Rule of 40

Young software companies often face a trade-off between growing quickly and being profitable. The Rule of 40 combines both into a single test of overall performance.

For example, a company growing revenue at 30% a year with a profit margin of 15% scores 45, passing the test. A company growing at 50% with a margin of minus 15% scores 35, falling short. A mature company growing at 10% with a 30% margin scores exactly 40.

The profit measure varies. Many investors use free cash flow margin, while others use EBITDA margin or operating margin, so scores are not always comparable.

The Rule of 40 is a rule of thumb, not a law. It gives a quick way to compare companies at different stages, allowing fast-growing but unprofitable companies to be assessed alongside slower but profitable ones. It does not capture other important factors, such as customer retention, market size or how the growth is being achieved.