a company can improve its score while damaging its future.
• Quoting a company's score without saying which margin was used. The score is not a disclosed number; it is a calculation, and calculations need their inputs stated.

Related terms

The Rule of 40 is read next to net-dollar-retention, which explains where the growth comes from, and next to burn-rate and runway, which explain what the margin term costs in cash. It shows up most in growth-equity and late-stage underwriting, is argued over at series-b-funding and series-c, and feeds into the valuation logic behind post-money-valuation.

Frequently asked questions

What is the Rule of 40 formula?

Add the revenue growth rate to the profit margin, each as a percentage, and compare the sum to 40. Brad Feld's 2015 formulation is growth rate plus profit adding up to 40 percent, with year-over-year monthly recurring revenue growth as the growth input and EBITDA as the profit input. Any other profit measure can be substituted, but the substitution changes the answer and should be stated.

Who invented the Rule of 40?

Brad Feld popularised it in a February 2015 post on his blog, and in that post he attributes it to a late-stage investor whose firm had developed the concept for assessing healthy software companies. Feld does not claim authorship. The rule circulated among growth investors before that and has no single documented origin.

Is the Rule of 40 based on EBITDA or free cash flow?

Both are used. Feld's original formulation used EBITDA. Public-market analysts frequently substitute free cash flow margin because it is harder to adjust. The two can differ by many percentage points for the same company, so any stated score should name which one it used.

Does the Rule of 40 apply to early-stage startups?

Not usefully. A company growing 300 percent off a small base with a deeply negative margin will produce a huge score one year and a meaningless one the next. The rule was framed as a check on companies at scale, where growth rates and margins are both in ranges where a point of each is comparable.

Why 40 and not some other number?

There is no derivation behind it. Forty is a round threshold that made the trade-off memorable, which is why variants at 50 and 60 exist for faster-growing cohorts. Treating it as a precise boundary rather than a rough dividing line reads more into the number than its origin supports.

Can a profitable slow-growing company pass the Rule of 40?

Yes, and that is the point of the construction. A company growing 10 percent with a 30 percent margin scores 40, exactly like a company growing 40 percent at breakeven. Whether investors value those two profiles equally is a separate question, and in practice they generally do not.

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