The Rule of 40 is the principle that a software company's combined growth rate and profit margin should exceed 40%, a high-level gauge of health used widely in venture capital and growth equity.
The rule trades growth against profitability, so a company can satisfy it in different ways. A company growing 20% a year should earn a 20% profit margin. A company growing 50% can run at a 10% loss and still pass. 📝Brad Feld popularized the heuristic in a 2015 post on his blog Feld Thoughts, crediting a late-stage investor who raised it at a board meeting. He suggested measuring growth as the year-over-year growth rate of monthly recurring revenue and profit as the EBITDA margin, while noting that other definitions are in use.
The Rule of 40 is most useful for comparing software and SaaS businesses at different stages, since it rewards neither growth at any cost nor profitability at the expense of growth. It is a screening benchmark rather than a valuation method, and results vary with the growth and profit measures chosen.