Rule of 40 for SaaS Companies: What Is It and How Do You Calculate It

Profitability and growth are two of the most important financial metrics to SaaS companies, but two that don’t usually move in the same direction—especially for startups. 

So which one is more important? Which should you focus on most? The Rule of 40, also known as the 40% rule, says you don’t have to choose. 
 
According to the Rule of 40, it’s the combined sum of profitability and growth that matters most to SaaS companies when it comes to measuring their financial health—and investors agree. 

IThe global SaaS market is projected to grow 349% by 2032. With so many new ventures joining the SaaS space, founders and finance leaders need to be clear on what metrics to prioritize. 

In this guide, we’ll define the Rule of 40 and explain how it works. We’ll also explain why it matters to SaaS companies, how to calculate it, how it relates to SaaS EBITDA margins and other key considerations. 

💡Key Takeaways 

• Rule of 40 definition: The sum of the growth rate and profit margin for a company should be greater or equal to 40 for sustainable success
• The Rule of 40 accounts for the fact that SaaS startups experience periods in their life cycles when growth is more important (during earlier stages), and others when profitability matters more (once maturity is reached).
• Typically, SaaS companies use MRR as their number for growth and EBITDA for profitability.
• Some investors prefer companies that use a Weighted Rule of 40, which places more emphasis on growth than profitability.  

What Is the Rule of 40 and Why Does It Matter? 

In the simplest terms, the Rule of 40 states that a company’s combined growth rate plus profit margin should always reach or exceed 40%. It was popularized when Techstars founder Brad Feld wrote about it in 2015, after he heard it from a late-stage investor at a board meeting. 

Feld called it “the minimum point of happiness” for high-growth SaaS companies, and ever since, finance teams and investors alike have used the Rule of 40 as a go-to valuation metric to determine the financial health, viability and growth potential of SaaS companies. 

But what makes the Rule of 40 so special? 

Mostly, it’s the ability to measure success of the SaaS startup journey as it matures. It prioritizes both growth and profitability as their importance changes throughout the company’s lifecycle. As long as the two metrics stay balanced, a company can still be deemed “healthy” and worth investing in. 

How Do You Calculate the Rule of 40? 

The simple Rule of 40 calculation is growth rate + profitability, as seen below: 

But before you can calculate your Rule of 40 number, you also must calculate your growth and profitability. So what numbers should you use to determine those? 

While there isn’t a singular answer, many SaaS startups choose to use the following two metrics:

• MRR: Year-over-year monthly recurring revenue works well because most SaaS revenue comes from recurring subscriptions.
• EBITDA: Earnings before interest, taxes, depreciation, and amortization can provide a basic growth metric, also helpful for comparing your company to other industry leaders.

Simple Rule of 40 Calculator

Once you know your growth rate and profitability, you can calculate your rule of 40. Input your numbers, and try our Rule of 40 calculator below. 

Understanding the Rule of 40 for SaaS: Two Hypothetical Examples 

Let’s consider the Rule of 40 in context. 

SaaS Company A: 

• A few years old but still in the fairly early stages of growth as a startup.
• Scaling rapidly and earning huge influxes of new users every month—the company’s growth rate is at 50%.
• They are investing heavily in growth-focused product development and marketing, so their profitability is in the negative at -5%. 

Although SaaS Company A has negative profitability, their Rule of 40 score is 45% because of the very high growth rate. That would mean Startup A is still considered healthy by the Rule of 40’s standards. 

SaaS Company B:

• Nearly a decade old now and has reached organizational maturity.
• As a result, their growth rate has flattened to around 10%.
• They have been able to shift their focus to increasing profitability, which stands at 35%. 

Just like SaaS Company A, SaaS Company B’s Rule of 40 result is 45%—they’re a healthy company. But the way they reach this metric is quite different. 

It all goes back to the trajectory of the SaaS startup journey—the main reason the Rule of 40 is needed in the first place. 

As you can see in the image below, after a company finds product/market fit and hits the market, it pours on resources to drive growth and scale the business. Once they reach maturity, their growth curve flattens out and they compensate by working to maximize profit margins through improved financial efficiency. 

When Should You Use the Rule of 40? 

It should be noted that the very earliest days of establishment and growth are often considered too early for SaaS companies to use the Rule of 40. 

Early-stage startups can and do use the 40% rule, but it can yield unreliable results if there isn’t a steady user base and some established demand yet. During the early stage of a SaaS company’s life cycle, growth and profitability are so volatile that either isn’t likely to stand the test of time—even to the next week or month. 

A better financial plan for SaaS companies at that stage is to focus on metrics like revenue run rate or cash runway, then adopt the Rule of 40 once the company achieves a more stable growth trajectory. 

A Growth-Focused Perspective: The Weighted Rule of 40

SaaS companies care a lot about investors’ perspective—even if a company’s founders and leaders feel comfortable with their financial health, they need investors to see things the same way if they’re going to earn funding. 

The Software Equity Group (SEG) 2024 Annual SaaS report found that companies with a Weighted Rule of 40 or higher have a higher enterprise value to trailing twelve months (EV/TTM) Revenue than those with a Rule of 40 or higher. 

This metric, which measures ​​the value of a company relative to its earnings over the past 12 months, indicates that the weighted Rule of 40 might be a better predictor of overall value. 

The Weighted Rule of 40 is calculated by adding 133% of the revenue growth rate to 67% of the EBITDA margin. This metric might be better for companies that are growing fast but are too young to have real profit. This is calculated as demonstrated below: 

The Weighted Rule of 40 of course benefits high-growth (and usually early-stage) SaaS companies because it prioritizes growth above profitability, and the fact that investors pay particular attention to this version of the rule is significant for any company seeking growth funding. You can try our free weighted rule of 40 calculator below. 

Weighted Rule of 40 Calculator

The Rule of 40: A Best of Both Worlds Approach 

The Rule of 40 avoids choosing between growth or profitability as a single measure of success. Instead, it accounts for the fact that these two metrics generally have an inverse relationship (as one moves one way, the other moves in the opposite direction). 

The Rule of 40 is a balanced metric that allows your company to focus on what it needs at that particular phase of its maturity while staying on track for long-term success. As long as you maintain the right balance between growth and profitability, you can drive profitable growth for your SaaS company. 

Although the Rule of 40 has become a valuable industry standard, it’s not the only SaaS KPI you should track. To build a complete growth strategy, you should also know your unit economics and other key SaaS metrics like customer acquisition cost, customer lifetime value, revenue retention, and churn. 

How can you monitor all this and do it efficiently? 

Ideally, with complete planning software that simplifies revenue planning by centralizing data from all your systems, such as your ERP, CRM, HRIS, and Payroll.

With Vena for SaaS, you can hit the ground running with proven SaaS dashboards, templates, and modeling tools—all within the Excel interface your finance team knows and loves.