The balance between growth and profitability is a struggle for any SaaS – from quickly expanding startups to successful enterprises seeking to gain traction in new markets. The Rule of 40 is a widely used efficiency metric that provides key insight and helps leadership maintain balance. It’s a metric that appeals to both investors and internal stakeholders by offering a clear framework for evaluating a company’s financial health. Knowing how to calculate Rule of 40 is critical. The formula is simple: a company’s revenue growth rate plus its profit margin should equal or exceed 40%.
What is the Rule of 40?
The Rule of 40 combines two essential financial metrics: a company’s revenue growth rate and its profit margin, typically measured using EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Occasionally, companies use operating income, net income, or free cash flow as profitability measures instead of EBITDA. The choice of profit margin metric depends on a company’s specific financial context and what investors prioritize. We use EBITDA for calculations throughout this article.
Knowing how to calculate Rule of 40 can help you quickly assess performance and financial health by providing a quick snapshot of your company’s ability to balance aggressive growth with financial sustainability.
To meet the Rule of 40, the sum of revenue growth rate and profit margin must total at least 40%. For example, if your SaaS company grows revenues by 25% and has a profit margin of 15%, your total score would be 40% (25% + 15%).
| “The higher the number, the greater the gain. Top-quartile SaaS companies generate nearly three times the multiples of those in the bottom.”
– McKinsey |
Why Rule of 40 Matters?
In the SaaS industry, where rapid growth often comes at the expense of profitability, the Rule of 40 ensures that companies don’t lose sight of long-term financial stability as they expand. Achieving a Rule of 40 score of 40% is considered an indicator of a healthy, well-balanced SaaS business. Higher scores are even more impressive.
Understanding how to calculate the Rule of 40 score is vital when seeking investment or preparing for acquisition. For investors, the Rule of 40 serves as a key indicator of operational efficiency. A recent McKinsey report states, “Investors tend to reward companies that are at or above the Rule of 40 with consistently higher variation multiples.” However, that same research found that fewer than one-third of companies reached that 40% benchmark and even fewer were able to stay above the line consistently. With only 16% achieving and sustaining the rule of 40, reaching that goal can ensure that your SaaS stands out when investors are making their choice.
The Rule of 40 isn’t just for investors—it’s also a valuable tool for SaaS management teams, who can use it to guide their companies through growing pains. It helps leaders make informed choices by assessing how well their business is straddling the line between expansion and profitability. For example, a company with high growth but low profitability might need to optimize operations, while one with strong profitability but slow growth may need to reinvest in customer acquisition.
Limitations of the Rule of 40
While the Rule of 40 offers a valuable benchmark, like any other metric, it must be viewed in context and compared to other key performance indicators.
The Rule of 40 simply may not be top priority for every company. Some experts believe that the Rule of 40 may be more relevant for more mature organizations than it is for early-stage SaaS startups. Those young companies are still establishing SaaS product market fit and prioritizing hyper-growth over profitability accordingly. Smaller companies often operate in a phase where growth takes precedence, and short-term losses are an acceptable trade-off for rapid customer acquisition and market share. These companies may focus heavily on expanding their user base, building product-market fit, and scaling quickly, making profitability a secondary concern at this stage.
Others believe that there are times when the traditional Rule of 40 may be an irrelevant benchmark. SaaS Capital notes, “The Rule of 40 is dead… for some companies, the focus should be on Rule of X—where growth is weighted far more than profitability.” This perspective acknowledges that not all SaaS businesses fit neatly into the 40% balance, especially those in the high-growth phase where profitability may take a backseat to aggressive expansion.
The Rule of 40 also fails to account for the unique circumstances that different companies face. Market conditions, access to capital, and the competitive environment all influence whether growth or profitability should take priority. For instance, during periods of strong investor confidence and easy access to funding, companies may push for rapid growth at the expense of margins. In contrast, during tighter capital markets, a focus on profitability may be more appropriate.
Finally, the metric overlooks other strategic factors. Knowing how to calculate LTV (customer lifetime value) and other metrics like customer acquisition cost (CAC) are also critical to understanding the underlying health of a SaaS business. Companies with high CAC may still meet the Rule of 40, but their long-term sustainability could be in question if they are unable to retain customers or drive sufficient LTV.
How to Calculate Rule of 40?
Begin with these metrics:
- Revenue Growth Rate: This is the year-over-year percentage increase in a SaaS company’s recurring revenue. It’s a key indicator of how quickly your company is expanding your customer base and market share.
- Profitability: Typically measured using EBITDA margin, this metric reflects how efficiently your company converts revenue into profits. Other alternatives include operating income or free cash flow, depending on the company’s financial model.
Next, use this simple Rule of 40 calculation:
(Growth) + (Profit) = Rule of 40 Percentage
Let’s take SaaS Company X as an example:
(25% Revenue Growth Rate) + (5% EBITDA margin) = 30% Rule of 40 Percentage
Company Y, on the other hand is able to exceed the Rule of 40, making it more competitive and appealing to investors:
(32% Revenue Growth Rate) + (9% EBITDA margin) = 41% Rule of 40 Percentage
Weighted Variations
In some cases, particularly in cloud and tech-heavy industries, companies or investors with SaaS finance to offer may apply a weighted version as they ask themselves how to calculate the Rule of 40, giving more importance to revenue growth than profitability. For instance, growth could be weighted 2-3x higher than profit to reflect the value of scaling quickly in fast-growing markets. This approach is becoming more common in rapidly evolving sectors, where hyper-growth often takes precedence over short-term profits. The term “Rule of X” is valid but less common as a formalized approach, so it’s more of an industry trend than a widely adopted standard.
Interpreting the Results of Your Rule of 40 Calculation
Companies with a Rule of 40 score above 40% are generally viewed as balanced, effectively managing rapid growth while keeping profitability under control. Falling below 40% does not automatically indicate failure, but it could signal potential inefficiencies or that the company is prioritizing growth at the expense of profitability. In such cases, management may need to reassess resource allocation or cost controls to improve long-term financial health.
| “Companies that consistently score above the Rule of 40 tend to be the ones that survive economic downturns and thrive in competitive markets.” |
Increasing Your Rule of 40 Score
Improving your Rule of 40 score and balancing revenue growth with profitability typically requires a combination of strategic adjustments, such as accelerating growth or cutting costs. These targeted approaches will help you improve performance in both areas:
Boost Revenue Growth
- Increase Customer Retention and Reduce SaaS Churn: Numerous studies have proven that it’s more cost-effective to retain customers than to acquire new ones. Implement stronger customer support, loyalty programs, and personalized experiences. Best-in-class SaaS companies with net revenue retention (NRR) rates above 120% often see significant boosts in their Rule of 40 scores.
- Upsell and Cross-Sell: Expand the value of existing customer relationships by offering premium features or complementary products to drive additional revenue without the need for expensive customer acquisition efforts. This increases Annual Recurring Revenue (ARR) while boosting growth in a cost-efficient manner.
- Expand Market Reach: Target new customer segments or explore geographic expansion to fuel revenue growth. Expand into untapped markets or tailor products for specific industries to create more sustainable growth.
Improve Profit Margins
Enhancing profitability is the other way to improve your Rule of 40 score. Companies can do this by focusing on these strategies:
- Optimize Operating Efficiency: Streamline operations and reduce unnecessary expenses to improve profit margins. Automate processes, improve workflows, and minimize operational redundancies to scale without proportionately increasing costs.
- Reevaluate Pricing Strategies: Align pricing with the value you deliver by exploring tiered pricing models or adjusting existing price points. A well-calibrated pricing strategy ensures that your product delivers higher margins, even as you grow. Pricing should reflect the value provided to customers, unlocking higher revenues without dramatically increasing operational expenses.
Optimize Customer Lifetime Value (CLTV)
Improving CLTV is a strategy that positively impacts both growth and profitability, making it a critical lever for maximizing the Rule of 40 score. Focus on these approaches:
- Enhance Customer Retention: Long-term relationships with customers not only reduce churn but also drive sustained revenue over time. By investing in customer success and consistently delivering value, you will extend the lifetime value of each customer, contributing to both revenue growth and profitability.
- Extract More Value from Each Customer: Upselling, cross-selling, and providing personalized experiences help increase the revenue generated per customer. Focus on CLTV to ensure that every customer relationship contributes more meaningfully to overall growth.
Balance Growth and Profitability When You Know How to Calculate Rule of 40
SaaS leaders can ensure their companies are on a path to sustainable success that effectively balances growth and profitability by learning how to calculate the Rule of 40 and regularly assessing performance against this metric. Whether your company is in the early stages of growth or a more mature phase, staying on the right side of the Rule of 40 helps you stay aligned with long-term value creation while navigating the complexities of scaling. After you have calculated your Rule of 40 score, informed, data-driven decisions will drive efficient growth and increase profitability to improve it. Adjust strategies around customer acquisition, retention, and operational efficiency to enhance your company’s financial health and attractiveness to investors.
Are you looking for a marketing partner that knows how to encourage fast, manageable growth that will keep your company on the right side of the Rule of 40? Learn more about how Bay Leaf Digital can help you achieve your goals. Contact us today.
