Rule of 40

Growth alone can hide a business that is burning cash to buy customers. Profit alone can hide a business that has stopped growing. Adding the two puts both on one scale and makes the trade-off visible. A business above the line has room to spend more on growth. A business below it needs to ask whether the weakness is growth or margin.

• Calculate growth as year-on-year revenue growth, ideally recurring revenue.
• Calculate margin on a consistent basis, and note which one.
• Add them and compare with 40.
• If the score is low, look at the weaker half first. Slow growth and thin margin call for different fixes.
• Track the score over several quarters, because one large deal or one large invoice can swing a single period.

The rule of 40 is a quick test for subscription and software businesses. Take the revenue growth rate for the year, add the profit margin, and compare the total with 40. A business growing 30 per cent with a 10 per cent margin scores 40. One growing 60 per cent while losing 20 per cent of revenue also scores 40. A business growing 5 per cent with a 5 per cent margin scores 10.

The margin used varies. Investors often use operating margin, free cash flow margin or EBITDA margin. The important thing is to pick one and stay with it, so the score is comparable over time.

• Treating it as a law. It is a rule of thumb that suits software with recurring revenue and applies poorly to early companies that are still finding a market.
• Comparing scores that use different margin definitions.
• Chasing the score by cutting spending that growth depends on.