Rule of 40

The Rule of 40 adds a company's revenue growth rate to its profit margin and checks whether the sum reaches 40%. A company growing annual recurring revenue at 30% a year with a 10% profit margin passes; one growing at 15% with a 10% margin does not. The idea is that fast growth can justify low or negative profitability, and vice versa, as long as the combined figure clears the threshold.

There is no single standardized formula behind it: "growth" is sometimes revenue growth and sometimes ARR growth, and "margin" is variously defined as EBITDA margin, free cash flow margin, or operating margin, so two companies' Rule of 40 scores are only comparable when both sides use the same definitions. This differs from looking at growth or margin in isolation, since it treats the two as a single tradeoff rather than separate targets.

The Rule of 40 matters as a quick, widely used screen investors apply to SaaS companies to judge whether growth is being bought at an unsustainable cost, or whether profitability is being prioritized at the expense of growth. The common pitfall is treating 40% as a hard pass or fail line rather than one point of comparison; a young company well below 40% with strong burn rate discipline and improving trends can still be a healthy business.