The Rule of 40: How to Calculate It and When It Does Not Apply to Your Business

The Rule of 40 says a company's growth rate plus its profit margin should reach 40 percent. You add the two numbers together. If the total is 40 or higher, the company passes. If it is lower, the growth, the profit or both need work. It is a quick health check, not a law, and it was written for software companies at scale. This guide shows how to calculate the rule of 40 step by step and where it stops being useful.

By Avi Vatsa, CEO, Exchange Four Agency. Avi leads the team that installs and runs AI-leveraged revenue systems for owner-led companies. His background spans law, technology, and marketing; he also co-founded Dialora, an AI voice-agent platform for automated lead capture and booking. (Marketer of the Day #1411)

What is the Rule of 40?

It is one test that balances growth and profit. A business can grow fast and lose money. It can make money and barely grow. The rule asks whether the two together add up to enough.

Brad Feld states it in one line:

"The 40% rule is that your growth rate + your profit should add up to 40%."

Bain & Company words it a little differently:

"Large software companies are, increasingly, measured against the Rule of 40: the idea that growth rate plus profit margin should exceed 40%."

Feld says add up to 40 and Bain says exceed 40. The gap is small. Decide whether exactly 40 counts as a pass, and use the same rule every time you report the score.

Where did the Rule of 40 come from?

Bain traces the spread of the rule to investors:

"Venture capitalists began to popularize the Rule of 40 in 2015 as a high-level health check for SaaS companies"

SaaS means software sold as a subscription. Feld published his own write-up the same year, in a post titled The Rule of 40% For a Healthy SaaS Company. We have not traced the rule back further than these two pages, so we do not credit it to any one person.

Two things follow. The audience was investors judging software companies. And a health check tells you whether to look closer. It does not tell you what is wrong.

How do you calculate the Rule of 40, step by step?

The formula is short: score = growth rate + profit margin. Here is the order of work.

1. Pick one period. A trailing twelve months is a common choice. Use the same period for both inputs.
2. Calculate the growth rate. Take the current figure, subtract the figure from a year earlier, then divide by the figure from a year earlier. Write the answer as a percentage.
3. Pick a profit measure and calculate the margin. Divide that profit by revenue for the same period. Write the answer as a percentage.
4. Add the two percentages. The sum is the score. Treat each as percentage points, so 20 percent growth and a 25 percent margin make 45.
5. Compare the score with 40. Then write down which growth measure and which profit measure you used, next to the score.

The last step is the one people skip. The score looks precise, but it depends on two choices the rule leaves open. The next two sections cover them.

Which growth measure should you use?

There is no single answer. Feld names his preference:

"Just do year-over-year growth rate of monthly MRR."

MRR means monthly recurring revenue, the subscription revenue a company bills in a month. Year over year means you compare this month with the same month a year ago, which keeps seasonal swings out of the number. Other teams use total revenue growth or annual recurring revenue growth.

Pick the one that matches how your business earns money, and keep it. A revenue run rate projects a recent month forward, so check how it was built before you feed it into a growth rate.

Which profit measure should you use?

This is the harder choice. Feld says so himself:

"Profit is harder to define. Are we talking about EBITDA, Operating Income, Net Income, Free Cash Flow, Cash Flow or something else."

EBITDA is earnings before interest, taxes, depreciation and amortization. Free cash flow is the cash left after the business pays its operating costs and its capital spending. The two can differ a lot in the same year.

Bain reports the same split. It notes that analysts have differed, that most use EBITDA, and that free cash flow, EBIT and net income have been proposed as alternatives. This is a summary of Bain, not a quote.

EBITDA is closer to the operating result. Free cash flow is closer to the money you can spend. To see why profit and revenue answer different questions, read revenue versus profit for the difference.

What does a worked example look like?

This is an illustrative example. The numbers are invented to show the arithmetic. They are not a benchmark and not a real company.

Work out the inputs first.

1. Revenue growth: ($10,800,000 minus $9,000,000) divided by $9,000,000 = $1,800,000 divided by $9,000,000, which is 20 percent.
2. MRR growth: ($1,000,000 minus $800,000) divided by $800,000 = $200,000 divided by $800,000, which is 25 percent.
3. EBITDA margin: $2,700,000 divided by $10,800,000, which is 25 percent.
4. Free cash flow margin: $1,080,000 divided by $10,800,000, which is 10 percent.

Now add them in each combination.

Same company, same year, and the score runs from 30 to 50. Two of the four versions pass and two fail. Only the definitions changed between rows. This is why the measures have to travel with the number.

What does a passing score tell you?

Less than it seems. A score is a sum, and a sum hides how it was made. In another illustrative case, a company growing 30 percent with a 10 percent margin scores 40. So does a company growing 10 percent with a 30 percent margin. One is spending hard to expand. The other is mature and profitable. They have the same score and need different decisions.

Time matters too. Bain makes the point about consistency:

"Beating the Rule of 40 in a single year is admirable, but the greater challenge is balancing growth and performance year after year."

One good year can come from a one-off sale or a pause in hiring. A score that holds across several periods is easier to trust.

Does the Rule of 40 apply to small companies?

The sources we read do not say that it does. Feld's post carries a condition on scale. He says the figures are for SaaS companies at scale, and then names the size:

"assume at least $50 million in revenue"

Bessemer publishes a related measure. Be clear about what that is. Bessemer Venture Partners defines an efficiency score, and its page does not define the Rule of 40 itself, so we do not credit the rule to Bessemer. Here is how it states its score:

"Efficiency score equals FCF margin of ARR plus ARR year-over-year growth rate"

FCF means free cash flow and ARR means annual recurring revenue. The shape is the same: a margin plus a growth rate. On the size at which that score makes sense, Bessemer says:

"it is generally only applicable after achieving $25MM+ of ARR (before which revenue bases are too small for it to be meaningful)"

That sentence is about Bessemer's score, not the rule itself. It still points the same way: a small revenue base makes the ratio unstable.

Here is our own reading, from arithmetic and not from the sources. In an illustrative case, a company that grows from $200,000 to $300,000 of revenue has grown 50 percent by adding $100,000. The percentage looks large, and it says little about whether the business is healthy. On the profit side, an owner-led company often has a margin set by what the owner pays themselves, which varies from one company to the next.

If you run a smaller company, use the rule as a conversation starter at most. Track your own growth and margin against your own history, and read them beside cash in the bank.

Does the Rule of 40 work outside software, or for hardware?

Feld wrote a separate post on this in 2026. His opening line is blunt:

"Point the Rule of 40 at a young hardware company and it looks broken."

He goes on:

"A hardware company doing everything right can fail the Rule of 40 for years."

His reason is about how the money arrives:

"Revenue often comes as one-off sales instead of a subscription, and even when recurring revenue shows up, it builds over time."

The rule was built around subscription revenue, where growth in monthly revenue is a clean signal. A one-off sale does not repeat on its own, so growth swings with each order. Feld ends the post with a rule of his own:

"Match the metric to the business model."

Our reading for a services firm or an agency is this. If your revenue comes from retainers, the recurring part is real, and a recurring measure fits. If it comes from projects, it does not. Net revenue retention shows whether the recurring base is growing or shrinking, and net revenue is the figure underneath both growth and margin.

What should you ask for when someone quotes the score?

A score without its working is a claim, not a measure. Ask for these:

1. The growth measure. Revenue, MRR or ARR, and over what period.
2. The profit measure. EBITDA, free cash flow or something else, and why.
3. The revenue scale. Ask how far the business is from the size the sources describe.
4. The revenue model. How much is recurring and how much is one-off.
5. The trend. Several periods, not one.

What is the short version?

The Rule of 40 adds a growth rate to a profit margin and asks for 40 or more. The sum is easy to compute and easy to move by changing a definition. It was written for software companies at scale, and the sources we read do not say it applies to small companies. For one-off-sale businesses, Feld says to match the metric to the business model. Use it as a health check, state both measures every time, and look at the trend, not one year.