Hong Life CalculatorsUnderstanding the SaaS Rule of 40 calculator — concept and principle
The Rule of 40 is a quick health check for software-as-a-service companies: revenue growth rate plus profit margin should add up to at least 40%. Investors, founders and finance teams use it to judge whether a company is balancing growth and profitability sensibly, especially when comparing a fast-growing, loss-making company with a slower but profitable one.
How it is calculated
Rule of 40 score = revenue growth rate (%) + profit margin (%).
- Revenue growth (%) is usually year-over-year growth in revenue or annual recurring revenue (ARR).
- Profit / FCF margin (%) is commonly EBITDA margin or free-cash-flow margin. A loss is entered as a negative number.
If the score is 40 or more, the calculator reports "passes"; otherwise it reports "below 40".
The principle
Growth and profit trade off against each other. A company can spend heavily on sales and marketing to grow faster, which depresses margins, or cut spending to become profitable, which slows growth. Adding the two percentages treats one point of growth as roughly equal to one point of margin, so a company growing 60% with a −20% margin and one growing 10% with a 30% margin both score 40. The rule was popularised in the venture capital community around 2015 as a simple benchmark, not as a law of economics.
Worked example
- Revenue growth = 25%.
- Profit or FCF margin = 10%.
- Score = 25 + 10 = 35.
- 35 is less than 40, so the result is below 40.
How to read the result
- 40 or more: the company is generally considered to balance growth and efficiency well.
- Somewhat below 40 (as in the example): not alarming on its own, but worth asking whether growth or margin can improve.
- Well below 40 or negative: the company is burning cash without enough growth to justify it.
The rule is most meaningful for companies past the early startup stage. Very young companies growing from a tiny base can show huge growth percentages that make the score meaningless, and mature companies may naturally score lower.
Common mistakes
- Mixing definitions: quarterly growth with annual margin, or ARR growth one year and revenue growth the next.
- Entering a loss as a positive number instead of a negative one.
- Using gross margin instead of an operating, EBITDA or FCF margin, which inflates the score.
- Comparing companies that measure margin differently.
Frequently asked questions
Which margin should I use?
EBITDA margin and free-cash-flow margin are the most common. Pick one, state it, and use it consistently over time and across peers.
Does a negative margin automatically fail?
No. A company growing 55% with a −10% margin scores 45 and passes.
Is the Rule of 40 used for non-SaaS companies?
It was designed for recurring-revenue software businesses. For other industries the trade-off between growth and margin works differently, so the 40 threshold has no particular meaning.
Sources: Brad Feld, "The Rule of 40% For a Healthy SaaS Company", Feld Thoughts (2015)