For SaaS founders, mastering the Rule of 40 is no longer optional—it’s essential. Focusing solely on growth or profitability won't be enough as the market grows more competitive and investor expectations rise.
The Rule of 40 combines a company’s revenue growth and profitability into a straightforward calculation: the total of your growth rate and EBITDA profit margin should equal or exceed 40%. This rule helps SaaS companies balance rapid expansion and financial stability, ensuring long-term sustainability.
In this article, we’ll break down the Rule of 40, explain how to calculate it, and explore why it’s one of the most important metrics you need to track in 2025.
Understanding the Rule of 40
The Rule of 40 is an important performance benchmark for SaaS companies. While it’s a relatively simple concept, it is highly effective in evaluating a company’s balance between growth and profitability.
The Rule of 40 originated in the SaaS industry as a guideline to help investors and founders assess the long-term sustainability of a SaaS business model. Venture capitalist Brad Feld popularized the concept in 2015. As SaaS companies tried to understand how to prioritize both recurring revenue and long-term customer retention, the Rule of 40 emerged as a balancing act between growth and profitability.
The Rule of 40 simply states:
Revenue Growth Rate (%) + EBITDA Margin (Profit Margin) (%) ≥ 40%
To meet the Rule of 40, a company’s total revenue growth rate and profit margin must be 40% or higher. If a SaaS company is growing rapidly, it may operate at a loss and still be considered an attractive proposition (i.e. revenue growth of 100% and EBITDA margins of -50%). Alternatively, a company with slower growth may need to focus on improving profitability to hit the Rule of 40.
When to Use the Rule of 40
The Rule of 40 provides the most value for mature SaaS companies with established business models. Early-stage startups often prioritize aggressive growth over immediate profitability, making this metric less applicable since the company is only focusing on half of the equation. Companies typically find the Rule of 40 most meaningful:
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- After achieving product-market fit
- When scaling beyond initial growth phases
- When balancing growth investments with a path to profitability
- For comparative analysis with similar companies in the market
How to Calculate the Rule of 40
To apply the Rule of 40, you need to calculate two key metrics: revenue growth and EBITDA margin.
Step 1: Calculate Revenue Growth Rate
Revenue growth rate measures how much a company’s revenue has increased compared to the previous period, typically annually. For SaaS companies, the revenue growth rate is often measured using Annual Recurring Revenue (ARR). To calculate ARR:
Monthly Recurring Revenue (MRR) = Total Active Customer Accounts × Average Revenue Per Account (ARPA)
ARR = MRR × 12 months
Once you have ARR for both the current and previous periods, calculate the revenue growth rate:
Revenue Growth Rate = (Current Year ARR – Prior Year ARR) ÷ Prior Year ARR
Step 2: Calculate the EBITDA Margin
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) measures profitability by excluding non-operational expenses and focusing on core operations. In other words, it shows how efficiently a company turns revenue into profit. The formula is:
EBITDA Margin (%) = EBITDA ÷ Revenue
Step 3: Apply the Rule of 40 Formula
Now, add the revenue growth rate and EBITDA margin:
Revenue Growth Rate (%) + EBITDA Margin (Profit Margin) (%) ≥ 40%
Calculating the Rule of 40 for a SaaS Company
Let’s consider a hypothetical SaaS company, TechSolutions, with the following financial data for the current year:
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- Annual Recurring Revenue (ARR) at the start of the year: $18 million
- ARR at the end of the year: $20 million
- EBITDA for the year: $2 million
- Revenue for the year: $22 million
To calculate TechSolutions’ revenue growth rate:
Revenue Growth Rate = ($20 million – $18 million) ÷ $18 million = 11.11%
To calculate TechSolutions’ EBITDA margin:
EBITDA Margin = $2 million ÷ $22 million = 9.09%
Now, apply the Rule of 40:
Rule of 40 = 11.11% + 9.09% = 20.2%
TechSolutions falls short of the Rule of 40, as its combined growth rate and EBITDA margin total 20.2%. The company might still be considered strong: after all, it’s growing and turning a profit. However, to meet the Rule of 40 and be more attractive to investors, the company needs to either accelerate revenue growth or improve profitability.
Growth vs. Profit: Exploring the Trade Off
In the early stages of growth, companies often prioritize expanding their customer base and increasing revenue, which typically leads to negative or low profit margins. In contrast, focusing on profitability usually means slowing down growth to optimize efficiency, limiting the company’s ability to scale rapidly.
Tech companies generally fall into three groups that influence how the Rule of 40 is applied:
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- Growth Stage: At this stage, revenue growth is the primary driver. The company may be operating at a loss, with profit margins often negative, but the focus is on scaling quickly. The Rule of 40 is typically met through strong growth rates rather than profitability.
- Balanced Stage: Companies in this phase aim to balance growth and profitability. Both revenue growth and profit margins contribute meaningfully to the Rule of 40, signaling a more mature, sustainable approach to scaling.
- Profitable, Stable Stage: At this point, the company focuses on profitability, with stable revenue growth and high profit margins. Growth may slow, but profitability becomes the dominant contributor to the Rule of 40.
Why is the Rule of 40 Important for SaaS Companies?
When you meet or exceed the Rule of 40, you can demonstrate your company’s ability to scale responsibly and maintain financial health. But what exactly does that mean?
Here are the three reasons why the Rule of 40 is important:
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- It Helps You Balance Growth and Profitability: The Rule of 40 allows companies to balance aggressive revenue growth and maintaining profitability. Focusing disproportionately on growth can lead to unsustainable losses, while prioritizing profit can limit expansion.
- It Operates as a Benchmark for Company Health: The Rule of 40 is a clear benchmark for evaluating a company’s financial health. It provides a quick snapshot of whether a SaaS company is scaling efficiently.
- It Attracts Potential Investors: Investors use the Rule of 40 as a key metric to assess a company's potential. It signals that a business is managing its growth and profitability well, making it an attractive investment opportunity. Meeting the Rule of 40 can lead to stronger investor confidence, higher valuations, and better funding opportunities.
Build More Comprehensive Financial Metrics with G-Squared Partners
The Rule of 40 is a valuable benchmark for assessing the balance between revenue growth and profitability in SaaS companies. Combining these two factors gives you a snapshot of your company’s financial health and scalability.
However, it’s important to remember that the Rule of 40 is just one metric among many that SaaS companies should track. How you use this metric depends on your company’s growth stage and overall strategy.
At G-Squared Partners, we have a team of expert SaaS accountants ready to handle your financials. Whether focusing on growth, profitability, or finding the right balance between the two, we can help you select and track the right metrics to guide your strategy and achieve long-term success.
Schedule a call with G-Squared Partners today to learn how we can help you build a robust financial strategy.
