Rule of 40

What is the Rule of 40?

Rule of 40 (in German Regel der 40) refers to a rule of thumb for software companies under which revenue growth and profit margin in percent should together amount to at least 40. The profit margin is the profit in relation to revenue. The sum is also called the Rule of 40 score. If a company grows by 30% and achieves a margin of 10%, the rule is met. At 60% growth, even a loss of 20% of revenue is still compatible. The metric condenses the trade-off between growth and profitability into one number. Losses are considered acceptable if matched by corresponding growth, low growth if the company achieves high margins in return.

The metric comes from the practice of growth and venture capital investors in the US software market and is now also used in Europe. It is common above all for subscription software (software as a service, SaaS). Analysts of listed software stocks also use it. It appears in documents for investors, in analyses ahead of growth-stage funding rounds, in due diligence and when comparing valuation multiples. There is no legal basis or binding definition.

Calculating the Rule of 40: formula and components

Formula: Rule of 40 value = revenue growth in percent + profit margin in percent. The rule is met if the value is at least 40.

Both quantities relate to the same period, as a rule the last financial year or the last twelve months.

Growth component

What is usually measured is revenue growth compared with the same period of the previous year (year over year growth, YoY growth for short). For subscription models it is often the growth of annual recurring revenue (ARR). One-off revenue from implementation projects or licence sales distorts the picture and is therefore often reported separately. Growth through acquisitions must be separated from organic growth, because it is bought with capital and says nothing about the company's own sales performance.

Profit component

The margin used is usually the EBITDA margin, that is, EBITDA (earnings before interest, taxes, depreciation and amortisation) divided by revenue, a variant of the return on sales. Stricter is the margin of free cash flow, that is, the cash surplus after investments. It also captures spending that EBITDA does not touch, for example on hardware, on development costs booked as an asset (capitalised) and on growing receivables from customers. If an adjusted EBITDA is used, the adjustments must be disclosed. Which margin is used matters less than applying it consistently across all periods.

Variants of the metric

Besides the basic form, variants are common. Some investors weight growth more heavily than margin. The reason: growth in recurring revenue has an effect over many years, whereas a higher margin can also be achieved in the short term through savings in sales. Others use the operating margin after depreciation or adjust for the expense of employee equity programmes. When comparing companies, it must therefore first be clarified which variant underlies the figures before values are placed side by side.

Informative value by company stage

• Early growth stage: With recurring revenue in the single-digit millions, growth determines the sum, often with very high rates and clearly negative margins. Investors here pay more attention to metrics of sales efficiency. These include the magic number, which relates the increase in recurring revenue to sales costs. A second is the CAC payback period, that is, the time until the cost of acquiring a customer has been earned back.
• Series B and C: As the revenue base grows, growth rates fall, and the question of how efficiently growth is bought comes to the fore. From this stage the Rule of 40 is often used as a summary yardstick.
• Mature software companies and sale: In practice, the metric is used mainly from recurring revenue in the double-digit millions. Typical occasions are the comparison with listed companies and sale processes to financial investors.

Role in funding round, valuation and due diligence

Ahead of a growth-stage funding round, the metric summarises whether a company converts its losses into adequate growth. In valuation it serves as an explanatory variable for differences in revenue multiples (revenue multiple). In practice a higher value is often seen as an argument for a higher multiple, because growth and profitability together determine future cash flows.

In due diligence, the detailed review by investors or buyers, the reported figure is traced back to its components. The reviewers check the separation of recurring and one-off revenue, the influence of acquisitions and the treatment of capitalised development costs. Reviewers also ask whether a good margin rests on deferred investments in sales and product that weaken future growth.

Worked example: Rule of 40 for three software companies

Three software companies present their figures for the last financial year:

• Company A: revenue rises from EUR 10.0 million to EUR 15.0 million, growth (15.0 minus 10.0) / 10.0 = 50%. EBITDA minus EUR 1.5 million, margin minus 1.5 / 15.0 = minus 10%. Rule of 40 value: 50 minus 10 = 40
• Company B: revenue rises from EUR 20.0 million to EUR 23.0 million, growth 3.0 / 20.0 = 15%. EBITDA EUR 6.9 million, margin 6.9 / 23.0 = 30%. Rule of 40 value: 15 plus 30 = 45
• Company C: revenue rises from EUR 8.0 million to EUR 10.0 million, growth 2.0 / 8.0 = 25%. EBITDA minus EUR 2.0 million, margin minus 2.0 / 10.0 = minus 20%. Rule of 40 value: 25 minus 20 = 5
• Company A on the basis of free cash flow of minus EUR 3.0 million: margin minus 3.0 / 15.0 = minus 20%. Rule of 40 value: 50 minus 20 = 30

A and B reach the threshold with completely different profiles, C misses it clearly: the company consumes liquidity without growing quickly in return. The last line shows how strongly the choice of margin determines the result. For A, EUR 1.5 million lies between EBITDA and free cash flow, for example through capitalised development costs and investments. On an EBITDA basis the threshold counts as reached, on a cash basis it is missed by ten points.

Distinction: Rule of 40, magic number, unit economics and burn rate

• Magic number: relates the annualised increase in recurring revenue of a quarter to the sales and marketing expense of the previous quarter. It explains why a company scores well or badly on the Rule of 40.
• Unit economics: the profitability per customer. The Rule of 40 looks at the company as a whole and can turn out well even though individual segments consume capital.
• Burn rate: the monthly cash consumption. It shows how long the capital lasts. The Rule of 40 shows whether the consumption is converted into adequate growth.
• Default alive: describes whether a company reaches profitability with the capital it has. A high Rule of 40 value is neither necessary nor sufficient for this.

Common mistakes

• Margin definition changed. Anyone who switches between EBITDA, operating and cash flow margin until the sum fits loses credibility in due diligence.
• Growth from acquisitions included. Acquired revenue raises the growth rate without saying anything about the company's own sales performance.
• One-off revenue counted. Project and licence revenue that does not recur overstates the growth of a subscription business.
• Margin optimised in the short term. A margin that results from cuts in sales and product development reaches the threshold in the current year and endangers it in the following ones.
• Rule as a management target. The Rule of 40 is a yardstick for comparison. Management works through its components, that is, sales efficiency, customer retention and cost structure.

Frequently asked questions

How is the Rule of 40 calculated?

Revenue growth in percent plus profit margin in percent, both for the same period. A company with 35% growth and an 8% EBITDA margin scores 43 and meets the rule. At a margin of minus 10% it would be only 25.

What is a good Rule of 40 value?

A value of 40 or more, because that is the threshold that gives the rule its name. Besides the level, the composition counts: many investors weight a value that comes predominantly from recurring growth more heavily than the same value from a margin improved in the short term.

Where does the number 40 come from?

From investment practice, not from a derivation. The threshold has become established among US growth and venture capital investors as the dividing line between software companies that grow efficiently and those that grow less efficiently.

Does the Rule of 40 also apply outside software?

Only to a limited extent. The threshold presupposes the high contribution margins and recurring revenue of software businesses. For business models with hardware, logistics or high staff input, whose margin structure is fundamentally different, it is not suitable as a yardstick.

What does a value below 40 mean for the valuation?

Not automatically a discount. Investors ask which component was deliberately deferred and when it will recover. A well-founded path back above the threshold, supported by cohort data and sales efficiency metrics, weighs more heavily than a single value that is only just reached.

Is the metric calculated annually or quarterly?

Usually on the basis of the last twelve months, rolled forward at each quarter-end. Extrapolated values for individual quarters fluctuate strongly, for example through seasonal contract signings, and should therefore be labelled as a snapshot.

The Roemer Capital view

In Series B and C funding rounds, Roemer Capital shows the Rule of 40 in the financial model and in the documents for investors. This always includes the margin definition used and a reconciliation to the annual financial statements. It shows the trend over several quarters and for the base case, the cautious case and the optimistic case of the plan. A single value at a reporting date says little about whether the company reaches the threshold under its own steam.

If a company is below 40, Roemer Capital prepares the explanation together with the management. It answers three questions: which component was deliberately deferred, which sales efficiency metrics support this decision and from when the plan reaches the threshold again.