The Rule of 40 Guide for SaaS Companies: Balancing Revenue Growth And Profitability

The Rule of 40 is a key metric for evaluating SaaS companies’ financial health. It combines a company’s revenue growth rate and profitability, usually measured by EBITDA margin, with a target sum of at least 40%. Popularized by venture capitalist Brad Feld in 2015, it helps assess whether a company balances rapid growth with sustainable profits.



This guide is for SaaS founders, executives, and investors aiming to master the balance between growth and profitability. Understanding the Rule of 40 is vital as it influences valuation, capital strategy, and operational decisions.

In SaaS, where subscription revenue drives predictable, recurring income, the Rule of 40 offers a quick snapshot of performance. Revenue growth is typically measured by monthly recurring revenue (MRR) or annual recurring revenue (ARR), while profitability is often gauged via EBITDA. Private equity investors and strategic buyers widely use this metric to evaluatethe balance between growth and profitability.

The Rule of 40 applies mainly to SaaS companies at scale—usually those with at least $1 million in MRR or $15–$20 million in ARR. It’s better suited for mature companies, as younger ones tend to show more volatility. Applying this rule helps SaaS businesses optimize growth strategies, improve efficiency, and build scalable, profitable operations for long-term success.

1. The Real Problem

For a decade, SaaS founders were rewarded for speed.

Rapid revenue growth often led to funding, while widening losses were labelled as “strategic investment” and high burn rates as “aggressive scaling.”

This approach is no longer favoured.

Today, capital is allocated more selectively, boards are cautious, and valuation multiples decline rapidly as efficiency declines.

The Rule of 40 is central to this shift.

It is not a vanity metric; it is a meaningful indicator.

If your revenue growth rate + profit margin ≥ 40%, you’re considered structurally healthy. However, only a handful of software companies achieve this benchmark—many SaaS companies fall short.

How rare is Rule of 40 performance?

McKinsey analyzed more than 200 software companies from 2011–2021 and found that:

• Only about one‑third achieved a Rule of 40 score ≥ 40% in any given year.
• Across all company‑years, the Rule of 40 threshold was exceeded only ~16% of the time.

In other words, consistently operating at or above the Rule of 40 is the exception, not the norm, even among public SaaS names.

Falling below this threshold indicates insufficient growth or inefficiency.

Markets may fluctuate. The discipline doesn’t.

The Rule of 40 is particularly useful in venture capital and private equity, where it helps evaluate SaaS companies for potential investment by balancing growth and profitability. It is valuable for both investors and internal planning, but timing matters. When and how a company achieves the Rule of 40 can significantly impact its attractiveness to venture capital.

2. What Most Leaders Get Wrong

Mistake #1: Treating It as a Pass/Fail Badge

The goal is not simply to reach a score of 40.

The goal is to build a durable engine that can fund growth without constant rescue capital.

The Rule of 40 score is a diagnostic tool, not the ultimate objective.

Mistake #2: Gaming the Margin

Cut marketing for one quarter. Freeze hiring. Delay cloud optimization projects. EBITDA improves temporarily. Growth slows quietly.

Your Rule of 40 “passes.” Your pipeline collapses six months later.

Short-term optimizations can undermine long-term growth.

Mistake #3: Ignoring Stage Context

A $5M ARR startup at 120% growth and -60% margin has a 60 Rule of 40 score.

Impressive? Maybe.

But if CAC payback is 36 months and churn is rising, you’re not “healthy.” You’re fragile.

Context matters more than the number.

The Rule of 40 does not account for differences in business models or life-cycle stages, which can lead to skewed analysis when comparing companies at different stages. For example, an early-stage SaaS company may prioritize rapid growth and scalability over profitability, while a more mature company may shift its focus toward profitability over growth. However, the Rule of 40 applies the same standard to both, so it's important to consider the company's stage when interpreting the metric.



3. The Framework

The Formula

Rule of 40 = Revenue Growth Rate (%) + Profit Margin (%) (both calculated YoY)

Typically:

• Growth = Year-over-Year ARR growth
• Margin = EBITDA margin (or Free Cash Flow margin, consistently applied)



Example:

But interpretation depends on structure.



4. Mechanics: Measuring Correctly

A. Revenue Growth

Use ARR unless you are sub-scale and operating purely monthly.

If using MRR:

ARR = MRR × 12

Monthly Recurring Revenue (MRR) is calculated as the total number of active accounts multiplied by the average revenue per account (ARPA). Annual recurring revenue (ARR) is calculated by multiplying MRR by 12 months. Some companies may use total revenue as the basis for Rule of 40 calculations, especially when ARR or MRR is unavailable.

Year-over-Year Growth:

(Current ARR – Prior ARR) / Prior ARR

Example:

• ARR 2023: $20M
• ARR 2024: $30M

Growth = ($30M – $20M) / $20M = 50%

Be precise. Don’t mix GAAP revenue and ARR. Investors will notice. Ask yourself: Are we mixing GAAP and ARR anywhere? A quick self-audit helps ensure rigour.

B. Profitability Margin

Choose one:

• EBITDA Margin (common for growth equity and PE)
• Free Cash Flow Margin (stronger signal for durability)

Formula:

Margin = Profit / Revenue

EBITDA margin is a profitability metric that helps assess a company’s financial health by focusing on earnings before interest, taxes, depreciation, and amortization. Notably, EBITDA excludes interest expense, which is a non-operating expense, to provide a clearer view of operational profitability. Improving cost efficiency is a key lever for enhancing profitability margins and supporting long-term profitability.

If EBITDA = -$3M on $30M ARR:

Margin = -10%

Be consistent across periods. Switching definitions mid-stream destroys credibility.

Benefits of the Rule of 40

Balanced Growth and Profitability

• Encourages SaaS companies to pursue revenue growth without sacrificing profit margins, ensuring a healthy balance that supports long-term sustainability.

Profitable Growth Focus

• Top-performing and healthy SaaS companies prioritize profitable growth by balancing revenue expansionwithd profit margins, which is essential for sustainable performance and higher company valuations.

Operational Efficiency

• By tracking both revenue growth rate and profitability, management teams can pinpoint inefficiencies and make targeted improvements across the business.

Investor Attractiveness

• A strong Rule of 40 score signals to investors that the company can balance growth and profitability, making it more appealing to fund and acquire.

Better Decision-Making

• The Rule of 40 provides a clear framework for making informed choices about growth strategies, resource allocation, and investment priorities.

Enhanced Customer Success

• Focusing on customer retention and recurring revenue streams helps drive both revenue growth and profitability, strengthening customer success metrics.

Competitive Advantage

• SaaS companies that consistently achieve a high Rule of 40 score can differentiate themselves in the market and establish leadership positions.

Scalable Growth

• The Rule of 40 supports scalable growth by ensuring that rapid expansion is matched with disciplined cost management and strong profit margins.

Improved Management Teams

• It pushes management teams to develop the skills and discipline needed to balance growth and profitability, leading to more effective leadership.

Increased Enterprise Value

• Companies with strong Rule of 40 performance often command higher enterprise values, attracting premium valuations from investors and buyers. Companies consistently exceeding the Rule of 40 tend to trade at higher revenue multiples, reflecting both growth and profitability.

Better Financial Modelling

• The Rule of 40 serves as a foundation for robust financial modelling, helping SaaS companies forecast future growth and profitability with greater accuracy.

By leveraging the Rule of 40, SaaS businesses can build a foundation for efficient growth, operational discipline, and long-term success in the fast-evolving SaaS sector.



Evaluating SaaS Company Performance

A Holistic Approach to Performance

Evaluating the performance of SaaS companies requires a holistic approach that goes beyond simply tracking top-line growth. While revenue growth is a critical indicator of market traction and business momentum, it must be considered alongside profit margins, customer acquisition cost, and overall cash flow.



The Role of the Rule of 40

The Rule of 40 has emerged as a key metric in the SaaS industry, providing a clear benchmark for balancing a company’s revenue growth rate with its profitability margin.

For management teams, the Rule of 40 provides a practical framework for assessing whether their SaaS business is achieving healthy, sustainable growth. By comparing revenue growth rates and profit margins, leaders can quickly identify if their company is prioritizing rapid growth at the expense of profitability, or vice versa.

For example, a SaaS company experiencing high growth but thin profit margins may need to focus on improving sales efficiency, optimizing customer acquisition strategies, and reducing churn to strengthen its bottom line. Conversely, a business with robust profit margins but a low growth rate might consider investing more aggressively in customer acquisition or expanding into new markets to accelerate future growth.

Balancing Growth and Profitability

In the fast-paced SaaS sector, high growth can attract premium valuations and investor interest, but unchecked expansion can also strain cash flow and erode profitability. The Rule of 40 helps management teams strike the right balance, ensuring that growth initiatives are supported by sound financial discipline.

By regularly tracking this key metric, SaaS companies can make informed decisions about resource allocation, identify areas for operational improvement, and benchmark their performance against industry peers.

Ultimately, the Rule of 40 empowers SaaS businesses to pursue both growth and profitability, positioning them for long-term success in a highly competitive market.

5. Interpreting the Tradeoff

The Rule balances speed and efficiency.



Here’s how that plays out:

Tradeoff matrix:

• High Growth + High Margin = Elite
• High Growth + Low Margin = Venture-dependent
• Low Growth + High Margin = PE candidate
• Low Growth + Low Margin = At risk



Growth stage companies often prioritize the SaaS company's growth rate, but a high Rule of 40 can be misleading if growth and margin are out of balance, such as when rapid growth is accompanied by significant cash burn.

You’re not just managing a metric. You’re choosing your capital strategy.

6. Benchmarks by ARR Band

Industry data (various public SaaS analyses over the past several years) consistently show:

• Public SaaS median Rule of 40 often clusters around 35–45%. Recent analyses of public SaaS cohorts show a median Rule of 40 score in the low‑to‑mid 20s, with only a minority of companies consistently exceeding the 40% benchmark.
• Across multiple studies, SaaS companies at or above the Rule of 40 consistently trade at higher revenue multiples than peers, and those with scores in the 50%+ range often sit in the top valuation quartile. Several analyses (McKinsey, Software Equity Group, Aventis Advisors) find that a 10‑point increase in Rule of 40 is associated with roughly +1–2x in EV/Revenue multiple, all else equal.
• Companies with sub‑20% Rule of 40 scores generally trade at discounted revenue multiples relative to peers, while those consistently above 40–50% tend to command premium valuations.



Companies consistently exceeding the Rule of 40 tend to trade at higher revenue multiples, and public SaaS companies with strong Rule of 40 scores typically enjoy higher revenue multiples.

Cohort differences:

The expectation shifts as you scale. The Rule of 40 is most applicable to SaaS companies that have reached scale, often defined as at least $1 million in MRR or $15–$20 million in ARR. For smaller companies, especially those in early stages or below these thresholds, the Rule of 40 should be used as a trend metric to track progress over time rather than as a strict benchmark during the growth phase.



7. Real-World Scenarios

Scenario 1: The Rocket Ship

$25M ARR. 70% growth. 45% EBITDA

Score = 115

Investors ask:

• What is CAC payback?
• What is net retention?
• Is burn funding durable?

At this stage, SaaS companies often prioritize customer acquisition and retention over increasing gross margins, focusing go-to-market spending on effective customer acquisition strategies to drive long-term growth and business valuation. Acquiring customers—both new customers and expanding relationships with existing customers—is a key focus for sales teams in early-stage SaaS companies.



If capital tightens, this company struggles.

Scenario 2: The Cash Machine

$80M ARR. 12% growth. 30% EBITDA

Score = 42

Private equity loves this. Growth equity? Less excited.

Capital type depends on score composition.

Scenario 3: The Balanced Engine

$40M ARR. 35% growth. 10% EBITDA

Score = 45

This company can:

• Raise capital on favourable terms
• Choose not to
• Self-fund expansion

Optionality is the real win.

8. Using It in Financial Modelling

You should not “check” the Rule of 40 after the fact.

You should design toward it.



In your model:

1. Set ARR growth assumptions
2. When forecasting revenue growth, consider the total addressable market to ensure your assumptions are realistic and aligned with market potential.
3. Layer gross margin assumptions
4. Forecast CAC efficiency
5. Model operating expense leverage
6. Derive EBITDA

Then:

Run sensitivity:

Which lever is easier to pull?

• Improve pricing?
• Reduce cloud costs?
• Increase net retention 5%?



This becomes capital allocation logic.

How to Improve Your Score

Revenue Levers

• Increase Net Revenue Retention. Best-in-class B2B SaaS often reports net revenue retention (NRR) in the 115–130% range, especially in mid-market and enterprise segments. Across multiple benchmark studies, an NRR > 120% is commonly used as a threshold for 'elite' cohorts.
• Reduce churn
• Expand ARPA via pricing refinement
• Focus GTM spend on high-LTV segments



To focus efforts more effectively, prioritize these revenue levers based on both their impact and probability of success. Implementing an expected-value table can help rank these levers, channelling resources where they are likely to yield the largest upside.

Margin Levers

• Optimize cloud infrastructure
• Shorten CAC payback
• Eliminate low-ROI channels
• Tie executive bonuses to efficiency metrics

The best companies do not cut growth to gain margin. They improve unit economics.

10. Risks and Failure Modes

• One-time layoffs inflate margin
• Delayed product investment erodes retention
• Accounting inconsistency destroys trust
• Growth fueled by unsustainable discounting



The Rule of 40 punishes shortcuts in the long run.

11. What’s Likely Next

AI Efficiency Compression

AI is lowering:

• Engineering costs
• Support costs
• Content production costs



This may raise expected margin baselines.

Early evidence suggests AI can lower engineering, support, and content costs. If AI enables a structural 5–10‑point margin improvement in SaaS over time, investors are likely to ratchet up their expectations accordingly—even though the full impact isn’t yet visible in large‑sample data.

Uncertain? Yes.

But directionally clear.

Capital Bifurcation

The gap between:

• 50+ Rule of 40 companies
• Sub-20 companies

Will widen.

Top quartile companies will raise capital easily. The middle will struggle.

Private Market Discipline as Default

Even earlier-stage investors are emphasizing:

• Gross margin durability
• CAC payback discipline
• Efficiency ratios

“Growth at any cost” is unlikely to return as a norm.

12. Monday Morning Playbook

• Calculate your trailing 12-month Rule of 40
• Validate inputs (ARR definition, margin consistency)
• Run two scenarios:
• +5% growth
• +5% margin
• Identify which lever is more realistic
• Build a monthly dashboard
• Annotate one-offs
• Tie executive incentives to multi-quarter improvement

Board slide format:

Slide 1: Growth, Margin, Score trend (8 quarters)
Slide 2: Operational drivers behind movement

Clarity builds trust.



13. Self-Qualification

You should be thinking seriously about the Rule of 40 if:

• You are >$10M ARR. SaaS companies should use the Rule of 40 metric as a benchmark when they reach scale and maturity. The Rule of 40 is generally better suited to mature companies than to startups, as younger companies exhibit greater volatility in growth and profitability. Most investors treat the Rule of 40 as most meaningful once a SaaS company has reached meaningful scale (e.g., >$5–10M ARR) and has a reasonably stable business model. Early‑stage startups should prioritize unit economics first and treat the Rule of 40 as directional at best.
• You are planning to raise in 12–24 months
• Your burn multiple is rising
• Your Board is asking tougher questions

If you cannot clearly explain:

• Why your score is what it is
• What levers move it
• How does the capital strategy tie to it?

Then you’re managing reactively.

The strongest companies don’t optimize a metric.

They build engines that make strong metrics inevitable.



If this framework sharpened how you think about growth, efficiency, and capital structure, you already understand the difference between reporting performance and designing it.

That’s the level where serious companies operate.

Conclusion

The Rule of 40 is a vital metric for SaaS companies aiming to achieve efficient growth and operational efficiency in the dynamic SaaS industry. By providing a clear framework for balancing growth and profitability, the Rule of 40 enables management teams to make data-driven decisions that support long-term growth and value creation.



SaaS companies that consistently monitor and optimize their Rule of 40 score are better equipped to prioritize growth, maintain healthy profit margins, and secure premium valuations in the marketplace.

As the SaaS sector continues to evolve, companies that embrace the Rule of 40 will be well-positioned to outperform their peers. By focusing on this key metric, management teams can drive sustainable growth, enhance operational efficiency, and deliver lasting value to stakeholders.

In a landscape where high growth and profitability are both essential for success, the Rule of 40 remains an indispensable tool for guiding SaaS businesses toward their strategic goals and ensuring long-term competitiveness.

Footnotes:

[1] Charles Chen et al., “SaaS and the Rule of 40: Keys to the critical value‑creation metric,” McKinsey & Company, 2021. McKinsey analyzed 200+ software companies (2011–2021) and found that companies met or exceeded the Rule of 40 in only ~33% of cases, and just 16% of company‑years.
[2] “Rule of 40 Lessons from the Top Performers in Software,” Boston Consulting Group, 2025. BCG’s benchmark of 100+ private B2B SaaS companies shows that only a minority exceed the Rule of 40, and that larger, more scaled businesses are significantly more likely to do so.
[3] “The Rule of 40: Understanding a Key Metric for SaaS Success,” Software Equity Group, 2025. SEG shows that public SaaS companies with strong (weighted) Rule of 40 scores typically enjoy higher EV/Revenue multiples than peers.
[4] “Growth, Profitability, and the ‘Rule of 40’ for Private SaaS Companies,” SaaS Capital, 2025. SaaS Capital’s analysis of private B2B SaaS data shows declining median Rule of 40 scores in recent years and a clear linkage between growth, profitability, and private valuation multiples.