What is the Rule of 40?

Full Explanation

The Rule of 40 is a heuristic for growth-stage companies: (Annual Growth Rate %) + (EBITDA Margin %) ≥ 40%. For example, a company growing 30% annually with a 15% EBITDA margin scores 45 — healthy. One growing 50% but with −20% margin also scores 30 — problematic because it is burning capital unsustainably. The rule forces trade-off thinking: you can invest heavily to grow fast (high growth, low margin) or optimise for profitability (lower growth, high margin), but you cannot sacrifice both. Companies above 40 are building sustainable businesses; below 40 suggests either unsustainable burn or insufficient growth momentum. High-growth SaaS companies routinely operate below 40 in early stages because they prioritise growth, accepting losses. However, by Series B/C, expectations shift toward higher scores — investors want to see a path to healthy unit economics. The Rule of 40 is a quick diagnostic, not gospel: it ignores factors like customer concentration risk, market conditions, and strategic investments. But it is a useful mental model for founders and investors to assess whether a company's growth-profitability balance makes sense.

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