Rule of 40

The Rule of 40 is a rule of thumb for software companies. According to it, revenue growth in percent and profit margin should together add up to at least 40. It helps assess whether a company maintains a healthy balance between growth and profitability. The underlying idea is simple: in a subscription business it is economically defensible to give up margin as long as that sacrifice converts into growth, because a customer won today produces revenue for years. A company that neither grows nor earns has no viable model.

A company growing at 60 percent with a margin of minus 20 percent satisfies the rule just as one growing at 15 percent with a 25 percent margin does. Which margin measure is used is decisive: free cash flow margin or adjusted EBITDA margin are customary, and results differ noticeably by definition, so comparisons are meaningful only on the same basis. The rule's limits are well known: it suits companies above a certain size with a high share of recurring revenue, says nothing about the quality of growth or about retention, and treats growth and margin as equivalent even though investors generally weight growth more heavily.

In practice it serves as a quick filter rather than a valuation method. For companies below roughly 10 million euros of revenue the rule tells you little, because growth rates on a small base easily produce high readings.