What is the Rule of 40?
The Rule of 40 is a key financial benchmark used in SaaS (Software as a Service) businesses to evaluate the balance between growth and profitability. It states that a company's revenue growth rate and profit margin should sum to at least 40%. If a SaaS company meets or exceeds the Rule of 40, it is considered financially healthy and attractive to investors.
Rule of 40 SaaS examples
For example, if your SaaS company is growing at 20% per year, you should be generating a profit margin of at least 20%. If you are growing at 40% per year you should be generating a profit margin of at least 0%. and lastly if you are growing 50% per year you can afford to have a negative profit margin of -10%.
How to calculate the Rule of 40
The Rule of 40 can be calculated in multiple ways. At its core, you need two metrics: your growth rate and your profit. The easiest way for SaaS companies to measure growth rate is by looking at the year-over-year growth of rate of monthly recurring revenue (MRR) or annual recurring revenue (ARR). This is often 'good enough', However, you need to be clear on what these numbers actually represent.
Calculating MRR growth rate
MRR growth rate = (( MRR End of Period - MRR Start of Period ) / MRR Start of Period ) * 100
Learn more about monthly recurring revenue (MRR)
Calculating ARR growth rate
ARR growth rate = (( ARR End of Year - ARR Start of Year ) / ARR Start of Year ) * 100
Learn more about annual recurring revenue (ARR)
Determining your profit margin can be a bit more tricky. The most common way to measure profit margin is by looking at either EBITDA or free cash flow, however EBITDA is the most common metric used in the SaaS industry.
Calculating EBITDA margin
EBITDA Margin = ( EBITDA / Total Revenue ) * 100
Learn more about EBITDA
For most SaaS companies, these numbers will be enough to calculate the Rule of 40. However, this can vary depending on your business model and SaaS infrastructure.
Formula for Rule of 40
Now that you have your revenue growth rate and profit margin, you can calculate the Rule of 40 using the following formula for calculating the Rule of 40:
Rule of 40 = Revenue Growth Rate (%) + Profit Margin (%)
An example using MRR growth rate and EBITDA margin could look like this: your MRR growth rate is 30% and your EBITDA margin is 15%. This would give you a Rule of 40 score of 45%. Since the total is above 40%, the company meets the Rule of 40 standard, indicating a strong balance between growth and profitability.
It is important to note that the Rule of 40 is a rule of thumb analysis for determining the health of a SaaS company, and it can vary depending on how you choose to calculate your growth rate and profit margin. This also means that the Rule of 40 can be difficult to compare between companies.
Rule of 40 benchmark
| Rule of 40 Score | Meaning |
|---|---|
| Above 40% | Strong financial health, balanced growth and profitability. |
| 30% - 40% | Competitive but may need optimization. |
| Below 30% | Potential financial risks, requiring strategic improvements. |
Rule of 40 benchmark calculator
Why is the Rule of 40 important for SaaS?
At the end of the day, the Rule of 40 is a simple way to assess the financial health of a SaaS company. It is also important to note that this score was invented by late stage investors and venture capitalists to risk assess SaaS investments. This also means that the Rule of 40 is most reliable for more mature SaaS companies.
However, it provides a good guiding principle for all SaaS companies, especially if you are chasing an investment. A report done by McKinsey showed that investors are in general rewarding SaaS companies that are at or above the Rule of 40 with consistently higher valuation multiples.
Read more at McKinsey
This means that if you intend to raise capital or sell your company, the Rule of 40 is a good benchmark to aim for if you want the best possible valuation.
How to improve your rule of 40 score
Achieving and maintaining a strong Rule of 40 score requires a strategic balance between growth and profitability. Here are three key ways to optimize your business performance and stay above the 40% threshold:
- Set Realistic Growth Targets – Avoid overestimating revenue potential. Adjust spending and efficiency strategies as growth stabilizes to sustain profitability.
- Prioritize Net Revenue Retention (NRR) – Retaining and expanding existing customers is crucial. A high NRR (120%+) drives organic growth without heavy reliance on new sales.
- Optimize Sales & Marketing Efficiency – Allocate resources based on future potential, not just current revenue. Improve customer acquisition cost (CAC) efficiency through data-driven strategies.
By focusing on realistic growth expectations, retention-driven expansion, and efficient go-to-market execution, SaaS companies can consistently meet or exceed the Rule of 40, ensuring long-term financial health and investor confidence.
The easiest way to continually monitor your Rule of 40 score and other metrics mentioned in this article is by automating this process. This is often done using a subscription management software or reporting tool. By using a tool like Fenerum you can easily keep track of your Rule of 40 score and other important metrics.
