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…