The Rule of 40 says a healthy software company’s revenue growth rate plus its profit margin should add up to at least 40%. It lets you trade growth for profitability: 60% growth with −20% margin and 20% growth with 20% margin both pass.
What is the Rule of 40?
Brad Feld summarized the rule in 2015: your growth rate plus your profit should add up to 40%, with anything above it “awesome.”1Source 1 · Brad Feld, Feld Thoughts, 2015The Rule of 40% For a Healthy SaaS Companyfeld.com He framed it for SaaS companies at scale (at least $50 million in revenue) and preferred EBITDA as the profit baseline, back-tested against other measures such as operating income, net income and free cash flow.1Source 1 · Brad Feld, Feld Thoughts, 2015The Rule of 40% For a Healthy SaaS Companyfeld.com McKinsey’s later framing uses free-cash-flow margin instead.2Source 2 · McKinsey & Company, 2021SaaS and the Rule of 40: Keys to the critical value creation metricmckinsey.com The appeal is a single score that treats burning cash for growth and harvesting profit as two valid strategies, as long as the sum clears the bar.
Rule of 40 score=Revenue growth rate (%) + Profit margin (%)
- Revenue growth rate
- Year-over-year growth in revenue or ARR (be consistent)
- Profit margin
- EBITDA margin or free-cash-flow margin, as a % of revenue
Worked example
| Company | Revenue growth | Profit margin | Score | Passes? |
|---|---|---|---|---|
| A: scaling fast | 55% | −20% (EBITDA) | 35 | No |
| B: efficient grower | 25% | 18% (FCF) | 43 | Yes |
| C: hypergrowth | 90% | −45% (EBITDA) | 45 | Yes |
How many companies actually meet the Rule of 40?
Fewer than you might think. McKinsey reports that barely one-third of software companies achieve it, and that in an analysis of more than 200 software companies between 2011 and 2021 businesses exceeded the benchmark only 16% of the time; companies at or above it earned consistently higher enterprise-value-to-revenue multiples.2Source 2 · McKinsey & Company, 2021SaaS and the Rule of 40: Keys to the critical value creation metricmckinsey.com
Common mistakes
- Applying it too early. Below a few million in revenue, growth rates are so high and margins so negative that the score is mostly noise; the burn multiple is more informative.
- Mixing definitions — ARR growth with GAAP revenue margin, or EBITDA one quarter and FCF the next.
- Using a single quarter annualized. Use trailing-twelve-month growth and margin.
- Ignoring stock-based compensation when it is large; disclose whether margin is before or after it.
How to track the Rule of 40 in Kimo
Kimo pulls revenue and operating costs from QuickBooks or Xero and ARR from Stripe, and stores the margin definition you choose in the semantic layer. The board deck template charts the trailing score quarter by quarter, and Ask Kimo can answer “what growth rate do we need to hit 40 at today’s margin?”
Frequently asked questions
Should the Rule of 40 use EBITDA or free cash flow?
Does the Rule of 40 apply to early-stage startups?
Sources
2 references- The Rule of 40% For a Healthy SaaS Company (opens in a new tab)Brad Feld, Feld Thoughts2015feld.com
Growth rate plus profit should add up to 40%; EBITDA preferred as baseline.
- SaaS and the Rule of 40: Keys to the critical value creation metric (opens in a new tab)McKinsey & Company2021mckinsey.com
Barely one-third of software companies achieve it; 200+ companies 2011–2021 exceeded it 16% of the time; valuation premium.
External sources were accessed at the time of writing. Kimo product details, customers and figures in examples are illustrative unless a source is cited.
