With all the macro noise out there, smart investors stay grounded by sticking to the basics especially in the software space
While software equities offer significant upside potential, not all revenue growth translates into long term value creation. Some firms achieve rapid top line expansion at the expense of profitability, while others generate solid earnings but lack growth momentum. The key for investors is identifying which businesses are scaling sustainably.
a widely adopted metric that combines revenue growth and profitability into a single efficiency benchmark. It’s particularly relevant when evaluating high growth SaaS and software companies.
Today we will cover :
- The definition of the Rule of 40
- The calculation methodology
- Its relevance in evaluating company performance
- Common misapplications and caveats
- How to use it across different growth phases
What Is the Rule of 40?
The Rule of 40 is a shorthand framework for assessing the financial health and capital efficiency of growth oriented software companies
Formula: Revenue Growth Rate (%) + Profit Margin (%) ≥ 40%
If the combined metric exceeds 40%, the company is generally considered to be operating efficiently striking a favorable balance between growth and profitability. Falling below this threshold may signal inefficiencies, excessive cash burn, or insufficient returns relative to growth.
It’s worth noting that “profit margin” can vary depending on the metric used operating margin, EBITDA, or free cash flow margin—so investors should apply context when interpreting results.
Compliance as a Growth Enabler
For scaling companies, regulatory compliance isn’t optional it’s foundational. Investing in compliance early safeguards sensitive data, streamlines adherence to industry standards, and establishes long-term credibility with customers, partners, and regulators.
Vanta accelerates compliance for high-growth businesses by automating over 35 frameworks, including SOC 2, ISO 27001, HIPAA, GDPR, and more. With continuous monitoring of your security posture, Vanta enables teams to maintain focus on scaling operations, stay ahead of shifting regulatory landscapes, and accelerate deal cycles.
Kickstart your journey with Vanta’s Compliance for Startups Bundle, which includes:
- Actionable compliance checklists
- Case studies from high-performing startups
- On-demand expert sessions
Origins of the Rule of 40
The Rule of 40 was introduced by venture capitalist Brad Feld as a pragmatic benchmark for evaluating the financial efficiency of SaaS companies. It distills complex growth dynamics into a simple equation that helps investors assess whether a company is pursuing growth responsibly.
Supporting research includes:
-McKinsey & Company: Only ~33% of software firms consistently exceeded the Rule of 40 from 2011–2021.
-Bain & Company: Just 16% sustained that performance over five years or more.
These insights reinforce how difficult and valuable it is to achieve long-term balance between growth and profitability.
Why the Rule of 40 Matters
At its core, the Rule of 40 offers a lens through which investors assess growth efficiency:
Is this company generating enough value through growth or margin to justify the investment risk? The answer depends heavily on maturity:
-Early stage companies may sacrifice margin for aggressive growth, and still be viable.
- Mature firms, however, are expected to demonstrate operational efficiency and margin discipline.
In short, the Rule of 40 provides a dynamic benchmark that adapts across growth stages—making it an essential tool for investor due diligence in the software space.
Interpreting Growth: More Than Just a Number
A mature software company with slowing topline growth can still deliver strong shareholder returns if it expands margins meaningfully. On the flip side, a high growth company with negative margins might still be attractive if the growth is durable and efficient
The trick? Understand the company’s stage and which financial lever it should prioritize
This is where the Rule of 40 becomes useful not as a rigid benchmark, but as a strategic lens. It helps assess whether a business is balancing growth with operational discipline.
Use the Rule of 40 to Monitor Progress
An improving Rule of 40 score over time suggests a company is scaling efficiently—growing revenue while tightening its cost structure. A declining score? That could signal slowing growth without profitability improvement—potential red flag for investors.
Bottom line, Know the business model. Know the phase then evaluate the tradeoffs.
Breaking It Down: Inputs Matter
The Rule of 40 may seem simple—Growth + Profitability ≥ 40%—but input quality is everything
Revenue: Prioritize Recurring
- ARR (Annual Recurring Revenue) and MRR (Monthly Recurring Revenue) are your go-to metrics. These capture reliable, subscription-based income—crucial for SaaS valuation.
- Total Revenue can be acceptable, especially for businesses without pure play subscription models. But watch for noise—hardware, services, or non-recurring deals can distort the picture.
Pro Tip: Not all growth is created equal. The best revenue growth is recurring, high margin, and customer-expansion driven think upsell, cross-sell, and strong net retention.
Profitability Metrics: Choose Wisely, Stay Consistent
When evaluating a company’s profitability, Free Cash Flow (FCF) margin is often preferred. It reflects how much real cash the business generates after capital expenditures not just earnings, but spendable liquidity
Adjusted EBITDA margin is widely reported, especially in public filings, but approach it with caution. It frequently omits real expenses under the guise of "non-core" adjustments. As Charlie Munger bluntly put it: bullsh*t earnings
Operating margin (GAAP) is more comprehensive, capturing all operating expenses and making peer comparisons easier. But it’s not perfect either one time charges like restructuring costs or impairments can cloud the picture.
The key: Pick your metric and stick with it. Watch for aggressive exclusions that flatter the numbers.
The SBC Trap: Stock Based Compensation Isn’t Free
Stock based compensation (SBC) is a major lever for tech companies to recruit and retain talent often accounting for 20% or more of revenue. Many management teams exclude it in adjusted earnings, painting a rosier profitability picture.
Yes, SBC is a non cash charge and doesn’t show up in FCF but that doesn’t mean it’s irrelevant. It’s a real cost to shareholders via dilution
Pro Tip: I default to GAAP operating income, unadjusted. It includes SBC and avoids distortion from investment gains, losses, or interest a clearer view of core business performance
In our next post, we’ll analyze three companies GitLab, Palantir, and Salesforce each representing a distinct maturity stage in the software lifecycle, to understand how the Rule of 40 applies in practice. Stay tuned, fellas!
While software equities offer significant upside potential, not all revenue growth translates into long term value creation. Some firms achieve rapid top line expansion at the expense of profitability, while others generate solid earnings but lack growth momentum. The key for investors is identifying which businesses are scaling sustainably.
a widely adopted metric that combines revenue growth and profitability into a single efficiency benchmark. It’s particularly relevant when evaluating high growth SaaS and software companies.
Today we will cover :
- The definition of the Rule of 40
- The calculation methodology
- Its relevance in evaluating company performance
- Common misapplications and caveats
- How to use it across different growth phases
What Is the Rule of 40?
The Rule of 40 is a shorthand framework for assessing the financial health and capital efficiency of growth oriented software companies
Formula: Revenue Growth Rate (%) + Profit Margin (%) ≥ 40%
If the combined metric exceeds 40%, the company is generally considered to be operating efficiently striking a favorable balance between growth and profitability. Falling below this threshold may signal inefficiencies, excessive cash burn, or insufficient returns relative to growth.
It’s worth noting that “profit margin” can vary depending on the metric used operating margin, EBITDA, or free cash flow margin—so investors should apply context when interpreting results.
Compliance as a Growth Enabler
For scaling companies, regulatory compliance isn’t optional it’s foundational. Investing in compliance early safeguards sensitive data, streamlines adherence to industry standards, and establishes long-term credibility with customers, partners, and regulators.
Vanta accelerates compliance for high-growth businesses by automating over 35 frameworks, including SOC 2, ISO 27001, HIPAA, GDPR, and more. With continuous monitoring of your security posture, Vanta enables teams to maintain focus on scaling operations, stay ahead of shifting regulatory landscapes, and accelerate deal cycles.
Kickstart your journey with Vanta’s Compliance for Startups Bundle, which includes:
- Actionable compliance checklists
- Case studies from high-performing startups
- On-demand expert sessions
Origins of the Rule of 40
The Rule of 40 was introduced by venture capitalist Brad Feld as a pragmatic benchmark for evaluating the financial efficiency of SaaS companies. It distills complex growth dynamics into a simple equation that helps investors assess whether a company is pursuing growth responsibly.
Supporting research includes:
-McKinsey & Company: Only ~33% of software firms consistently exceeded the Rule of 40 from 2011–2021.
-Bain & Company: Just 16% sustained that performance over five years or more.
These insights reinforce how difficult and valuable it is to achieve long-term balance between growth and profitability.
Why the Rule of 40 Matters
At its core, the Rule of 40 offers a lens through which investors assess growth efficiency:
Is this company generating enough value through growth or margin to justify the investment risk? The answer depends heavily on maturity:
-Early stage companies may sacrifice margin for aggressive growth, and still be viable.
- Mature firms, however, are expected to demonstrate operational efficiency and margin discipline.
In short, the Rule of 40 provides a dynamic benchmark that adapts across growth stages—making it an essential tool for investor due diligence in the software space.
Interpreting Growth: More Than Just a Number
A mature software company with slowing topline growth can still deliver strong shareholder returns if it expands margins meaningfully. On the flip side, a high growth company with negative margins might still be attractive if the growth is durable and efficient
The trick? Understand the company’s stage and which financial lever it should prioritize
This is where the Rule of 40 becomes useful not as a rigid benchmark, but as a strategic lens. It helps assess whether a business is balancing growth with operational discipline.
Use the Rule of 40 to Monitor Progress
An improving Rule of 40 score over time suggests a company is scaling efficiently—growing revenue while tightening its cost structure. A declining score? That could signal slowing growth without profitability improvement—potential red flag for investors.
Bottom line, Know the business model. Know the phase then evaluate the tradeoffs.
Breaking It Down: Inputs Matter
The Rule of 40 may seem simple—Growth + Profitability ≥ 40%—but input quality is everything
Revenue: Prioritize Recurring
- ARR (Annual Recurring Revenue) and MRR (Monthly Recurring Revenue) are your go-to metrics. These capture reliable, subscription-based income—crucial for SaaS valuation.
- Total Revenue can be acceptable, especially for businesses without pure play subscription models. But watch for noise—hardware, services, or non-recurring deals can distort the picture.
Pro Tip: Not all growth is created equal. The best revenue growth is recurring, high margin, and customer-expansion driven think upsell, cross-sell, and strong net retention.
Profitability Metrics: Choose Wisely, Stay Consistent
When evaluating a company’s profitability, Free Cash Flow (FCF) margin is often preferred. It reflects how much real cash the business generates after capital expenditures not just earnings, but spendable liquidity
Adjusted EBITDA margin is widely reported, especially in public filings, but approach it with caution. It frequently omits real expenses under the guise of "non-core" adjustments. As Charlie Munger bluntly put it: bullsh*t earnings
Operating margin (GAAP) is more comprehensive, capturing all operating expenses and making peer comparisons easier. But it’s not perfect either one time charges like restructuring costs or impairments can cloud the picture.
The key: Pick your metric and stick with it. Watch for aggressive exclusions that flatter the numbers.
The SBC Trap: Stock Based Compensation Isn’t Free
Stock based compensation (SBC) is a major lever for tech companies to recruit and retain talent often accounting for 20% or more of revenue. Many management teams exclude it in adjusted earnings, painting a rosier profitability picture.
Yes, SBC is a non cash charge and doesn’t show up in FCF but that doesn’t mean it’s irrelevant. It’s a real cost to shareholders via dilution
Pro Tip: I default to GAAP operating income, unadjusted. It includes SBC and avoids distortion from investment gains, losses, or interest a clearer view of core business performance
In our next post, we’ll analyze three companies GitLab, Palantir, and Salesforce each representing a distinct maturity stage in the software lifecycle, to understand how the Rule of 40 applies in practice. Stay tuned, fellas!
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Disclaimer
The information and publications are not meant to be, and do not constitute, financial, investment, trading, or other types of advice or recommendations supplied or endorsed by TradingView. Read more in the Terms of Use.
🟣MasterClass moonypto.com/masterclass
🟢Signal moonypto.com/signal
🔵News t.me/moonypto
⚪ t.me/moonyptofarsi
🟢Signal moonypto.com/signal
🔵News t.me/moonypto
⚪ t.me/moonyptofarsi
Related publications
Disclaimer
The information and publications are not meant to be, and do not constitute, financial, investment, trading, or other types of advice or recommendations supplied or endorsed by TradingView. Read more in the Terms of Use.