The Rule of 40 has become the standard framework for evaluating whether a SaaS company is balancing growth and profitability appropriately. The concept is simple: a company’s revenue growth rate plus its profit margin should equal or exceed 40%. But behind that simplicity lies a rich set of efficiency metrics that together tell the story of how well a company converts spending into durable growth.
This article explains the Rule of 40, the supporting efficiency metrics every SaaS finance team should track, and how to use them to make better capital allocation decisions.
The Rule of 40 Explained
The Rule of 40 states that a healthy SaaS company’s combined growth rate and profitability should be at least 40%.
Rule of 40 Score = Revenue Growth Rate (%) + Profit Margin (%)
For example:
- A company growing at 60% with a -15% operating margin scores 45. This passes.
- A company growing at 25% with a 20% operating margin scores 45. This also passes.
- A company growing at 30% with a -15% operating margin scores 15. This does not pass.
The framework acknowledges that growth and profitability exist on a spectrum. A fast-growing company can justify losses if growth is strong enough. A slower-growing company needs to show it can generate profit. The Rule of 40 provides a single number that captures this tradeoff.
Which Growth Metric to Use
Most practitioners use year-over-year ARR growth as the growth component. Some use revenue growth, which can differ from ARR growth if the revenue mix includes services or if there are timing differences between bookings and recognized revenue. Be consistent in your methodology and transparent about which definition you use.
Which Profit Metric to Use
There is more debate on the profitability side:
- EBITDA margin: Common in private company analysis. Excludes stock-based compensation and other non-cash charges.
- Operating margin (GAAP): Includes stock-based compensation, which is a real cost. More conservative and increasingly preferred by public market investors.
- Free cash flow margin: Measures actual cash generation. Particularly relevant for companies with significant working capital dynamics.
Each choice produces a different Rule of 40 score. EBITDA-based scores tend to be the most flattering, while operating margin-based scores are the most conservative. For internal analysis, use multiple definitions to understand the range. For external communication, be prepared to discuss whichever definition your investors or board prefers.
Why the Rule of 40 Matters
Investor Perspective
Research consistently shows a strong correlation between Rule of 40 performance and enterprise value multiples in public SaaS companies. Companies above 40% trade at significantly higher revenue multiples than those below. The relationship is not perfectly linear, but the threshold effect is real.
Strategic Planning Perspective
The Rule of 40 forces an explicit conversation about the growth-profitability tradeoff. It prevents two dangerous extremes: growing at all costs with no path to profitability, and cutting so aggressively that growth stalls. It provides a framework for answering the perennial question, “How much should we invest in growth?”
Operational Perspective
Tracking the Rule of 40 over time reveals whether the company is improving its ability to grow efficiently. A company whose Rule of 40 score is rising is building operational leverage. One whose score is falling is either decelerating without compensating margin improvement or spending more without generating proportional growth.
Supporting Efficiency Metrics
The Rule of 40 is the summary metric. The supporting metrics below explain why the score is what it is and where to focus improvement efforts.
Magic Number
The Magic Number measures sales and marketing efficiency.
Magic Number = Net New ARR (Current Quarter) / Sales and Marketing Spend (Prior Quarter)
Using the prior quarter’s spend accounts for the lag between investment and results.
- Above 1.0: Very efficient. The company generates more than a dollar of new ARR for each dollar of sales and marketing spend.
- 0.75 - 1.0: Healthy. The go-to-market engine is working well.
- 0.5 - 0.75: Acceptable for earlier-stage companies but warrants monitoring.
- Below 0.5: Inefficient. Sales and marketing spend is not translating into proportional growth.
Burn Multiple
Burn multiple is an increasingly popular efficiency metric, particularly among venture-backed companies.
Burn Multiple = Net Burn / Net New ARR
A burn multiple of 1.5x means the company is burning $1.50 for every dollar of new ARR generated.
- Below 1.0x: Exceptional efficiency. The company is growing faster than it is burning cash.
- 1.0x - 1.5x: Strong. This is the target range for growth-stage companies.
- 1.5x - 2.0x: Acceptable in the early stages, concerning at scale.
- Above 2.0x: Inefficient. The company is spending too much relative to its growth output.
The burn multiple is valuable because it captures all spending, not just sales and marketing. A company with efficient go-to-market but bloated R&D or G&A will show a healthy Magic Number but a poor burn multiple.
Net New ARR per Employee
This metric measures organizational productivity.
Net New ARR per Employee = Net New ARR / Average Total Headcount
Benchmarks vary significantly by stage, but generally:
- Below $30K: The organization may be overstaffed relative to its growth output.
- $30K - $60K: Typical for growth-stage SaaS companies.
- Above $60K: Strong organizational efficiency.
Track this metric over time. It should improve as the company scales, reflecting operational leverage.
Revenue per Employee
A broader productivity metric that measures how efficiently the entire organization generates revenue.
Revenue per Employee = Annualized Revenue / Total Headcount
Best-in-class public SaaS companies achieve $300K-$400K in revenue per employee. Earlier-stage companies typically range from $100K-$200K. This metric improves naturally with scale as fixed costs (G&A, management) are spread across a larger revenue base.
Operating Expense Ratios
Break down operating expenses as a percentage of revenue to identify where the company is investing and where there may be inefficiency:
- Sales and marketing as % of revenue: Typically 30-50% for growth-stage SaaS, declining to 20-35% at scale.
- R&D as % of revenue: Typically 20-35% for growth-stage, declining to 15-25% at scale.
- G&A as % of revenue: Should stay below 15%, declining to 8-12% at scale. G&A is the most scrutinized category because it has the least direct connection to growth.
Applying the Rule of 40 in Practice
Annual Planning
During the annual planning process, use the Rule of 40 as a constraint. Start with the growth target, then determine what level of investment (and resulting margin) maintains the score at or above 40%.
For example, if the team targets 40% ARR growth, the company needs to achieve at least breakeven profitability to hit the Rule of 40. If the team believes it can grow at 50%, there is room for -10% margins, allowing more aggressive investment.
Scenario Modeling
Build three to five scenarios that vary the growth-profitability mix while maintaining a Rule of 40 score at or above the target. Present these scenarios to leadership and the board to facilitate a structured discussion about strategic priorities.
Investment Case Evaluation
When evaluating major investments (a new sales team, a new product line, a geographic expansion), model the impact on both growth and profitability. The Rule of 40 framework forces you to consider whether the expected growth justifies the margin impact.
Quarterly Business Reviews
Track the Rule of 40 and its component metrics quarterly. Present a trend line alongside the individual components so leadership can see whether improvements are coming from the growth side, the profitability side, or both.
Common Misconceptions
“Growth always matters more than profitability.” This was true in the zero-interest-rate era. In the current environment, investors and boards expect balanced performance. A company growing at 100% with a -60% margin (Rule of 40 score of 40) may technically pass, but the cash burn required to sustain that growth is often not viable.
“The Rule of 40 is only for later-stage companies.” While the rule is most commonly applied to companies above $10M ARR, the underlying principle of balancing growth and efficiency applies at every stage. Earlier-stage companies should track their trajectory toward the Rule of 40 even if they do not yet meet it.
“Hitting 40 means the company is healthy.” The Rule of 40 is a necessary but not sufficient condition. A company could score 45 by growing at 50% with -5% margins, but if the growth is coming from unsustainably cheap customer acquisition or one-time deals, the score is misleading. Always examine the quality and durability of both components.
Building a Culture of Efficiency
The most valuable outcome of tracking efficiency metrics is the cultural shift they create. When teams see that growth spending is evaluated on a return-on-investment basis, they naturally become more thoughtful about resource allocation. Engineering teams consider the cost of infrastructure. Marketing teams track cost per lead and cost per acquisition. Sales teams focus on deal quality, not just deal volume.
This efficiency mindset does not replace a growth mindset—it complements it. The goal is to grow as fast as possible within the constraint of building a durable, economically sound business. The Rule of 40 and its supporting metrics provide the measurement framework that makes this balance achievable.