What Is the Rule of 40?
The Rule of 40 was popularised by Brad Feld and others in the venture community as a quick test of SaaS business health. The insight: growth and profitability are interchangeable — you can sacrifice one for the other, but the sum should be at least 40 to signal a viable business model.
A company growing 80% YoY at −40% FCF margin scores 40. A company growing 10% at 30% margin also scores 40. The rule doesn't care which lever you pull — it only checks that the balance exists.
Why Investors Use Rule of 40
At high growth rates, profitability is expected to be negative — capital is being deployed to win market share. The Rule of 40 prevents investors from funding companies that burn capital without proportional growth. A 10% grower with −30% margins is not a growth company; it's a declining business with high costs.
FCF Margin vs EBITDA — Which to Use?
FCF (Free Cash Flow) margin is the most honest measure because it accounts for actual cash collected and spent, including capital expenditure and working capital. Most institutional investors calculate Rule of 40 using FCF margin for this reason.
EBITDA margin excludes depreciation, amortisation, interest, and taxes — useful for comparing companies with different capital structures, but can overstate profitability for capex-heavy businesses. For asset-light SaaS, EBITDA and FCF are often similar.
40+
Minimum Rule of 40 score
60+
Top-quartile public SaaS score
FCF
Preferred margin type for most investors
2×
Valuation premium for 60+ vs 40 score