The Rule of 40: Your Complete Guide to SaaS Financial Health

If you're running a SaaS business, there's one metric that investors, board members, and acquirers care about more than almost any other: the Rule of 40. This simple yet powerful benchmark has become the gold standard for measuring SaaS company health. But what exactly is it, and how can you use it to drive better decisions about growth and profitability?

What Is the Rule of 40?

The rule of 40 is a performance benchmark stating that a healthy SaaS company's combined revenue growth rate and profit margin should equal or exceed 40%. This straightforward metric, popularized by venture capitalist Brad Feld, helps investors and executives evaluate how well a software company balances growth investments with profitability.

Here's the beauty of this metric: it acknowledges that SaaS companies operate on a spectrum. You might be investing heavily in growth while operating at a loss, or you might be growing slowly but generating strong profits. Both strategies can work—as long as the math adds up to 40% or more.

How to Calculate the Rule of 40

The rule of 40 formula is simple: add your annual revenue growth percentage to your profit margin percentage. But getting the inputs right matters.

Measuring Growth Rate

Use recurring revenue metrics like Annual Recurring Revenue (ARR) or Monthly Recurring Revenue (MRR) rather than GAAP revenue. For most SaaS businesses, recurring revenue provides a clearer picture of sustainable growth than one-time services or implementation fees.

Calculate your year-over-year growth rate using ARR. For example, if your ARR grew from $10 million to $13 million over the past year, your growth rate is 30%.

Measuring Profitability

For the profitability component, most SaaS companies use EBITDA margin (Earnings Before Interest, Taxes, Depreciation, and Amortization). This metric focuses on operational profitability without the complications of capital structure or non-cash expenses.

EBITDA tries to place companies on a common playing field by stripping out interest from debt, differences in taxation, and accounting policies to approximate its operating cash flow. This is why EBITDA has become the standard for Rule of 40 calculations.

The Final Calculation

Growth rate: 30% + Profit margin: 20% = Rule of 40 score: 50% This company exceeds the 40% benchmark, indicating strong financial health.

Companies can achieve this threshold through different combinations – high growth with negative margins, moderate growth with moderate profitability, or slower growth with high profitability.

Why the Rule of 40 Matters for Your Valuation

The impact on company valuation is substantial. Companies with Rule of 40 >40% get valued at 9.4x median revenue. Companies <20%? 3.5x. That's a 121% valuation premium.

Data show that investors reward companies that are at or above the Rule of 40 with consistently higher enterprise value (EV) to revenue multiples. In fact, top-quartile SaaS companies generate nearly three times the multiples of those in the bottom.

This makes the Rule of 40 more than just an academic exercise. It's a framework that directly impacts fundraising, M&A opportunities, and your company's strategic positioning in the market.

Current Benchmarks: Where Do You Stand?

The reality check might surprise you. As of Q1 2025, the median Rule of 40 score across tracked SaaS companies is 12%, with a median growth rate of 10% and EBITDA margins of just 6%. Only 11-30% of companies achieve it.

McKinsey research finds that barely one-third of software companies achieve the Rule of 40. This scarcity is precisely what makes hitting the benchmark so valuable.

There are bright spots. Only a handful of high performers, such as Doximity (55%), Klaviyo (25%), and MeridianLink (36%), are comfortably above the 40% threshold. TechnologyOne, an ASX-listed SaaS firm, reported a Rule of 40 score of 49% in the first half of 2025, demonstrating how consistent, profitable growth can be embedded as a strategic priority.

Connecting Rule of 40 to Unit Economics

The Rule of 40 doesn't exist in a vacuum—it's intimately connected to your unit economics. To improve your score sustainably, you need to understand the metrics that drive both sides of the equation.

ARR and MRR Growth Drivers

Annual recurring revenue (ARR) growth: This measure reflects a company's ability to drive topline growth, crucial for Rule of 40 performance since revenue lags behind ARR for SaaS companies (the median for top-quartile SaaS companies is 45 percent; bottom quartile is 14 percent).

Your ARR growth depends on three factors: new customer acquisition, expansion revenue from existing customers, and churn. These efforts, combined with strong pricing and product support, result in median net retention rates (NRR) of 120 percent or more—which means these businesses are able to deliver 20 percent growth every year without adding a single new customer.

Customer Acquisition Efficiency

The LTM median payback period is calculated as sales and marketing spend over the prior quarter divided by the sum of net new ARR multiplied by gross margin (the median for top-quartile SaaS companies is 16 months; bottom quartile is 47 months). If you're spending too much to acquire customers relative to the revenue they generate, you'll struggle to maintain profitability while growing.

This is where understanding your customer lifetime value (LTV) relative to customer acquisition cost (CAC) becomes critical. Strong unit economics mean each dollar you invest in growth returns multiple dollars in profit over time.

When Should You Start Tracking the Rule of 40?

SaaS companies should use the Rule of 40 metric as a benchmark when it reaches scale and maturity, with consistent recurring revenue and a validated customer base. At this stage, the Rule of 40 can be used to gauge financial efficiency and how ready you are to scale.

For early-stage companies with less than $5 million in ARR, high growth and low or negative EBITDA are the norm, as the priority is capturing market share and achieving product–market fit. In this phase, a Rule of 40 score well below 40% is acceptable as long as growth is rapid and customer retention is improving, and the score is trending upward over time.

Practical Strategies to Improve Your Score

If your Rule of 40 score needs work, here's where to focus:

Set realistic growth targets. Of the 100 SaaS businesses McKinsey analyzed in May, only the top quartile had growth rates north of 40 percent. Yet many SaaS players continue to set inflated growth projections and spend based on revenues that don't materialize quickly enough. Overspending on unrealistic growth targets kills your profitability without delivering the growth to compensate.

Focus on net retention. The most efficient growth doesn't come from new customers—it comes from expanding relationships with existing ones. Invest in customer success, identify upsell opportunities, and build products that grow with your customers.

Optimize your sales and marketing efficiency. Track your CAC payback period religiously. If it's taking longer than 16-18 months to recover acquisition costs, you have a problem that will prevent you from achieving healthy Rule of 40 scores at scale.

Mind your gross margins. SaaS EBITDA margins typically range from negative (for high-growth companies) to 30%+ for mature businesses. But sustainable SaaS businesses typically maintain gross margins of 70% or higher. If your margins are lower, investigate whether you have infrastructure inefficiencies or pricing problems.

Don't Obsess Over One Metric

While the Rule of 40 is powerful, it's not perfect. At its core, the rule of 40 SaaS focuses on the never-ending quest to balance the tradeoff between growth and profit. It's hard to have a high profit AND high growth at the same time. There's a trade-off, and you need to determine where you fall in this equation.

The Rule of 40 is most effective when paired with other metrics like CAC efficiency, churn, and customer segment profitability. This broader view helps you make smarter growth and cost decisions as you scale.

Use the Rule of 40 as your North Star metric for balanced growth, but don't sacrifice fundamental business health to hit an arbitrary number. Understanding the why behind your score matters more than the score itself.

The Bottom Line

The Rule of 40 gives you a simple framework to answer a complex question: Is your SaaS business growing efficiently? By combining growth rate and profitability into a single metric, it forces you to think about the tradeoffs between investing in expansion and maintaining financial discipline.

Most SaaS companies aren't hitting the 40% benchmark today, but those that do earn premium valuations and stronger investor interest. Whether you're at 15% or 55%, what matters is understanding your current position, tracking the trend over time, and making strategic decisions that move you in the right direction.

Start measuring your Rule of 40 quarterly, share it with your leadership team, and use it to guide conversations about where to invest your resources. Your future investors and acquirers are already looking at this number—you should be too.