Definition

Rule of 40

One number that says whether a software company is growing responsibly or just growing.

Brian Feroldi

By Brian Feroldi, co-founder of Long Term Mindset

Investing since 2004. 3,000+ articles for the Motley Fool. Author of Why Does The Stock Market Go Up?

Last updated

The Rule of 40 is a guideline for software companies: revenue growth rate plus profit margin should be at least 40%. It captures the trade-off between growing fast and being profitable, allowing low margins if growth is high, or slow growth if margins are strong. Either is fine. Neither is not.

FormulaRevenue Growth Rate (%) + Profit Margin (%) ≥ 40%

What it is really testing

Software companies can buy growth. Spend enough on sales and marketing and revenue will rise, whether or not the underlying business deserves it. The Rule of 40 exists to price that trade honestly: you may run negative margins, provided the growth you bought with them is large enough to justify the spending.

A company growing 60% with a margin of minus 20% scores 40 and passes. So does one growing 10% with a 30% margin. Both are coherent strategies. A company growing 15% with a minus 10% margin scores 5, and the question that follows is what exactly the money is being spent on.

Worked example

Three companies, each measured on free cash flow margin.

Hypergrowth: 85% growth + (−45%) margin = 40 pass
Growth: 20% growth + 20% margin = 40 pass
Maturity: 10% growth + 30% margin = 40 pass

All three score identically and are completely different businesses at different points in their lives. That is the rule working as intended: it is a test of coherence, not of quality.

Which margin to use

The rule does not specify, which is its biggest practical weakness. Companies pick the definition that flatters them, and EBITDA margin is the most flattering because it excludes stock-based compensation, which for software is an enormous real cost paid in shareholder ownership.

Free cash flow margin is the most honest choice for an outside investor, and operating margin is a reasonable second. Whichever you pick, apply it consistently across every company you compare, and be suspicious when a company quotes its own Rule of 40 score without saying which margin it used.

What a good score looks like

Forty is the pass mark, not the target. In practice the distribution matters more than the threshold: scores cluster low, so consistently exceeding 40 puts a company well into the upper part of the field, and a score above 60 is genuinely rare.

Consistency counts for more than any single reading. A company that scores 55 one year and 20 the next has not demonstrated anything except volatility. Four or five years above 40 says the economics are structural.

Where the rule stops working

The rule across three stages of a software company

The same score of 40 describes three completely different companies. This is what each one looks like, with the traits and public examples of each, and where the benchmark quartiles fall.

Rule of 40 infographic by Brian Feroldi. Defines the rule as a guideline that a software company's combined revenue growth rate and profit margin should be at least 40%, noting profit margin could be EBITDA, free cash flow, operating or net margin. A chart tracks revenue growth against profit margin across three stages: hypergrowth, where revenue growth runs 85% falling to 55% and margins are negative 45% improving to negative 15%, with traits of over 40% annual growth, negative margins and heavy spending on R&D, sales and marketing, examples Zscaler and Samsara; growth, at 20% revenue growth and 20% margin, with traits of 10 to 40% growth, positive margins and a focus on margin improvement and customer acquisition cost, examples Palo Alto Networks and Fortinet; and maturity, at 10% growth and 30% margin, with traits of under 10% growth, optimized margins and a focus on retention, cost reduction and acquisitions, examples Microsoft and Adobe. A benchmark bar runs from poor in the first quartile to great in the fourth.
Rule of 40. Original graphic by Brian Feroldi.
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The Rule of 40 is really a phase question

Hypergrowth, growth and maturity in this graphic map onto the lifecycle phases, and the score means something different in each. Phase Check places any US-listed company on that curve and names the metric that matters most where it sits.

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Frequently asked questions

Forty is the pass mark. Consistently exceeding it puts a company well into the upper part of the field, and a score above 60 is rare. Consistency matters more than any single reading, since one strong year can come from a cost cut rather than from the underlying economics.
The rule does not specify, which is its main weakness. Free cash flow margin is the most honest choice for an outside investor because it captures the real cost of the business. EBITDA margin is the most flattering since it excludes stock-based compensation, which for software is a very large real cost.
Not usefully. It was built for businesses with high gross margins and low marginal costs, where growth and profitability genuinely trade off against each other. Applied to a manufacturer or a retailer it produces a number that does not describe anything real.
Easily. The rule says nothing about the quality or durability of the growth, the amount of dilution funding it, the strength of the balance sheet, or the price you are paying. It is one coherence check among several, not a verdict.
It is a convention from venture and growth investing rather than a derived result, chosen because it roughly separated companies whose spending produced proportionate growth from those whose did not. Treat the threshold as a rough dividing line, and the trend in the score as the more informative part.

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