Rule of 40: definition and calculation for SaaS

Rule of 40

The Rule of 40 holds that a software company’s revenue growth rate and profit margin, added together, should be at least 40%. It allows a trade-off between growth and profitability: a company growing at 50% can run at a margin of −10%, and one growing at 10% should run at a margin of 30%.

Formula

Score  = growth rate % + profit margin %
growth = year-on-year revenue or ARR growth
margin = EBITDA margin or free cash flow margin

Worked example

Illustrative figures. ARR growth and free cash flow margin for one year.

Growth = (15,600,000 − 12,000,000) ÷ 12,000,000 = 30.0%

Score = 30.0% + 6.0% = 36.0%

Choice of measures

Revenue or ARR growth, and EBITDA or free cash flow margin, give different scores. Free cash flow reflects the timing benefit of annual prepayment; EBITDA does not. State the measures and keep them.

Constant currency

For a multi-currency company, translation changes the growth rate. Use constant-currency ARR growth when the score is used to judge operating performance.

Limits

The rule is a heuristic applied mainly to later-stage companies. At small scale, high growth on a low base dominates the score.

What Revnewed provides

The twelve-month ARR bridge in the board pack gives year-on-year ARR growth, with FX impact shown separately.

Profit margin comes from the financial statements and is not held in Revnewed.

Common misstatements

Mismatched periods: Growth and margin must cover the same twelve months.
Bookings growth: Bookings growth overstates the score in a strong sales year.
Unstated measures: A score without its growth and margin definitions cannot be compared.