Software Growth

Rule of 40

The Rule of 40 says a healthy SaaS company's growth rate plus profit margin should add up to at least 40 percent.

The Rule of 40 is a quick check on whether a software company is balancing growth and profit. Add your growth rate to your profit margin. If the sum is 40% or more, you are in good shape, whether you got there by growing fast and losing money or growing slowly and earning a lot.

Brad Feld wrote about it in 2015, describing it as a benchmark a late-stage investor introduced at a board meeting. He did not credit a single originator, and the idea spread through venture capital from there.

How to calculate the Rule of 40

Example A: a product with $1.2 million ARR grew 30% over the last year and has a 10% profit margin. Score: 30 + 10 = 40. It passes.

Example B: a company growing 60% with a margin of negative 20%. Score: 60 + (-20) = 40. It also passes, because heavy growth spending is allowed to offset losses.

Example C: a business growing 15% with a 15% margin scores 30. It does not pass, even though it is profitable.

Which numbers to use

Feld recommends year-over-year MRR growth as the cleanest growth measure, though some companies use ARR or revenue. For profit, he starts with EBITDA and suggests checking against operating income, net income and free cash flow. Bessemer's efficiency score uses free cash flow margin plus year-over-year ARR growth. Pick one definition and keep it fixed, because changing the margin measure can move your score by ten points or more.

What good looks like

Feld applies the rule to companies around $1 million in MRR and above, and the metric is meant for scaled businesses. Bessemer reports that the average for its cloud index was 31% in late 2023, and the top decile reached 48%. Passing 40 is better than most.

Criticism

Bessemer argues that treating growth and profit as equal is flawed for late-stage companies, because a point of growth compounds while a point of margin does not. Its alternative, the Rule of X, weights growth at roughly 2x for private companies. Under that view, 30% growth with a 15% FCF margin scores 45 on the Rule of 40 but 75 on the Rule of X.

Where it applies to small SaaS

  • Under about $1 million ARR the score swings wildly, so growth rates of 100% and a margin of negative 60% say little.
  • Bootstrapped companies usually have high margins and moderate growth. A 25% growth rate with 25% margin passes at 50, which is a fine target to use on yourself.
  • Use it with the burn multiple if you are losing money, since that tells you what the growth costs.

Using it as a decision tool

The rule works best as a trade-off guide. If your score is 30 and you want 40, you have two levers: grow faster or earn more. Decide which is cheaper for you. A product with sticky customers and low churn may find it easier to raise prices and lift margin. A product in a hot market may be better off spending more to grow. Track the score every quarter on the same definition, and note which margin you used so the trend is real.

Sources

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