TL;DR: The Rule of 40 is a guideline for software companies stating that a healthy business should have its revenue growth rate plus its profit margin sum to at least 40%. It balances growth against profitability, recognising that a company can be healthy by excelling at either or both.
The Rule of 40 is a simple heuristic for assessing the health of a software business. Add the company's revenue growth rate to its profitability margin (most commonly EBITDA or free cash flow margin); if the total is 40% or more, the business is generally considered to be in good shape. The logic is that growth and profitability are both valuable, and a company can compensate for less of one with more of the other.
A company growing 50% while running a -10% margin scores 40 and passes. So does a company growing 10% at a 30% margin. The rule captures the trade-off founders constantly manage: spend to grow, or hold back to show profit.
The Rule of 40 gives a quick read on whether a company's growth is being achieved at a reasonable cost. A business that grows fast while bleeding cash, or grows slowly with thin margins, falls short and warrants closer scrutiny. For a lender, a healthy Rule of 40 score is one signal among several that growth is efficient and the revenue base can support a facility.
Which profit margin should be used? Commonly EBITDA margin or free cash flow margin. Consistency matters more than the specific choice; use the same measure when comparing over time.
Is the Rule of 40 a hard threshold? No. It is a guideline, most relevant for scaled software companies, and it is best used alongside other measures rather than as a single pass-fail test.
Related terms: EBITDA · Gross Margin · Unit Economics · Annual Recurring Revenue
