Rule of 40 for SaaS companies: How to calculate + 5 fixes

What is the Rule of 40 for SaaS companies?

The Rule of 40 in SaaS companies is simple: Your revenue growth rate plus your profit margin should be at least 40%. If you hit it, you’re balancing growth and profitability. 

If you miss it, you need a plan. The Rule of 40 metric for SaaS companies blends growth and operating margin to judge financial health. Our guide explains the meaning of the Rule of 40, the Rule of 40 calculation, when it helps, when it misleads, and how to improve your score.

Formula:

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

Which margin should you use?

You should use EBITDA margin for most private or mid-market SaaS companies. Some investors prefer free cash flow (FCF) margin on a larger scale. Pick one method and stay consistent over time.

Example (ARR + EBITDA):

• If ARR growth went from $10M to $13M = 30%
  
  
• An EBITDA margin with $3M / $13M = 23%
  
  
• Then the Rule of 40 score = 53%. That passes the threshold and shows profitable growth for SaaS businesses.

Why is this rule specific to SaaS?

SaaS companies often post 70% to 90% gross margins (revenue minus COGS). EBITDA margins are much lower: typical SaaS EBITDA margins range from -20% to +30%, and mature, efficient companies can reach 30–40%. 

Because the Rule of 40 uses an operating margin like EBITDA, compare growth with SaaS EBITDA margins, not gross margin.

Remember: Use the Rule of 40 with other metrics to benchmark a SaaS company’s financial health.

Why the Rule of 40 matters

The Rule of 40 helps you balance growth and cash discipline. It’s a fast way to see if your current plan is sustainable. Investors also reward balanced companies with better multiples. 

Where teams use it day-to-day:

• Board updates: One line that ties growth and margins together.
• Budget season: Set targets for ARR growth, CAC payback, and operating efficiency that roll up into 40.
• Pricing cycles: Test whether price changes, discounts, or packaging push you toward or away from 40.

Limitations to keep in mind:

• It’s a heuristic, not a full diagnostic.
  
  
• Definitions vary (EBITDA vs FCF), which can skew comparisons.
  
  
• Early-stage outliers can “pass” the test with high growth and negative margins. Track the quality of growth, not only the sum. 

Note: For deeper levers that improve revenue per dollar spent, read our take on revenue efficiency.

How to use the Rule of 40 formula

As you know, the Rule of 40 in SaaS states that a company's revenue growth rate plus its profit margin should equal 40% or more. Its formula is deceptively simple, but understanding its components is key to using it. Let's take a closer look at each component of the formula:

Calculating revenue growth rate

The revenue growth rate typically focuses on recurring revenue. Recurring revenue drives most SaaS companies. It is usually measured as ARR, the predictable revenue generated from customer subscriptions over a year.  

To calculate the ARR growth rate, you can use this formula:

ARR Growth Rate (%) = (Current Year ARR - Prior Year ARR) / Prior Year ARR  

For example, imagine a SaaS company with an ARR of $10 million in 2022 and $13 million in 2023. Their ARR growth rate would be:

(13 million - 10 million) / 10 million = 0.3 or 30%

Calculating profit margin

The most common method for the Rule of 40 is using the EBITDA margin. As stated before, it reflects a company's profitability from its core operations. Here's the formula for the EBITDA margin:

EBITDA Margin (%) = EBITDA / Revenue  

Let's continue our example. If the same SaaS company had an EBITDA of $3 million in 2023, its EBITDA margin would be:

3 million / 13 million = 0.23 or 23%

Putting it all together

Now, let's plug those numbers back into the Rule of 40 formula:

30% (ARR Growth Rate) + 23% (EBITDA Margin) = 53%

In this example, the company has a score of 53%. It’s comfortably exceeding the 40% benchmark. This percentage indicates that the company is doing well in balancing growth and profitability.

Remember: Exceeding 40% is generally a good sign, but it's important to consider the context. A very high growth rate with a negative profit margin might not be sustainable in the long run. 

Similarly, a high profit margin with minimal growth could indicate missed opportunities. Avoid chasing quick profits for SaaS solutions at the expense of durable growth and margin quality.

Benefits of using the Rule of 40

The Rule of 40 offers several advantages for SaaS companies. Here are some key benefits:

• Find a sustainable balance between growth and profit. Instead of focusing solely on new customers, the Rule of 40 encourages companies to also prioritize their bottom line. This approach ensures they are building a sustainable business for the long term.
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• Uncover potential financial red flags early on. A low score can signal issues like high customer acquisition costs, inefficient operations, or pricing issues. Addressing these issues early can prevent larger problems in the future.
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• Gain clarity on where to invest your resources. A high growth rate with a low profit margin might lead you to focus on operational efficiency. Conversely, a healthy profit margin with slow growth might encourage you to invest more in sales and marketing.
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• Promote transparency and accountability within your company. When everyone understands the Rule of 40, it creates a shared understanding of the company's financial goals. It can help align everyone toward achieving those goals and foster accountability.
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• Adapt your financial strategy to different stages of your company's lifecycle. Early-stage startups might prioritize growth over profitability. Mature companies may focus more on profits. You can adjust the Rule of 40 to reflect these priorities.

Note: If you’re building a model, this pairs well with our SaaS financial model walkthrough.

What does it mean if you pass the Rule of 40?

Passing the Rule of 40 is a considerable achievement for any SaaS company. But what does this mean in practice, and what new opportunities does it create? Let’s answer those questions.

A mark of financial health

First and foremost, exceeding the 40% benchmark signals strong financial health. It shows that the company is growing its revenue while also generating profits. The goal? Long-term sustainability. 

Sustainability is particularly important in the current economic climate. Why? Because investors are increasingly prioritizing profitability alongside growth.

Increased valuation premiums

SaaS firms that pass the Rule of 40 are now attracting higher valuations. Aalto’s analysis of over 500 software companies yielded some interesting findings. 

The valuation premium for companies meeting the Rule of 40 has jumped from 23% in 2022 to a remarkable 129% in 2024. A Rule of 40 company often earns a valuation premium versus peers.

Fueling further growth

Passing the Rule of 40 can create a positive feedback loop. Reinvest higher profitability into the business to fuel growth. This growth could involve expanding into new markets or developing new products or features. 

Building competitive advantage

A healthy Rule of 40 score can also provide a competitive advantage. Companies that pass the Rule of 40 are often in a stronger position to weather economic downturns. They’re also more likely to invest in innovation and outmaneuver their competitors.

Greater flexibility

Passing the Rule of 40 gives companies more flexibility in their strategic decision-making. They might choose to reinvest profits to accelerate growth. Maybe they might decide to prioritize profitability to build a stronger financial foundation. 

This extra flexibility allows companies to adapt to changing market conditions. It can also help them pursue the strategies that best align with their long-term goals.

Note: Curious how growth rates affect your score by stage? Check our SaaS growth rates primer.

What does it mean if you're below 40%?

Exceeding the Rule of 40 is a desirable goal. However, falling short of this benchmark isn't necessarily a cause for panic. It's important to understand what a lower score might indicate and what steps you can take to improve. That’s exactly what we’ll discuss now.

Potential concerns

A Rule of 40 score below 40% suggests that a company may face challenges related to:

• Cash flow: The company might be spending more than it's earning, leading to cash flow problems.
• Liquidity: A low score could indicate that the company doesn't have enough liquid assets to cover its short-term obligations.
• Sustainability: It might signal that the company's current growth trajectory isn't sustainable in the long run.

How to address a low score

If your company finds itself below the 40% threshold, here are some potential solutions to consider:

• Improve operational efficiency: Reduce costs without hurting growth. Negotiate better vendor terms. Identify and eliminate redundant processes.
• Increase pricing: Consider raising prices. You should do this especially if your product offers significant value and your customers are happy.
• Focus on customer retention: Retaining existing customers is usually more cost-effective than getting new ones. Invest in customer success initiatives to reduce churn and increase customer lifetime value.
• Re-evaluate your growth strategy: Are you spending too much on customer acquisition? Consider adjusting your marketing and sales strategies to improve efficiency.
• Seek external funding: If cash flow is a major concern, consider raising capital from investors to provide a financial cushion.

Exceptions to the rule

A score below 40% often warrants attention. However, there are some exceptions where it might not be as concerning:

• Early-stage startups: Young companies often prioritize rapid growth. They do so even if it means sacrificing profitability in the short term. As they mature and gain market share, they can shift their focus towards profitability.
• Companies with disruptive innovations: Investors might be willing to overlook a lower Rule of 40 score in the early stages. This exception applies if a company has a truly disruptive product with the potential to dominate a large market. 
• Strategic investments: A company might temporarily fall below 40% if it's making big investments. Think research and development, new market expansion, or acquisitions. These investments can pay off long-term with higher growth and profitability.

Note: Need a primer on packaging and charging for value? See our guide to SaaS revenue models.

Get ahead of your finances with the help of Orb

We've explored the ins and outs of the Rule of 40 in SaaS. We’ve also explained how crucial it is for companies to balance growth with profitability. To achieve this balance, you need accurate insights into your financial performance to adapt your pricing strategy as you scale.

That's where Orb comes in.

Orb is a done-for-you billing platform designed to help SaaS businesses like yours achieve and exceed the Rule of 40. We do so by providing accurate billing, flexible pricing structures, and in-depth financial reporting. 

Here's how Orb can help you maintain a healthy SaaS Rule of 40 score:

• Define billable metrics without engineering. Orb ingests raw usage events, which can be easily turned into billable metrics using the Orb SQL Editor or a visual editor.
• Reduce billing errors as you iterate. Orb ingests raw events at scale and with high accuracy. Invoices are automatically recalculated so they stay accurate as pricing changes. This feature is powered by Orb RevGraph that decouples usage data from pricing logic.
• Launch and test new pricing faster. Use Orb Simulations to run scenarios on historical data and preview revenue and usage outcomes before you ship. Finance and product teams can make more informed decisions, faster.
• Integrate your stack. Direct integrations help keep usage and revenue data in sync across your CRM, data warehouse, and ERP.

Ready to take control of your finances and grow your SaaS company? Try Orb to see how we help you reach a healthy Rule of 40. Check our pricing to find a plan that fits your needs.