Rule of 40 Calculator

Understanding the Rule of 40

The Rule of 40 is a key performance indicator (KPI) used to evaluate the health and efficiency of SaaS (Software as a Service) companies. It states that a healthy SaaS company’s combined growth rate and profit margin should equal or exceed 40%.

Formula: Revenue Growth Rate % + Profit Margin % ≥ 40%

This simple metric helps balance the trade-off between growth and profitability, two critical factors for SaaS success.

Why is it important?

• Investor Benchmark: VCs and investors use it to quickly assess SaaS company performance
• Strategic Balance: Helps management balance growth investments with profitability
• Performance Comparison: Enables benchmarking against industry peers
• Resource Allocation: Guides decisions on whether to prioritize growth or efficiency

How to Calculate Rule of 40

The calculation is straightforward:

1. Determine Your Growth Rate:

   • Calculate year-over-year (YoY) revenue growth percentage
   • Example: If revenue grew from $10M to $13M, growth rate = 30%

2. Calculate Your Profit Margin:

   • Use EBITDA margin for most companies: (EBITDA / Revenue) × 100
   • Use FCF margin for mature companies: (Free Cash Flow / Revenue) × 100
   • Example: EBITDA of $2M on $13M revenue = 15.4% margin

3. Add Them Together:

   • Rule of 40 Score = 30% + 15.4% = 45.4%
   • This company exceeds the Rule of 40 benchmark

Interpreting Your Score

Score Ranges:

• ≥50%: Excellent - Top-tier SaaS performance
• 40-50%: Good - Meeting industry benchmarks
• < 40%: Needs Improvement - Review strategy

Common Profiles:

1. High Growth, Low Margin (50% growth, -10% margin = 40%)

   • Typical of early-stage SaaS companies
   • Investing heavily in customer acquisition
   • Acceptable if growth is efficient (low CAC, high retention)

2. Balanced (25% growth, 15% margin = 40%)

   • Sustainable growth with healthy margins
   • Common in mid-stage companies
   • Good position for scaling

3. Low Growth, High Margin (10% growth, 30% margin = 40%)

   • Mature SaaS companies
   • Focus on efficiency and cash generation
   • May need growth initiatives to maintain valuation

When to Use EBITDA vs FCF

EBITDA Margin

• Best for: Most SaaS companies, especially growth-stage
• Advantages: Excludes non-operating expenses, easier to calculate
• Formula: (Revenue - Operating Expenses) / Revenue

Free Cash Flow Margin

• Best for: Mature SaaS companies, public companies
• Advantages: Shows actual cash generation capability
• Formula: (Operating Cash Flow - CapEx) / Revenue

Improving Your Rule of 40 Score

To Increase Growth:

• Expand into new markets or verticals
• Increase product adoption and upsells
• Improve customer retention (reduce churn)
• Launch new products or features
• Optimize pricing strategy

To Improve Margins:

• Increase operational efficiency
• Optimize customer acquisition costs (CAC)
• Improve gross margins through automation
• Reduce infrastructure costs
• Focus on higher-margin customer segments

Limitations to Consider

• Stage Matters: Early-stage companies may justifiably score below 40% while building
• Quality of Growth: Not all growth is equal - consider retention and unit economics
• Industry Context: Some verticals have different margin profiles
• Short-term vs Long-term: Temporary investments may depress scores
• Accounting Methods: Different approaches to revenue recognition affect calculations

Industry Benchmarks

Typical Rule of 40 scores by company stage:

• Early Stage (< $10M ARR): Often 20-30%, focusing on growth
• Growth Stage ($10-50M ARR): Target 35-45%, balancing growth and efficiency
• Scale Stage ($50M+ ARR): Should consistently exceed 40%
• Public SaaS Companies: Top performers maintain 50%+

Remember, the Rule of 40 is a guideline, not a rigid requirement. Use it as one of several metrics to evaluate your SaaS business health and make strategic decisions about resource allocation between growth and profitability.