Rule of 40 Calculator

Written out

The rule of 40 states that a software business's growth rate plus its profit margin should exceed 40. Growth % + profit margin % ≥ 40.

Profit margin here is usually taken as EBITDA margin or free cash flow margin, and which is used changes the result materially.

It is a heuristic for balancing growth against profitability rather than a law, and it applies to businesses of a certain scale and model.

In practice

A business growing 74% annually with a −30% EBITDA margin scores 44, passing, with growth funded by losses.

One growing 15% with a 28% margin scores 43, passing, through profitability rather than growth.

One growing 20% with a 5% margin scores 25, failing, and it is the most common position for a business that is neither growing fast enough to justify losses nor profitable enough to compound.

The rule's usefulness is exactly that: it identifies the uncomfortable middle where a business is doing neither thing well.

The limitations

It was formulated for venture-scale software businesses and is applied far more widely. A bootstrapped business growing 15% at a 35% margin scores 50 and would be considered an outstanding business by any measure other than venture returns.

The margin definition is also inconsistently applied, and businesses select whichever of EBITDA, operating margin or free cash flow produces the better score.

Putting it to use

State which margin definition is being used, and use the same one consistently over time. The score is only meaningful as a trend.

Then treat it as a check on balance rather than a target. A business deliberately choosing profitability over growth, or the reverse, may score below 40 and be executing a coherent strategy.

What the rule is actually encoding

It expresses the idea that growth and profit are substitutes funded from the same margin, and that a business should be doing enough of at least one to justify its cost of capital.

That underlying logic applies to any business, even where the specific threshold does not. A business growing slowly and unprofitably is in trouble regardless of what industry convention says the number should be.

For a small business the more useful version is simply the sum of growth rate and net margin tracked over time. Whether it clears 40 matters less than whether it is rising or falling, and the trend answers the question the rule was designed to ask.

Tracking the two components separately alongside the combined score prevents the common failure where a business improves the number by cutting growth investment rather than by improving either underlying variable.

The score can be raised temporarily by stopping spending, and doing so usually damages the growth term in the following period.

Businesses below the threshold are not necessarily unhealthy, and applying it to a bootstrapped company optimising for owner income rather than exit value produces a misleading verdict.

Calculating it quarterly on a trailing twelve-month basis smooths the volatility that makes a single quarter's figure unreliable.

The rule was written for software businesses with high gross margins and recurring revenue, and applying it unchanged to a product business is a category error. A retailer at 25% growth and 15% profit margin scores 40 while operating on completely different economics from a SaaS company with the same score. The threshold is a convention from one industry rather than a general standard.