What Is the Rule of 40?
The Rule of 40 says a healthy software company should have a revenue growth rate and a profit margin that together total 40% or more. A business growing 50% a year can justify losing money, while a business growing 5% needs strong margins to earn the same score. Venture investors, most visibly Brad Feld, popularized the heuristic around 2015, and it has since become standard vocabulary across public and private software investing.
The margin input varies by practitioner. Free cash flow margin is the most common choice because it is hard to manipulate, though EBITDA margin and operating margin appear frequently as well. Whichever measure is used, consistency matters — comparing one company's score built on adjusted EBITDA against another's built on free cash flow tilts the comparison.
How to Apply the Rule of 40
The arithmetic is deliberately simple. A company growing revenue 60% with a negative 15% free cash flow margin scores 45 and passes. A company growing 10% with a 25% margin scores 35 and falls short, even though it is solidly profitable. The rule's insight is that a point of growth and a point of margin are roughly interchangeable in the eyes of software investors.
The balance typically shifts over a company's life: young businesses clear the bar almost entirely through growth, while mature ones rely on expanding margins. Some practitioners use a weighted variant that counts growth more heavily than margin, reflecting evidence that public markets have historically paid more for a point of growth than for a point of profitability.
Why the Rule of 40 Matters
Empirically, software companies scoring above 40 have tended to command materially higher revenue multiples than those below it, which is why the metric shows up in equity research reports, growth equity screens, sponsor pitch decks, and management's own investor presentations. After 2022, when unprofitable growth fell out of favor, the rule regained prominence as a quick test of whether growth was worth its cost.
It remains a blunt instrument. The rule ignores the quality and durability of growth, says nothing about capital intensity or dilution from stock compensation, and treats a 40 achieved with 45% growth very differently in practice than one achieved with 35% margins. For interviews and diligence work, knowing both the formula and these limitations signals genuine fluency rather than buzzword familiarity.
