Growth versus profit
Software and subscription companies face a constant trade-off: spend heavily on sales and product to grow faster, or slow down and become profitable. The rule of 40 is a simple test of whether a company balances the two well. It became popular among venture capital and growth equity investors in the mid-2010s.
Rule of 40 score = revenue growth rate + profit margin
A score of 40% or more is considered healthy.
Which numbers to use
- Growth: usually year-over-year revenue growth. For subscription businesses, growth in annual recurring revenue (ARR) is a common substitute.
- Margin: most often the EBITDA margin or the free cash flow margin. Free cash flow is harder to flatter with accounting choices, so many investors prefer it.
Whichever you choose, use the same definition when comparing companies or tracking one company over time.
Worked example
Revenue grew from $10 million to $13 million (30% growth) and the EBITDA margin is 15%:
| Result | Value |
|---|---|
| Revenue growth | 30% |
| Rule of 40 score | 45% |
| Gap to 40% | +5 points |
| Margin needed at this growth | 10% |
The company passes, with room to invest five more points of margin in growth if it wished.
Many paths to 40
| Growth | Margin | Score |
|---|---|---|
| 60% | −20% | 40% |
| 40% | 0% | 40% |
| 20% | 20% | 40% |
| 5% | 35% | 40% |
An early company burning cash can pass if it grows very fast; a mature company can pass with slow growth and high margins. The rule says nothing about which profile is better, only that the combination is sound.
Why investors care
Studies of listed software companies have found that those above 40% tend to trade at higher revenue multiples. The rule turns a complex judgment into a single number that is easy to compare across companies and quarters.
Limits
The rule is a rough screen, not a valuation method. It ignores the quality of growth (churn, customer concentration), the size of the market, and how efficiently the company acquires customers. It is not meaningful for very early startups with small revenue bases, where growth of 200% is common, nor for businesses outside software and subscriptions.
This calculator gives estimates for education and planning. It is not investment, tax or legal advice; for decisions about your own situation, talk to a qualified financial professional.