Rule of 40
The Rule of 40 says a software firm's annual revenue growth percentage plus its EBITDA margin percentage should total 40 or more. A firm growing 50% with -10% EBITDA hits the rule (50 + -10 = 40); a firm growing 20% with 20% EBITDA also hits it (20 + 20 = 40). PE buyers use the Rule as a coarse filter for institutional readiness; venture growth investors use it as a metering signal between hypergrowth and capital efficiency. Failing the Rule below $50M ARR is recoverable; failing it above $50M ARR signals a structural problem with unit economics or capital-deployment discipline.
The Rule of 40 is a heuristic, not a model. Two firms can both score 40 with very different operational realities. A 60% grower at -20% EBITDA is burning cash to acquire revenue; a 5% grower at 35% EBITDA is harvesting an installed base. The valuation multiple the market assigns each is dramatically different despite identical Rule scores — the market discounts low-growth profitability because it implies a near-term ceiling.
Operationally, Rule-of-40 work splits into two playbooks: if you fail the Rule because of growth, the work is GTM Execution and Revenue Architecture (where 90% of misses live). If you fail because of margin, the work is Unit Economics and Financial Infrastructure (where the misses are usually CAC overspend or pricing discipline).
Related terms
- CAC Payback — The number of months a SaaS firm needs to recover the fully-loaded sales-and-marketing cost of acquiring a customer. The leading indicator of capital efficiency.
- EBITDA — Earnings Before Interest, Taxes, Depreciation, and Amortization. The proxy for operating cash flow that PE buyers use to set valuation multiples.
- Net Revenue Retention (NRR) — The percentage of recurring revenue retained from existing customers a year later, including expansion, after subtracting churn and contraction. The single most-watched B2B SaaS valuation metric.
Where this gets applied
- Unit Economics — CAC payback, NRR, gross margin by segment, cohort analysis, paid-on-bookings vs. paid-on-cash.
- Financial Infrastructure — ARR waterfalls, deferred-revenue rules, board-pack standardization, FP&A architecture.