The Rule of 40 adds a software company's year-on-year revenue growth rate to its profit margin and asks whether the total clears 40. It is a sanity check on the trade between growth and burn, not a target, and the definitions behind each half decide what it is worth.
The Rule of 40 formula
Growth rate (%) + profit margin (%) ≥ 40. Both halves are expressed as a percentage of revenue and both are measured over the same period. A business growing 60% with an EBITDA margin of negative 25% scores 35 and is under the line. A business growing 15% at a 30% margin scores 45 and is over it. The same total can describe two very different companies, which is the first thing worth knowing about it.
It is a convention, not an accounting rule. Nothing in the AASB accounting standards defines it and it will never appear in a statutory report, so no auditor has ever signed one off.
How to calculate it on your own numbers
Two inputs, and each has a defensible version and a flattering one. For growth, most SaaS businesses use year-on-year ARR or MRR growth. For margin, the common choices are EBITDA margin or free cash flow margin. Free cash flow is the harder number to argue with, because it cannot be improved by capitalising something.
Whichever pair you pick, hold them. A score calculated on annualised MRR growth one quarter and recognised revenue growth the next is not a trend, it is two unrelated numbers on the same chart. Trailing twelve months on both halves is the usual choice for a reason.
| How the number usually gets put together | What an investor will actually ask for | |
|---|---|---|
| Growth rate | Whichever growth figure looks best this quarter, usually the most recent month of MRR annualised. | One defined measure held consistent period to period, with new and expansion revenue split out so the source of the growth is visible. |
| Profit margin | EBITDA margin, because it is the kinder of the two numbers. | EBITDA margin and free cash flow margin side by side, so the gap between them is on the page rather than buried. |
| The period | The last good quarter, annualised. | Trailing twelve months, with both halves measured on the same window and the prior year shown next to it. |
What a score above 40 tells you, and what it does not
Above 40 is widely treated as the healthy mark for a scaled software business, because it says the growth is not being funded entirely out of the cash balance. Below it, growth is being bought, and the question becomes what it is being bought with and for how long.
For an early-stage Australian company the score is often well under 40 and that is not automatically a problem. Most SaaS businesses at the scale-up stage are burning cash.[1] Profitability at that stage is genuinely rare, which is exactly why it is worth remarking on when a business gets near $20M ARR and is profitable.[2] The Rule of 40 is most useful as a direction of travel, not a pass mark applied to a Series A.
The growth half of the score is much easier to read alongside net revenue retention, which shows how much of it came from customers you already had.
Who owns the number in a growing company
In most early-stage Australian businesses this sits with the founder, assembled by hand ahead of a board meeting. That works right up until it does not. Finance is a commercial driver and enabler rather than a scorekeeper, the number two next to the founder or CEO helping them make decisions.[3] It is also the distinction I keep testing with the CFOs I interview on The CFO Track. A Rule of 40 score built by the person who also decides what goes into it is not an independent read on the business.
What a founder should expect from a finance hire here is not the arithmetic. It is the argument: which definition of growth we are using and why, what sits between EBITDA and free cash flow, and what the number would look like on the definitions a specific investor prefers. For the next phase of a business, a CFO needs to be a strong commercial leader, not just technically commercial but with the drive to build commercial acumen across the whole business.[4]
What the score says about who you hire next
A score that is falling because growth is slowing is a different hire from a score that is falling because burn is climbing. The first is a commercial and pricing problem. The second is a controls and planning problem. Founders often reach for the same job title for both.
Stage matters more than the score itself. A single-product SaaS business can run on a fractional arrangement until Series C, while a complex deep tech business carrying R&D and inventory needs a finance leader much sooner.[5] And when a business does go looking for a CFO, the brief is usually about the road ahead rather than the current score. On a recent search for a client at $19M ARR, what mattered was candidates who had taken a business through significant growth, ideally from a similar size up to $40M to $50M ARR or more.[6]
If the score is the reason you are asking, start with when a SaaS business actually needs a CFO rather than with the title.
Common questions
What is the Rule of 40?
The Rule of 40 is a benchmark used mainly for software businesses. It adds the revenue growth rate to the profit margin, both as percentages over the same period, and asks whether the total reaches at least 40. The idea is that growth and profitability are tradeable against one another so long as the sum of the two holds. Its weakness is that the total hides the mix. Two companies can land on the same score with entirely different risk profiles, and only the split between the halves tells you which of them survives a funding market closing.
Should I use EBITDA or free cash flow for the margin?
Both are used, and the useful answer is to show both. EBITDA margin is more common and more flattering; free cash flow margin is harder to argue with, because capitalising a cost does not improve it. Putting them side by side gets the gap between them onto the page, and the size of that gap is usually more informative than either number by itself. An investor who prefers one will recalculate on their own definition regardless, so showing only the kinder figure buys nothing except a worse first meeting.
Does the Rule of 40 apply to early-stage startups?
Not really, and applying it too early causes more confusion than it resolves. At the scale-up stage the margin half is deeply negative by design, so the score sits well under 40 for reasons the founder chose deliberately. Scoring it anyway invites a board conversation about a number nobody is managing towards. Once growth has stabilised and the burn is a choice rather than a condition of being early, it becomes a genuine health check.
Who should be calculating the Rule of 40 in a startup?
In an early business it is usually the founder, put together by hand before a board meeting. The problem is not competence. It is that the person choosing the inputs is also the person the number reflects on, and no board reads that as independent. Short of hiring for it, write the definitions down once and refuse to change them mid-year. The trend then stays honest even while the level remains arguable.
References
- What I see across the market: most SaaS businesses at the scale-up stage are burning cash.
- From a live search: a client of mine is approaching $20,000,000 ARR and is profitable, which is worth saying out loud because profitability is rare in the SaaS space.
- My view on the function: finance is a commercial driver and enabler, not just a scorekeeper or back office, acting as number two next to the founder or the CEO helping them make decisions.
- What I brief for on a CFO search: for the next phase of a business a CFO needs to be a really strong commercial leader, not just from a technical skill set commerciality, but with the personality and drive to build commercial acumen across the whole business.
- How I map stage to need: a single-product SaaS might use fractional until Series C, while complex deep tech with R&D and inventory needs a finance leader sooner.
- From a CFO search I ran: the client, at $19M ARR, sought candidates who had taken a business through a period of significant growth, ideally from a similar size to $40M-$50M ARR or more.