Rule of 40
A SaaS-investing heuristic: a healthy software company's growth rate plus its profit margin should sum to at least 40. The rule trades growth for profitability — either 40% growth with 0% margin or 0% growth with 40% margin clears the bar.
Rule of 40 is a SaaS valuation heuristic that says a healthy software company's annual growth rate plus its profit margin should be at least 40%. The rule was popularized by Brad Feld in a 2015 blog post and has since become a standard public-market and late-stage VC benchmark.
Growth Rate (%) + Profit Margin (%) ≥ 40
Either definition of margin is acceptable depending on stage — EBITDA margin for mature companies, FCF margin for public companies, gross-margin-adjusted contribution for early-stage.
Examples
- Snowflake (FY 2023): 36% growth + 4% FCF margin = 40 ✓
- Datadog (FY 2023): 27% growth + 26% FCF margin = 53 ✓ (well above)
- A hypothetical struggling SaaS: 15% growth + 8% loss margin = 7 ✗
The 40 threshold isn't magic — it's an empirically observed bar where best-in-class SaaS companies tend to cluster across stages. Companies under 40 typically trade at lower revenue multiples in public markets.
When the Rule of 40 misleads
The Rule of 40 is most reliable for mid-to-late-stage SaaS. It can mislead at early stage where growth is volatile and margin is heavily influenced by one-time hires. It also undercounts companies investing heavily in distribution to capture a winnable market — high burn now in exchange for category dominance later may produce a 'failing' Rule of 40 score that VCs nonetheless rationally fund.
The other failure mode: optimizing for the metric itself. A team can clear 40 by cutting R&D spend, which boosts margin in the short term but compromises the product roadmap. Use Rule of 40 as a diagnostic, not as a target.