Sign inWhat is the Rule of 40?
The Rule of 40 says a software company's revenue growth rate plus its profit margin should total at least 40%, balancing growth against efficiency.
Rule of 40 score = revenue growth % + EBITDA or free cash flow margin %
How practitioners use it
The rule is a shorthand for whether growth is being bought at a reasonable price. A company growing 60% at a negative 20% margin scores 40, and so does one growing 10% at a 30% margin.
It is a screen, not a valuation. Two businesses with identical scores can deserve very different multiples depending on retention, gross margin, and how durable the growth is.
The score is most useful over time. A deteriorating score usually shows up before a growth miss does.
Worked example with round numbers
01
Revenue growth of 25% and an EBITDA margin of 10% gives a score of 35.
02
That is below the threshold, so either growth or efficiency needs work.
03
Holding growth flat and lifting margin to 15% brings the score to 40.
Where people get it wrong
- Mixing margin definitions between EBITDA and free cash flow across comparables.
- Using the rule outside software, where the norms do not hold.
- Treating a score above 40 as proof the price is justified.
Learn it by using it
Definitions stick once you have run the numbers yourself. The desk below is free and needs no signup.
Score a company