The Rule of 40: formula, worked examples and when it applies

The formula

Rule of 40 score = revenue growth rate (%) + profit margin (%).

Growth is usually year-on-year revenue or ARR growth. A loss is a negative margin, so a company growing 60% with a 25% loss scores 60 − 25 = 35, below the line. A score of 40 or more passes.

Why 40? It is a convention, not a derived number. It became a widely used shorthand for a healthy balance between growing and making money.

Which margin to use

There is no single standard, so say which margin you use and stick to it.

• EBITDA margin: the most common choice, and easy to calculate from the profit and loss statement.
• Free cash flow margin: preferred by many investors because it reflects real cash, after capital spending, capitalised development costs and working-capital changes. Annual upfront billing can lift it.
• Adjusted EBITDA: adding back items such as stock-based compensation raises the score, so label it clearly if you use it.

Worked examples

Three illustrative software companies, using EBITDA margin on the latest year's revenue:

Company A grew revenue from ₹40 crore to ₹68 crore, growth of 28 ÷ 40 = 70%, with an EBITDA loss of ₹17 crore, a margin of −17 ÷ 68 = −25%. Score: 70 − 25 = 45.

Company B grew from ₹200 crore to ₹230 crore, growth of 30 ÷ 200 = 15%, with EBITDA of ₹69 crore, a margin of 69 ÷ 230 = 30%. Score: 15 + 30 = 45.

Company C grew from ₹20 crore to ₹30 crore, growth of 10 ÷ 20 = 50%, with an EBITDA loss of ₹6 crore, a margin of −6 ÷ 30 = −20%. Score: 50 − 20 = 30.

A and B score the same despite being very different businesses. C is growing quickly but losing too much money for that growth.

When it applies

The rule is mainly used for scaled software companies with predictable revenue, typically later-stage private companies and listed SaaS businesses. It is much less useful earlier on:

• Early-stage startups can grow several times over from a small base while losing heavily, so the score swings and says little.
• At that stage, retention, burn multiple and progress towards product–market fit are better guides.
• Businesses with different cost structures, such as hardware, consumer brands and marketplaces, have different healthy margins, so a 40% bar may not fit.

Reading the score sensibly

The score is a starting point, not a verdict. Many investors give more weight to the growth half than the margin half, because growth compounds, so two companies with the same score are not always valued alike.

One year can also mislead. A company can lift its score by cutting investment that would have driven future growth, or dip below 40 during a deliberate push into a new market. Look at the trend over several years and at what is driving each half.

Common mistakes

• Comparing one company's EBITDA-based score with another's free-cash-flow-based score.
• Annualising a single strong quarter's growth.
• Using ARR growth for one company and recognised revenue growth for another.
• Applying it to a seed-stage company and drawing conclusions from the result.