Rule of 40

Growth and profitability usually trade off. The Rule of 40 tells you if you’re managing the trade-off well.

The formula

Rule of 40 = Revenue growth rate (%) + Profit margin (%)

A company growing 30% with 15% margins scores 45. One growing 10% with 35% margins also scores 45. Both pass the threshold; neither is obviously better.

The profit margin component varies. Some use EBITDA margin, others free cash flow margin, others operating margin. The principle is the same: growth plus profitability should sum to at least 40.

What it measures

The Rule of 40 captures the growth-profitability trade-off in a single number.

Most businesses can grow faster by spending more — on sales, marketing, R&D, expansion. That spending depresses margins. Alternatively, they can harvest profits by cutting investment, which slows growth. The Rule of 40 asks: whatever balance you’ve struck, is the sum healthy?

A score above 40 suggests the business is performing well on at least one dimension without completely sacrificing the other. Below 40 suggests it’s mediocre at both, or sacrificing too much of one for too little of the other.

For SaaS businesses, the metric became a benchmark because growth rates and margin structures follow somewhat predictable patterns. A venture-stage company might score 60 (50% growth, 10% margin). A mature one might also score 60 (15% growth, 45% margin). Different strategies, same outcome.

What it hides

The Rule of 40 treats growth and profitability as interchangeable. They’re not.

Growth is harder to reignite. A company that sacrificed growth for profitability often can’t reverse course. Sales teams were cut, product investment paused, market position eroded. The margin is real but the growth option may be gone.

Not all growth is equal. 30% growth from a small base is different from 30% growth from a large one. The Rule of 40 doesn’t adjust for scale. A £10m company growing 40% is adding £4m; a £100m company growing 40% is adding £40m — ten times harder.

Margin quality varies. 20% EBITDA margin means different things for different businesses. A software company with 80% gross margins and 20% EBITDA is spending heavily on sales and R&D. A services company with 40% gross margins and 20% EBITDA has a completely different cost structure. The Rule of 40 treats them identically.

It’s a single point in time. A company scoring 45 this year might be decelerating — last year was 55, next year might be 35. The trajectory matters more than the snapshot.

The investor lens

Investors use the Rule of 40 as a quick filter because it correlates with valuation.

Companies scoring above 40 typically command premium multiples. The logic: high growth alone might not be sustainable, and high margins alone might mean stagnation, but both together suggest a healthy business that can compound.

The relationship isn’t linear. A company scoring 60 isn’t worth 50% more than one scoring 40. But below 40, investors start asking harder questions about the path to either growth re-acceleration or margin expansion.

Private equity buyers often target businesses scoring below 40 with a thesis to improve one side. A company growing 5% with 25% margins (Rule of 40: 30) might be underinvesting. Add growth spend, accelerate to 15%, accept 20% margins, and you’ve created value even though the Rule of 40 score barely moved.

Where it breaks down

Early-stage companies. A startup growing 50% annually while burning cash at a -20% margin scores 30 — below the threshold despite rational investment in growth. The negative margin is investment, not failure, but the Rule of 40 doesn’t distinguish.

Cyclical businesses. A company with 30% growth and 20% margin at cycle peak (Rule of 40: 50) might show 5% growth and 10% margin at trough (Rule of 40: 15). The underlying business didn’t change; the cycle moved.

Different margin definitions. EBITDA margin, operating margin, and free cash flow margin can differ by 20+ points for the same company. A business scoring 45 on one definition might score 25 on another. Cross-company comparisons require consistent definitions.

Non-SaaS businesses. The Rule of 40 emerged from SaaS where gross margins are high (70-80%) and the growth-profitability trade-off is relatively clean. For lower-margin businesses or those with different cost structures, the threshold doesn’t translate directly.

The decision it enables

The Rule of 40 frames strategic choices. If you’re below 40, you need a plan to get there — either invest to accelerate growth or cut costs to improve margins. If you’re above 40, you have options.

The more useful question is direction: are you moving toward 40 or away from it? A company at 35 and improving is more attractive than one at 42 and declining.

For operators, the metric forces explicit trade-offs. Increasing sales spend by 10 points to accelerate growth by 5 points is a bad trade (Rule of 40 drops). Increasing it by 10 points to accelerate growth by 15 points is a good one (Rule of 40 rises). The framework makes the maths visible.

The Rule of 40 doesn’t tell you what to optimise. It tells you whether your current balance is working.

The metric series: Part of a series on metrics that reveal what headline numbers hide.