If you run a SaaS business, you’ve probably heard someone mention the Rule of 40. It gets thrown around in board meetings, investor pitches, and late-night founder conversations. But what actually is it, and should you care?
Short answer: yes. Here’s why.
What is the Rule of 40?
The Rule of 40 is a financial metric designed for high-growth businesses, particularly software companies. It’s calculated by adding together two numbers:
Revenue growth rate (%) + Profit margin (%) = Rule of 40 score
If your combined score is 40% or higher, you’re considered to be performing well. Below 40%? Your SaaS business may be underperforming, at least by this measure.
Why does it matter?
In every company, there’s a trade-off between growth and profits. Growth costs money (for example, marketing, sales teams, product development, etc.), and that spending often eats into your margins.
The Rule of 40 acknowledges this tension. It says: fine, you can sacrifice profits for growth, or growth for profits, but the combination of the two should still hit a certain threshold.
A 2017 study found that around 40% of US software businesses beat the Rule of 40. However, other reports put this figure closer to 17–23%. Either way, it’s a meaningful benchmark, and businesses that consistently exceed it tend to command higher valuations.
Read: Strategic Goal Planning: A Blueprint for Business Success
How do you calculate it?
There’s some flexibility in how you measure the two inputs:
- Revenue growth: You could use total revenue growth or, if you’re a subscription-based business, recurring revenue growth. The latter is usually more relevant for SaaS.
- Profit margin: EBITDA margin is the most common measure, as it strips out interest, tax, depreciation, and amortisation to provide a clearer view of operating performance.
Example: If your recurring revenue grew 25% year-on-year and your EBITDA margin is 18%, your Rule of 40 score is 43%. You’re in good shape.
When should you use it?
Like any KPI, the Rule of 40 works best when tracked over time. Make sure to measure it monthly, quarterly, and annually, then plot it on a graph to identify trends.
That said, there are times when you need to interpret it carefully:
- If you’re a low-revenue or early-stage startup, your true profit margin might be hidden. Founders often don’t take a commercial salary, and revenue might still be negligible, so some commentators suggest not relying on the Rule of 40 until you’ve hit a substantial level of monthly recurring revenue.
- If your business context is unusual – say, you’re deliberately investing heavily in a new product line – the Rule of 40 might not tell the full story.
One KPI among many
The Rule of 40 is a useful benchmark, but it’s not the only number that matters. Think of it as one tool in your KPI toolkit, alongside churn rate, customer lifetime value, CAC payback period, and all the rest.
Used properly, it helps you balance the eternal tension between growth and profitability. And if you’re ever pitching to investors? A Rule of 40 score above 40% is a very nice number to have in your back pocket.
| Want help tracking the metrics that matter for your SaaS business? Drop us an email at [email protected]; we love a good spreadsheet. |
