Subscription metrics
Rule of 40 calculator
Growth rate plus profit margin. The idea is that a software business can trade one for the other, as long as the two together clear forty.
Usually free cash flow margin or EBITDA margin. Negative is fine.
Rule of 40 score
37%
- Distance from 40
- -3%
Rule of 40 = revenue growth rate % + profit margin %
What the rule says
A software business growing 45% a year while burning 8% of revenue scores 37. One growing 15% with a 30% margin scores 45. The rule treats those as comparable, on the view that early growth is worth sacrificing profit for and that mature businesses should convert that growth into margin.
The threshold of forty is a convention rather than a law. It became a benchmark because it is roughly where publicly traded software businesses separated into two groups.
Which margin to use
Free cash flow margin is the most common input, because it is hard to flatter. EBITDA margin is also used and usually produces a higher score for the same business, since it adds back costs that are genuinely cash leaving the building for most software companies.
Net margin is rarely used, because non-cash charges swamp the signal at small scale. Whichever you pick, say which, and do not change it between quarters.
Where the rule misleads
It is designed for businesses at scale, and it breaks at small revenue. Growing from $100k to $300k is 200% growth, which clears forty while burning 160% of revenue. That is not a signal about anything.
It also treats a point of growth as exactly equal to a point of margin, which the market plainly does not. High-growth businesses are usually valued well above a profitable slow-growing business with an identical score.
And it says nothing about retention. A business can hit forty while losing customers fast, as long as it is replacing them faster. Read it alongside net revenue retention.
Questions
- What is the Rule of 40?
- A benchmark for software businesses that adds the revenue growth rate to the profit margin. If the two together reach forty or more, the business is considered to be balancing growth and profitability well.
- Which margin should I use for the Rule of 40?
- Free cash flow margin is the most common, because it is hard to flatter. EBITDA margin is also used and usually gives a higher score for the same business. Pick one, say which, and do not change it between quarters.
- Does the Rule of 40 apply to small startups?
- Not usefully. At small revenue, growth percentages are enormous and clear forty while burning heavily. Growing from $100k to $300k is 200% growth, which passes while losing a lot of money and signals nothing.
- Is a high Rule of 40 score always good?
- Not on its own. The rule treats a point of growth as equal to a point of margin, which the market does not, and it says nothing about retention. A business can clear forty while losing customers quickly, as long as it replaces them faster.