Rule of 40: The Growth-Plus-Margin Test for Reading Software Company Results

Some software companies grow fast and burn cash. Others barely grow but throw off profits every quarter. Which one is doing better? The rule of 40 is a quick way to put both on the same scale: add the company’s revenue growth rate to its profit margin, and if the total is 40% or more, the business is considered to be balancing growth and profitability well.

It’s a blunt tool. We like it anyway, because it forces one honest question when you read a tech company’s results: is this growth being paid for, and by whom?

Where the Rule of 40 Came From

The idea went mainstream through a February 2015 post by venture capitalist Brad Feld, who wrote that he first heard about a “40% rule” from a late-stage investor at a board meeting. His version was simple: your growth rate plus your profit should add up to 40%. Growing at 20%? You should be making a 20% profit. Growing at 40%? Breaking even is fine. Growing at 50%? You can lose 10%.

Feld was clear that he meant software-as-a-service (SaaS) companies at scale, which he described as having at least $50 million in revenue. That detail gets lost a lot. The rule was never meant for a startup with a few crore in sales, and it was never meant for every kind of business.

The SaaS Metrics Standards Board, in its June 2023 standards document, credits the term to Feld and fellow venture capitalist Fred Wilson and describes the metric as a single number that weights growth and profitability equally.

How to Calculate the Rule of 40

The formula itself fits on one line:

Rule of 40 score = annual revenue growth (%) + profit margin (%)

The hard part is deciding which “growth” and which “profit” you mean. Different people plug in different numbers, and the answer can change a lot depending on the choice.

The growth half

For a subscription business, the purest measure is growth in annual recurring revenue (ARR), the yearly value of the subscriptions a company has on its books. The SaaS Metrics Standards Board recommends ARR growth as its first choice, but it also accepts plain reported revenue growth, because most listed companies disclose revenue and not ARR. If you’re working from an Indian company’s results, you’ll almost always be using reported revenue, measured year on year. Our explainer on YoY vs QoQ growth covers why the year-on-year comparison is the one to use here.

The profit half

This is where the arguments start. Feld preferred EBITDA (earnings before interest, tax, depreciation and amortisation) as the baseline, and then checking it against other measures. The SaaS Metrics Standards Board recommends free cash flow (FCF) margin instead, defining FCF as cash from operations minus capital expenditure. McKinsey’s definition also uses free cash flow.

We lean towards free cash flow. EBITDA can look healthy while cash quietly drains out through rising receivables, capitalised spending or heavy upfront customer costs. Cash is harder to dress up. If you need a refresher, our guide to free cash flow walks through how it’s built from the cash flow statement.

The rule of 40 doesn’t ask whether a company is growing or profitable. It asks whether the mix of the two is good enough to justify the money going in.

A Worked Example the Standards Board Uses

The SaaS Metrics Standards Board document includes a sample calculation that shows the mechanics cleanly. A company’s revenue rises from $30 million to $38 million in a year, and it generates $8 million of free cash flow in the second year.

• Revenue growth: ($38 million minus $30 million) divided by $30 million, which the board rounds to 27%.
• FCF margin: $8 million divided by $38 million revenue, rounded to 21%.
• Rule of 40 score: 27% plus 21%, or 48%.

That clears the bar comfortably. Now let’s make it more interesting.

Three Made-Up Indian Software Companies, Side by Side

The numbers below are purely illustrative. They are not real companies; we’ve built them only to show how the rule of 40 changes the way you read a set of results. All figures are in ₹ crore, for one financial year compared with the previous one.

Look at what happens. Company B has the most exciting headline: 40% revenue growth. A results-day news flash would probably lead with it. But it is burning cash to get there, and its score of 34.6 is the weakest of the three.

Company C looks dull on the top line, growing at just 12%. Yet it turns almost a third of its revenue into free cash flow, and it scores 42.1. Company A sits in the middle on both counts and edges ahead on the combined score at 43.5.

None of this tells you which stock to buy. It tells you that “fast growth” and “good business” are not the same statement, and the rule of 40 makes you check both halves.

Same company, different margin, different verdict

Now suppose Company B reports EBITDA of ₹84 crore. On ₹560 crore of revenue, that’s an EBITDA margin of 15%. Plug that into the formula instead of FCF margin and Company B’s score jumps from 34.6 to 55.

That 20-point swing comes entirely from the choice of profit measure. The company didn’t change. This is the single most common way the rule of 40 gets misused in presentations: a management team picks the margin that makes the number look best. When you see a rule of 40 figure quoted, the first thing to ask is which margin went into it.

If a company’s rule of 40 score is strong on EBITDA but weak on free cash flow, the gap between those two numbers is the real story.

What the Research Says About the Rule of 40

The rule of 40 is harder to hit than its popularity suggests. McKinsey’s analysis of more than 200 software companies between 2011 and 2021 found that companies exceeded the rule of 40 only 16% of the time, and that barely one-third of software companies achieve it at all.

The same McKinsey piece notes that investors reward companies at or above the rule of 40 with higher enterprise value to revenue multiples, and that top-quartile SaaS companies get nearly three times the multiples of those in the bottom quartile. In its sample of 100 US public SaaS companies with revenue above $100 million, analysed in May 2021, the median revenue growth rate was 22% and the median last-twelve-months free cash flow was 10% of revenue. Add those two medians and you get 32, well short of 40. In other words, the typical company in that set did not pass.

That’s useful context. A score in the 30s isn’t a disaster. A score above 40, held for several years, is genuinely rare.

Using the Rule of 40 on Indian Results

A few practical things change when you apply this to companies listed on NSE and BSE.

Cash flow numbers come every six months

Indian listed companies report profit and loss every quarter, but the full cash flow statement comes with half-yearly results. SEBI’s FAQ on the LODR regulations confirms that half-yearly financial results must include a statement of assets and liabilities and the cash flows for the half-year. So if you want an FCF-based rule of 40, work with half-year or full-year figures, or build a trailing twelve-month number from the two most recent half-years. Don’t try to force it out of a single quarter.

It was built for software products, not every tech company

Feld’s rule was aimed at SaaS businesses, where customers pay recurring subscriptions and the cost of serving one more customer is low. An IT services firm that bills clients for people’s time has a very different economic model, and so do internet platforms that carry inventory, run deliveries or lend money. You can still calculate a score for them, but don’t hold it up against the 40% bar as if the comparison were like for like.

Watch for one-offs on both sides

An acquisition can inflate revenue growth for a year without any underlying improvement. A large one-time client payment can lift operating cash flow. Under Ind AS, the timing of revenue recognition also matters; our piece on deferred revenue explains how subscription money collected upfront sits on the balance sheet before it shows up as revenue. Strip out the obvious one-offs before you add the two numbers together.

Look at the trend, not one reading

A single year’s score is a snapshot. A company moving from 25 to 32 to 38 over three years is telling you a very different story from one sliding from 48 to 41 to 35, even though both are near 40 at some point. The SaaS Metrics Standards Board suggests calculating the metric at least once a year and tracking it more often to see the trend.

Where the Rule of 40 Misleads

Let’s be honest about its limits.

• It treats growth and margin as interchangeable. One point of growth counts the same as one point of margin. For a company with a huge untapped market, a point of growth may be worth far more. For a mature company, cash may matter more.
• It ignores the size of the company. Feld himself framed it for companies with at least $50 million of revenue. Applying it to a tiny business gives you noise.
• It says nothing about valuation. A company scoring 50 can still be an expensive stock. The rule describes the business, not the price.
• It can be gamed. As the Company B example shows, picking EBITDA over free cash flow can shift the score by 20 points or more.

McKinsey’s research makes a related point: the companies it found doing best on this measure weren’t chasing growth at any cost. They set growth targets they could actually reach and managed spending around them.

A Quick Rule of 40 Checklist for Results Season

1. Take year-on-year revenue growth from the results statement, for a full year or a trailing twelve months.
2. Build free cash flow from the cash flow statement: cash from operations minus capital expenditure.
3. Divide free cash flow by revenue for the same period to get the FCF margin.
4. Add the two. Then calculate it again using EBITDA margin and note the gap.
5. Remove obvious one-offs, such as acquisitions or a lumpy client payment.
6. Compare against the company’s own history before comparing with peers.

For the wider framework that this fits into, start with our guide on how to analyse quarterly results of a company.

The rule of 40 won’t pick stocks for you. What it does well is stop you from getting carried away by a big growth number, or writing off a slow grower that is quietly printing cash. In a results season full of headline percentages, that’s a useful filter to have.

Disclaimer: This article is for educational purposes only and is not investment advice. The company examples in the table are hypothetical and made up for illustration. Research figures are from the McKinsey and SaaS Metrics Standards Board sources linked above. Please do your own research or consult a SEBI-registered investment adviser before making investment decisions.