Do You Hit the Rule of 40?
Have you heard of the Rule of 40?
Since the mid-2010s, venture capital firms have used this rule of thumb to evaluate SaaS companies and other recurring revenue businesses. These types of businesses often operate at a loss in the early years while investing heavily in building their product and customer base. The Rule of 40 provides a way for investors to evaluate the health of a business even when traditional profit multiples don’t yet apply.
What Is the Rule of 40?
It’s a simple heuristic: Growth + Profitability ≧ 40%. If the sum of your revenue growth rate and profit margin is at least 40%, your business is considered healthy. If it falls below that threshold, you likely have room to improve.
For example, if your startup is doubling revenue year-over-year, you could be operating at a negative 60% profit margin and still pass the Rule of 40. Or if you’re growing at 35% annually and holding a 5% profit margin, you’re in the healthy zone. On the other hand, a company growing 20% with a 10% EBITDA margin would not meet investor expectations.
What If You’re Not in SaaS?
You might say, “I’m in manufacturing or retail—my business is stable and low-risk.” That may be true, but buyers of these types of businesses often create returns through cutting costs (so-called “synergies”), delaying capital investments, or taking on leverage. The reality is that slow-growth, low-profit companies tend to attract fewer investors.
Even among small to mid-sized businesses, the Rule of 40 serves as a powerful benchmark for financial performance and enterprise value growth.
How Summit OS Guides Use the Rule of 40
As Summit OS Guides™, we work with clients to triple their company’s value over a three-year period. This can be achieved by growing both revenue and profitability by 20% per year—effectively hitting the Rule of 40.
In the book Pinnacle: Five Principles That Take Your Business to the Top of the Mountain, we advocate for an even more ambitious approach: 5x-ing your business in five years. That goal can be met by following the Rule of 35—growing the top line by 20% and improving your profit margin by 15% annually.
Tracking this progress consistently is critical. The Scoreboard Sketcher™ is a straightforward tool we use to help teams measure their weekly, monthly, and quarterly performance against growth and profitability targets, keeping the Rule of 40 within reach.
Applying the Rule to Service Businesses
If you run a service-oriented business like consulting, recruiting, or home services, 20% top-line growth is sustainable. You can drive output by leaning into sales, hiring more staff, or deploying AI tools. In most cases, you can expand your team by up to 20% a year without harming your culture or compromising customer experience.
How to Improve Profit Margins
There are two primary ways to increase profitability: improving productivity and strengthening differentiation. Productivity gains come from better execution and from systematizing your business using internal playbooks.
Managing and evolving those internal systems is much easier with the Playbook Manager™, which gives teams a living platform to document, improve, and train around their best practices.
Differentiation involves designing unique activities—your “secret sauce”—that allow you to charge premium prices and earn premium profits.
Start With Execution
In our experience, the quickest wins come from putting execution into high gear. At Summit OS®, we’ve developed a 45-Day Execution Momentum™ process that gets the ball rolling toward hitting the Rule of 40, often starting within the first year.
Want to Hit the Rule of 40?
Read the updated edition of Pinnacle: Five Principles, visit the Summit OS website, or connect with a Summit OS Guide to help you put the Rule of 40 into action.
