What is Rule of 40?

The Rule of 40 is a simple way to measure the financial health of a SaaS business. It states that a company's revenue growth rate and profit margin should add up to at least 40%. If a company grows quickly but isn’t profitable, or if it’s profitable but barely growing, it may struggle in the long run.

Venture capitalists use the Rule of 40 to assess whether a SaaS company is worth investing in. While it’s not a perfect metric, it helps businesses balance growth and sustainability.

In this blog, we’ll break down how the Rule of 40 works, why it matters and how Customer Success plays a role in helping companies achieve it. Whether you’re new to SaaS or looking for ways to improve profitability, this guide has you covered.

Components of the Rule of 40

Understanding the Rule of 40 starts with its two key components: revenue growth rate and profit margin. These metrics provide insight into how well a SaaS company is expanding and how efficiently it operates. 

A high Rule of 40 score means a company is striking the right balance between the two.

Revenue growth rate

This measures how much a company’s revenue has increased over a year. It’s a sign of how effectively a business is acquiring new customers, expanding existing accounts and gaining market share. Fast-growing companies tend to have higher revenue growth rates, but that often comes at the cost of profitability.

Profit margin

Profit margin shows what percentage of revenue turns into profit. In SaaS, it’s often measured using EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). A strong margin indicates operational efficiency.

Balancing these two factors is essential. Next, we’ll look at how to calculate the Rule of 40.

Calculating the Rule of 40

Now that we’ve covered revenue growth rate and profit margin, let’s see how they come together in the Rule of 40 formula. This calculation helps SaaS companies assess whether they are balancing growth and profitability effectively.

The Rule of 40 is calculated using a simple equation:

Rule of 40 = Revenue growth rate (%) + Profit margin (%)

If the result is 40% or higher, the company is generally considered financially healthy.

Example

Let’s say a SaaS company has:

A revenue growth rate of 25% and a profit margin of 15%, the Rule of 40 score would be 25% + 15% = 40%, meeting the benchmark.

Understanding this number is useful, but it’s not a perfect metric. Next, we’ll explore why the Rule of 40 matters and how it’s used in the SaaS industry.

Importance of the Rule of 40 in SaaS

The Rule of 40 is more than just a number – it’s a useful benchmark for evaluating the financial health of a SaaS company. 

While it doesn’t tell the full story, it provides a quick way to assess whether a company is balancing growth and profitability in a sustainable way.

It is particularly valuable in two key areas: helping businesses evaluate their performance and attracting investor interest.

Performance benchmark

For SaaS businesses, it’s easy to focus heavily on growth at the expense of profitability or vice versa. The Rule of 40 helps companies gauge whether they are maintaining the right balance. 

If a company falls below 40%, it may need to reassess its growth strategy or find ways to improve efficiency.

Investor attraction

Investors look at the Rule of 40 when evaluating SaaS businesses. Companies that meet or exceed the benchmark signal strong financial management and a sustainable business model. 

A company that grows too fast without a path to profitability can be risky, just as a highly profitable company with little growth potential may struggle to scale. The Rule of 40 provides a helpful reference point for investment decisions.

While this metric is widely used, it’s not one-size-fits-all. Different companies may calculate it differently, which can impact comparisons. 

Variations in calculation

Not all companies calculate the Rule of 40 the same way. While the standard formula uses EBITDA to measure profitability, some businesses adjust the calculation based on their financial priorities and stage of growth. 

Two common variations are using alternative profit measures and the weighted Rule of 40 approach.

Alternative profit measures

Some companies use free cash flow or net income instead of EBITDA when calculating profit margin. Free cash flow accounts for actual cash available, while net income reflects bottom-line profitability. 

These alternatives can impact the Rule of 40 score, sometimes making a company appear stronger or weaker depending on the method used.

Weighted Rule of 40

Instead of treating growth and profitability equally, some companies weigh one factor more heavily than the other. 

Early-stage SaaS companies may prioritize growth, while mature businesses may focus on profitability. 

Understanding these variations is important when comparing companies. Next, we’ll look at some limitations of the Rule of 40.

Limitations and criticisms

The Rule of 40 is a helpful metric, but it has limitations. While it provides a quick snapshot of a SaaS company’s financial health, it doesn’t always give the full picture. Two key issues are the lack of standardization and the overemphasis on simplification.

Lack of standardization

Not all companies calculate profitability the same way – some use EBITDA, while others rely on net income or free cash flow. 

These differences can make direct comparisons misleading, as a company with a strong Rule of 40 score might not necessarily be more efficient; it could simply be using a different calculation method.

Overemphasis on simplification

The Rule of 40 focuses solely on growth and profitability, leaving out important factors like customer satisfaction, retention rates and market trends. 

As a result, a company might meet the benchmark but still face challenges in maintaining long-term sustainability.

Despite these drawbacks, the Rule of 40 remains a useful guide. Next, we’ll explore how SaaS companies apply it in practice.

The role of Customer Success in achieving the Rule of 40

Customer Success (CS) plays a direct role in helping SaaS companies achieve the Rule of 40 by influencing both revenue growth and profitability. 

A strong CS strategy ensures that customers see value in the product, leading to higher retention, expansion opportunities and overall business efficiency.

1. Driving revenue growth

One of the most significant ways CS contributes to the Rule of 40 is by improving Net Revenue Retention (NRR). By retaining existing customers and reducing churn, CS helps create a stable revenue base. 

At the same time, CS teams drive expansion through upsells and cross-sells, increasing customer lifetime value (CLV) without the high costs of acquiring new customers.

2. Improving profitability

Higher retention rates have a direct impact on Customer Acquisition Cost (CAC). When customers stay longer, companies don’t have to replace lost revenue with expensive new acquisitions, leading to improved margins. 

Additionally, CS teams provide valuable customer insights, helping product and marketing teams refine their approach. This leads to better product-market fit, reducing churn and optimizing operational costs.

3. Balancing growth and efficiency

A well-structured Customer Success strategy enables a company to scale efficiently while maintaining profitability. By proactively engaging with customers, CS teams help reduce support costs, prevent churn and drive higher contract values through long-term renewals and expansions. 

This balance between growth and efficiency is essential for meeting or exceeding the Rule of 40 benchmark. However, while the Rule of 40 is a useful metric, it is only one piece of the puzzle when evaluating a company’s overall success.

Key takeaways

• The Rule of 40 is a financial benchmark for SaaS companies, stating that the sum of a company’s revenue growth rate and profit margin should equal or exceed 40%.
• It helps SaaS companies evaluate their financial health, ensuring they strike a balance between growth and profitability.
• Investors use the Rule of 40 to assess business sustainability, with companies meeting or exceeding the benchmark often seen as more attractive investment opportunities.
• Different companies may calculate the Rule of 40 in different ways, using alternative profit measures like free cash flow or net income instead of EBITDA, or applying a weighted approach based on growth stage.
• Customer Success plays a direct role in achieving the Rule of 40, driving revenue growth through retention and expansion while improving profitability by reducing churn and operational costs.
• While useful, the Rule of 40 is not a standalone metric and should be considered alongside other factors like customer satisfaction, market trends, and long-term strategic goals.

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