A rough test for software companies: growth rate plus profit margin should reach forty. It is a shorthand for the trade-off between growing and earning, not a law, and it means little for a company early enough that both numbers are volatile.
Why it matters
Growth and profit trade off against each other for most software companies: spending more to
grow faster usually means giving up margin, and holding onto margin usually means growing more
slowly. The Rule of 40 is a shorthand for that trade-off — add the growth rate to the profit
margin, and look at the combined number rather than either one alone.
Its usefulness is exactly that it stops a reader from over-weighting either side by itself. A
company growing fast while burning heavily and a company profitable but barely growing can land at
a similar combined figure, and the Rule of 40 is a prompt to ask which mix actually reflects a
healthier business, not a verdict that the number itself supplies.
How it works
The calculation is simple: year-over-year revenue growth rate, plus profit margin, usually
EBITDA margin or free cash flow margin depending on which the company reports most reliably. Add
the two together.
Which margin to use is a real choice. EBITDA margin and free cash flow margin can diverge
meaningfully for a capital-intensive business, and an AI company with real ongoing infrastructure
and inference costs is exactly the kind of business where that divergence shows up. Ask which
margin figure is being used before comparing the combined number to anything else.
It says nothing about the composition underneath it. A company growing very fast with a
deeply negative margin and a company growing slowly with a strongly positive one can add to the
same combined figure. Whether that combination is a strength or a warning sign depends entirely
on the strategy behind it — a deliberate, well-funded growth push looks very different from
growth that is simply expensive to sustain.
It means little at the extremes. For a company early enough that both growth rate and margin
are still volatile month to month, the combined figure moves too much to be a stable read on
anything, and is better treated as noise than as a signal at that stage.
On GetDeal
GetDeal does not publish a Rule of 40 figure on a listing. The two inputs behind it — growth rate
and margin — are both presented on the Deep Dive tab and both read by the AI analysis report when
it builds its valuation range, so a buyer can work the combined figure out themselves from
numbers the report has already scored for confidence.
Get a free AI valuationthe in-product glossary — the same definitions, alongside your deals
Questions people ask
- What two numbers make up the Rule of 40?
- Year-over-year revenue growth rate and profit margin, most often EBITDA margin or free cash flow margin, added together into one combined figure. The idea is to look at growth and profitability as a pair rather than judging either one in isolation, since a company can reasonably choose to be strong on one and weaker on the other.
- Why is the Rule of 40 called a rough test rather than a rule?
- Because it collapses two very different kinds of numbers into one figure without saying anything about which margin measure was used, how sustainable the growth is, or whether the underlying mix reflects a deliberate strategy or a struggling business. Two companies can arrive at an identical combined figure through very different, and not equally healthy, paths.
- Does the Rule of 40 work for an early-stage AI startup?
- Not reliably. When a company is early enough that both its growth rate and its margin are still swinging significantly month to month, the combined figure swings just as much and is better read as noise than as a stable measurement of anything. It becomes more informative once both underlying numbers have settled into a more consistent pattern.
See also
More in Metrics
- ARR — The annualised value of subscription revenue that repeats — contracted and expected to continue.
- Burn rate — How much cash the company consumes each month.
- CAC — What it costs, on average, to win one customer — sales and marketing spend divided by customers gained.
- Churn — The rate at which customers or their revenue leave.
- EBITDA — A measure of operating profit that strips out financing, tax and accounting charges for past spending, so two businesses can be compared on how well the operations themselves earn..
Keep reading
Updated 2026-09-09