What the Rule of 40 measures
Your board chair circles one line in the deck and asks why you aren’t at 40.
The Rule of 40 measures whether a SaaS company is paying a fair price in profit for the growth it’s buying. Rule of 40 SaaS scoring adds revenue growth rate percent to profit margin percent, with 40 or higher as the target. One number for the growth versus profitability tradeoff. The margin you plug in can move the answer by double digits, which is where most board conversations go sideways, and it’s the part indinero spends the most time on with growth-stage finance teams.
Brad Feld published “The Rule of 40% For a Healthy SaaS Company” on February 3, 2015. He didn’t invent it, and he says so in the first paragraph. He credits a late stage investor he heard it from at a board meeting. The rule was never a research finding. It spread because it’s easy to compute in a board deck.
Feld’s own three examples set the shape of it:
- Growing at 20 percent, you should be generating a 20 percent profit.
- Growing at 40 percent, you should be generating a 0 percent profit.
- Growing at 50 percent, you can lose 10 percent.
Two details get dropped in almost every repetition. Feld scoped the rule to SaaS companies above $50 million in revenue, and he treated the margin choice as a sensitivity test rather than a definition, preferring EBITDA as the baseline and then back testing with the other percentages.
So what is the score scoring? Balance, not efficiency. A company at 40 percent growth and breakeven posts the same 40 as a company at 10 percent growth and a 30 percent margin. Investors don’t treat those two as equivalent, which is the rule’s central weakness and the reason Bessemer later built a growth-weighted alternative. Our guide to the SaaS metrics that belong on a board dashboard places the score alongside retention, payback, and capital efficiency.
The formula, and which margin you plug into it
Rule of 40 equals revenue growth rate percent plus profit margin percent, and 40 or higher clears the bar.
Rule of 40 score = revenue growth rate (%) + profit margin (%)
Target: 40 or higher
For a recurring-revenue business the growth term is built off ARR: (current ARR minus prior ARR) / prior ARR x 100.
The ambiguity is all in the second term. Anyone asking how to calculate Rule of 40 scores consistently hits three margin choices, and they can land more than 15 points apart for the same company in the same twelve months. Start with what the published benchmarks actually use.
| Publisher | Edition or date | Margin used in its Rule of 40 |
|---|---|---|
| Brad Feld, origin | February 3, 2015 | EBITDA as the baseline, back tested with others |
| SaaS Capital | Rule of 40 research, August 21, 2025 | EBITDA margin |
| Bessemer Venture Partners | “Scaling to $100 Million” (2021), “The Rule of X” (January 2, 2024) | Free cash flow margin of ARR |
| OpenView | 2023 SaaS Benchmarks Report, the final edition | ARR growth plus trailing twelve month FCF margin |
| Benchmarkit and High Alpha | 2026 B2B SaaS and AI-Native Metrics | Growth rate percent plus profit margin percent |
| Aventis Advisors | May 6, 2026 public SaaS analysis | Reports EBITDA basis and FCF basis side by side |
If your board quotes the Bessemer Cloud Index, it’s quoting a free cash flow number. If it quotes SaaS Capital, it’s quoting EBITDA. Comparing an internal EBITDA-basis score against an external FCF-basis benchmark is the most common reason the conversation breaks down.
Stock-based compensation is the wedge at public scale. Aventis Advisors’ May 6, 2026 analysis of 55 listed SaaS companies found a median Rule of 40 of 22.6 percent on an EBITDA basis against 39.1 percent on a free cash flow basis. A median gap of roughly 16 percentage points, almost all of it stock-based compensation, which sits inside EBITDA as an operating expense and washes out of free cash flow as a non-cash charge.
Capitalized software is the wedge at private growth stage. Under ASC 350-40, internal-use development costs that meet the capitalization criteria move onto the balance sheet, which raises EBITDA. ASC 230-10-45-13(c) treats that same spend as an investing cash outflow, so it reduces free cash flow. The cash left the building either way.
So which basis is stricter? That depends on which company you are, and most content gets it backwards. A large public company carrying heavy stock-based compensation scores more generously on an FCF basis. A private growth-stage company with modest equity compensation and real capitalized development spend scores more strictly on it, because capex and capitalized software bite with too little stock-based compensation to offset them.
Work out which one you are before you pick a basis, then write the definition into the board package footnote. Our walkthrough of how to build a financial model that ties to your books covers the same bridge work.
A worked example at 8 million in ARR
A SaaS company at $8 million in ARR with 25 percent growth scores 12, 10, or 6 depending on the margin basis.
| Input | Value |
|---|---|
| Prior year ending ARR | $6,400,000 |
| Current year ending ARR | $8,000,000 |
| Net new ARR for the year | $1,600,000 |
| Trailing twelve month revenue, the margin denominator | $8,000,000 |
| Trailing twelve month EBITDA | ($1,040,000) |
| Depreciation and amortization | $480,000 |
| Stock-based compensation, non-cash, inside EBITDA | $240,000 |
| Increase in deferred revenue from annual prepay contracts | $560,000 |
| Cash interest and cash taxes paid | ($80,000) |
| Capitalized internal-use software development, ASC 350-40 | ($800,000) |
| All other capital expenditures | ($80,000) |
Step 1. The growth rate. ($8,000,000 minus $6,400,000) divided by $6,400,000 is 25 percent. The 2026 private B2B SaaS growth benchmarks, the 15th annual edition of a SaaS Capital survey of more than 1,000 private companies, put the median growth rate at 22 percent and the equity-backed median at 25 percent. An ordinary growth-stage company.
Step 2. The EBITDA basis. EBITDA of ($1,040,000) on $8,000,000 of revenue is a negative 13 percent margin. 25 minus 13 gives a score of 12. That’s the number most boards quote, because EBITDA is the basis Feld named and the basis most private studies use.
Step 3. The operating basis. Subtract $480,000 of depreciation and amortization and operating income is ($1,520,000), a negative 19 percent margin. 25 minus 19 gives a score of 6. Six points below the EBITDA score, purely because amortization of previously capitalized software now sits inside the margin.
Step 4. The free cash flow basis. Build it up from EBITDA so the bridge is auditable.
| Free cash flow bridge | Amount |
|---|---|
| EBITDA | ($1,040,000) |
| Add back stock-based compensation, non-cash | $240,000 |
| Increase in deferred revenue | $560,000 |
| Cash interest and cash taxes | ($80,000) |
| Operating cash flow | ($320,000) |
| Less capitalized software development | ($800,000) |
| Less all other capital expenditures | ($80,000) |
| Free cash flow | ($1,200,000) |
Free cash flow of ($1,200,000) on $8,000,000 is a negative 15 percent margin. 25 minus 15 gives a score of 10.
| Margin basis | Margin | Rule of 40 score |
|---|---|---|
| EBITDA | (13%) | 12 |
| Free cash flow | (15%) | 10 |
| Operating income | (19%) | 6 |
Same company, same twelve months, same closed books. A six point spread between the best and worst presentation, and nobody lied.
Now change one thing. Suppose the company expensed all $800,000 of development cost instead of capitalizing it. EBITDA becomes ($1,840,000), a negative 23 percent margin, and the EBITDA-basis score falls from 12 to 2. Rebuild free cash flow under that policy and it is identical at ($1,200,000), because the $800,000 simply moves from the investing section into operating cash flow. The FCF-basis score holds at 10.
An accounting policy moved the score 10 points.
Free cash flow is immune to the capitalize versus expense choice, because ASC 230-10-45-13(c) only reclassifies the spend between the operating and investing sections of the cash flow statement. EBITDA isn’t immune. That boundary is also being redrawn. FASB’s ASU 2025-06 on internal-use software replaces the project-stage model with a probable-to-complete recognition threshold, effective for annual reporting periods beginning after December 15, 2027, with early adoption permitted. An early adoption decision shifts the capitalization start date, which shifts EBITDA, which shifts the score with nothing changing in the business.
To run the same arithmetic in something you can hand an investor, start from our Series A financial model template walkthrough.
What a good score looks like in 2026
The bar is still 40, and every major 2026 Rule of 40 benchmark puts the median in the low to mid 20s.
| Source | As of | Finding |
|---|---|---|
| Aventis Advisors | May 6, 2026 | Median of 22.6 percent on an EBITDA basis and 39.1 percent on an FCF basis across 55 public SaaS companies. Only 8 of 55 clear 40 on EBITDA, 25 of 55 on FCF. |
| Benchmarkit, 2026 B2B SaaS and AI-Native Metrics | 2026 | Median Rule of 40 of 25 percent, up from 15 percent the prior year. Top quartile 43 percent. |
| High Alpha | January 16, 2026 | Median by ARR band: $1M to $5M, 33 percent. $5M to $20M, 20 percent. $20M to $50M, 24 percent. Above $50M, 30 percent. |
| SaaS Capital Index | February and Q1 2026 | The median company is generating an operating profit for the first time in more than a decade, at a positive 3 percent operating margin. Median year on year growth has fallen to the low teens. |
The public figure for 2026 is derivable rather than published. Combine those two SaaS Capital readings, a low-teens median growth rate and a positive 3 percent median operating margin as of February 2026, and the median public SaaS company lands in the mid teens on an operating-margin basis. That reconciles with the 22.6 percent EBITDA-basis median Aventis reported in May 2026, since EBITDA sits above operating income.
One honesty note on the private side. SaaS Capital’s 2026 Rule of 40 work is published in charts, and it tells readers to focus on direction and change rather than absolute values, so there is no absolute 2026 private figure from SaaS Capital to quote. The best credible private read is Benchmarkit’s 2026 median of 25, and High Alpha’s January 2026 by-band data puts every ARR band below 40 at the median.
The private median is well below 40, and it isn’t close.
So what do you do when a board treats 40 as a pass or fail line? Five moves.
- Pin the margin basis in writing. EBITDA, operating, or free cash flow, with the bridge shown in a footnote. A 16 point median gap is how much room there is to move the number without changing the business.
- Bring the matching benchmark. An EBITDA-basis report compares to SaaS Capital, not the Bessemer Cloud Index. An FCF-basis report compares to Bessemer and OpenView’s 2023 methodology.
- Bring the percentile, not just the median. Benchmarkit’s top quartile is 43, so 40 is roughly a top-quartile outcome. That reframes a 25 from a failure into a median result.
- Bring the by-band number. Rule of 40 by stage matters more than the headline. The $5M to $20M band medians 20, so a company scoring 20 there is at its own cohort median.
- Decompose the delta. SaaS Capital’s August 2025 research found score contraction was driven by slowing growth, not margin deterioration. A score that fell on growth needs a pipeline answer. A score that fell on margin needs a cost answer.
If the score is feeding a spend decision rather than a board slide, the SaaS financial decision tree walks the same tradeoff.
Where the rule stops working below 10 million in ARR
Below roughly $10 million in ARR the growth term can carry the whole score, so the Rule of 40 stops being informative.
Take a company going from $2 million to $4 million in ARR. That’s 100 percent growth. On EBITDA of ($2,400,000) against $4,000,000 of revenue, the margin is a negative 60 percent, and the score is exactly 40. It clears the bar while burning more than half of every revenue dollar.
Now compare a company going from $16 million to $20 million in ARR at a positive 10 percent EBITDA margin. Growth of 25 percent plus a 10 percent margin is 35. It fails the bar while generating $2 million of real EBITDA.
Any investor asked to choose would take the $20 million company. The score points the other way.
The reason is the denominator. At $2 million of ARR, $2 million of net new ARR is 100 percent growth. At $20 million of ARR, that same $2 million is 10 percent growth. The score rewards a small base for being small.
The people closest to the rule have said so for years. Feld scoped it to $50 million in revenue and up. Bessemer says its version is “generally only meaningful for companies that have achieved $25MM+ of ARR.” SaaS Capital’s May 2017 empirical analysis called the metric “least useful” at the small end, because growth rates run higher for smaller companies when the denominator is smaller.
Two 2026 datasets show the distortion in the numbers:
- High Alpha’s $1M to $5M band carries an upper quartile of 80 percent. Every other band sits between 35 and 41 percent. That isn’t a sign of exceptional businesses. It’s the growth term running wild on a tiny denominator.
- Growth expectations aren’t stage-neutral. SaaS Capital’s 2026 benchmarks put the top-quartile bar at more than 50 percent growth for a $2 million company and 31 percent for a $20 million company. A stage-neutral score measures you against the wrong distribution.
Three better measures below $10 million in ARR. Burn multiple first. Then growth against a stage-matched benchmark rather than a flat 40. Then net revenue retention, because SaaS Capital’s 2026 survey found growth is positively and exponentially correlated with NRR, with the highest-NRR companies reporting median growth 173 percent above the population median.
At this size, cash is the real question anyway. Our explainer on burn rate versus runway and the startup runway calculator cover the two numbers a seed-stage board actually acts on.
Rule of 40 versus burn multiple, and when to use each
The Rule of 40 scores the balance of growth and margin, while the burn multiple measures cash burned per dollar of net new ARR.
Rule of 40 = revenue growth rate (%) + profit margin (%). Both terms are percentages of revenue.
Burn multiple = net burn / net new ARR. Cash in the numerator, growth in the denominator.
David Sacks published “The Burn Multiple” on April 23, 2020. In his own framing, around 2x is reasonable for an early-stage startup, 3x or higher is problematic, and 5x means cut costs now. His argument for the metric was that “too many startups report their growth without contextualizing it as a function of investment.”
| Dimension | Rule of 40 | Burn multiple |
|---|---|---|
| Denominator | Revenue, on both terms | Net new ARR |
| Numerator type | Accrual margin | Cash |
| Effect of faster growth | Raises the score directly | Raises the denominator, which lowers the multiple |
| Can growth alone pass the test | Yes, below roughly $10M ARR | No, burn has to move with it |
| Moved by an accounting policy | Yes, on an EBITDA or operating basis | No, net burn is a cash figure |
The fourth row is the whole argument. Because growth sits in the denominator, a company can’t clear the burn multiple just by growing fast on a small base.
Run both metrics over the two companies already built above.
- The $8 million ARR company. Net new ARR of $1,600,000 against net burn of $1,200,000 is a 0.75x burn multiple. Its EBITDA-basis Rule of 40 score is 12.
- The $2 million to $4 million company. Net new ARR of $2,000,000 against net burn of $2,400,000 is a 1.2x burn multiple. Its Rule of 40 score is 40.
The company that passes the Rule of 40 is the less capital-efficient of the two. A 12 reads like a failing grade and a 40 reads like a pass, and the business scoring 12 is buying growth at well under half the cash cost.
When to use each:
- Burn multiple below roughly $10 million in ARR, wherever runway is the real question, and in venture diligence generally since 2022. It’s cash-based, so a capitalization policy can’t move it.
- Rule of 40 above roughly $25 million in ARR, once a board or a late-stage investor is already using it, and in any conversation about valuation multiples.
- Both, between $10 million and $25 million in ARR. Boards start asking for the Rule of 40 in this band while the burn multiple is still the more honest read. Showing both, with the bridge, pre-empts the argument.
The stage bands, the drivers behind a bad multiple, and how to improve one are covered in our post on burn multiple benchmarks by SaaS stage.
How investors read the score in diligence and valuation
Investors read the Rule of 40 as a continuous variable that prices the business, not a pass or fail gate.
The 2026 regression work puts a number on it. Aventis Advisors’ May 2026 analysis, covering 55 public SaaS companies with outliers removed, found three things worth quoting to a board.
- Each 10 percentage point increase in the FCF-basis score is associated with roughly +1.0x EV/Revenue.
- Each 10 percentage point increase in the EBITDA-basis score is associated with roughly +0.7x EV/Revenue.
- Companies clearing the FCF-basis rule traded at a median 4.8x EV/Revenue against 2.7x for those that didn’t. A 74 percent premium.
The market doesn’t weight the two terms equally, though, and that’s where a VP of Finance gets caught out. Meritech’s April 10, 2026 Software Pulse found growth is 2.9 times as correlated with the revenue multiple as free cash flow margin, with similar scores trading at 8.1x versus 3.0x depending on how much of the score came from growth. Bessemer’s “The Rule of X”, published January 2, 2024, says it outright: “assigning equal weighting to growth and profitability for late stage businesses is flawed,” because a margin increase moves value linearly while a growth increase can compound. Its alternative multiplies the growth term by roughly 2x for private companies before adding free cash flow margin.
So a 30 built from 30 percent growth and a breakeven margin usually prices above a 30 built from 5 percent growth and a 25 percent margin. If a board is pushing you to trade growth for margin to reach 40, that’s the argument that the trade can cut enterprise value while improving the score. Context matters too. SaaS Capital reported the index ARR multiple at decade-plus lows in Q1 2026, and Meritech’s April 2026 read put the median implied ARR multiple for public software at 3.2x. When the median compresses and dispersion widens, each point of score is worth more, not less.
Diligence doesn’t accept the score either. It rebuilds it. Expect all of this.
- The ARR schedule reconciled to GAAP revenue. The growth term comes off ARR, the margin term off GAAP revenue. If they don’t tie through a documented bridge, the score isn’t auditable.
- The margin definition held constant across every period shown. A score that was EBITDA-basis last year and FCF-basis this year reads as a red flag, not an improvement.
- The ASC 350-40 capitalization policy, period by period, plus the ASU 2025-06 adoption decision. A policy that tightened or loosened mid-series moved EBITDA, and so moved the score.
- Stock-based compensation treatment. Inside EBITDA or added back, disclosed either way.
- Add-backs. A one-time expense appearing in three consecutive periods is a recurring expense, and every disallowed add-back lowers the margin term.
- Deferred revenue and working capital. A billing-terms change from monthly to annual prepay can flatter an FCF-basis margin with no operating improvement.
Lead with the decomposition, not the score. Growth term, margin term, basis, and the period movement in each, then the stage-matched benchmark, then the number. Our guides to financial due diligence and CFO support during a raise cover what that package looks like.
How Indinero tracks the Rule of 40 for growth-stage clients
Both inputs come out of the same closed books, so the growth rate and the margin can’t drift apart.
Look back at the worked example. The growth term came off an ARR schedule. The margin term came off the general ledger. Three of the inputs sit on the boundary between those two systems, and every one of them is a closing entry.
- The deferred revenue movement that drove the free cash flow bridge. That’s a subledger balance.
- The $800,000 of capitalized software under ASC 350-40. That’s a judgment call made during the close.
- The $480,000 of depreciation and amortization that separated the EBITDA score of 12 from the operating score of 6. That’s a fixed asset schedule.
If the close is late, those entries are estimates. If they’re estimates, the margin term is an estimate wearing a metric’s clothing. That’s how a company ends up telling its board 12 one quarter and 2 the next with nothing having changed except who did the capitalization analysis.
Indinero has operated continuously since 2009 and serves 500+ regular customers. Bookkeeping, accounting, tax, and fractional CFO sit inside one monthly engagement rather than being bought from three vendors. For this score specifically, that structure changes four things.
- One close feeds both terms. The ARR schedule behind the growth rate and the general ledger behind the margin are maintained by the same team, so reconciling them is a standing part of the monthly close rather than a fire drill before a board meeting.
- The margin basis is fixed once and held. Defined in writing, with the EBITDA to free cash flow bridge shown every period. Nobody gets surprised by a 16 point swing that came from a definition change.
- The capitalization policy is a documented accounting position. Our CPA team applies the ASC 350-40 criteria consistently on an accrual basis and plans the ASU 2025-06 transition ahead of its effective date. The team that books the entry is the team that defends it in diligence. Audit-ready, not reconstructed later.
- The score arrives decomposed. Growth term, margin term, basis, and the period movement in each, next to a stage-matched benchmark instead of a bare 40.
A template library can give you the formula. A benchmark database can give you the median. Neither one closes your books.
So if your score changes depending on who builds it, that’s a close problem before it’s a reporting problem. Indinero’s fractional CFO services work on top of the same team that keeps the books, so the number you take to a board has one source and one definition. We’d love to hear how your current reporting is holding up.
Frequently asked questions
The same handful of questions comes up every time a board starts quoting the score. Margin basis and stage-matched benchmarks explain most of the disagreement.
Is the Rule of 40 still relevant for private SaaS companies?
The Rule of 40 still matters for private SaaS companies, but as a directional check rather than a pass or fail gate. Benchmarkit’s 2026 median is 25, and High Alpha’s January 2026 data puts every ARR band below 40 at the median, so the bar isn’t where most private companies live. The rule also rewards balance rather than efficiency, so 40 percent growth at breakeven scores the same as 10 percent growth at a 30 percent margin.
Should I use EBITDA margin or free cash flow margin in the calculation?
Use EBITDA margin for comparability against published private benchmarks, then confirm which basis your board’s Rule of 40 benchmark uses. Which one is stricter depends on scale. At public scale free cash flow reads more generously, a 22.6 percent EBITDA-basis median against 39.1 percent on an FCF basis, almost all of that gap stock-based compensation. At private growth stage FCF is stricter, because capitalized software and capex bite with little offsetting equity compensation. Indinero fixes the basis in writing and shows the bridge every period.
What is a good Rule of 40 score at Series A?
At Series A, a Rule of 40 score in the 20s is a normal result, because the private median sits well below 40. Benchmarkit’s 2026 B2B SaaS data puts the median at 25 with a top quartile of 43, and High Alpha’s January 2026 by-band medians run 33 percent at $1M to $5M ARR and 20 percent at $5M to $20M. Read the score as directional at this stage, and lean on burn multiple below $10 million in ARR.
Can a company with a negative margin still clear 40 percent?
Yes, a company can clear the Rule of 40 on growth alone while posting a deeply negative margin, especially at small ARR. A business going from $2 million to $4 million in ARR posts 100 percent growth. On a negative 60 percent EBITDA margin that scores exactly 40 while burning more than half of every revenue dollar, which tells an investor nothing about efficiency. Below $10 million in ARR, burn multiple is the more honest read.
Does the Rule of 40 work for businesses that are not SaaS?
The Rule of 40 was built for SaaS economics, specifically recurring revenue with high gross margin, so it travels poorly outside that model. The growth term comes off ARR, which a business without a recurring contract base doesn’t have. Every published benchmark, from SaaS Capital to Benchmarkit and High Alpha, is drawn from SaaS companies, so a non-SaaS score has nothing comparable to measure against. For other models, gross margin and cash burn per dollar of new revenue are more informative.
How often should the Rule of 40 go in front of the board?
Put the Rule of 40 in the board package quarterly, computed monthly off a closed set of books so the trend is the story. A single reading says little. Show the decomposed score over four quarters, growth term and margin term separately on a fixed basis, next to a stage-matched benchmark rather than a bare 40. At indinero both terms come out of the same monthly close, so the number doesn’t change depending on who built it.
Who came up with the Rule of 40?
Brad Feld published the Rule of 40 on February 3, 2015, crediting a late-stage investor who raised it at a board meeting. Feld didn’t claim to invent it, and said so in his first paragraph. Two details get dropped in nearly every repetition. He scoped the rule to SaaS companies above $50 million in revenue, and he preferred EBITDA as the baseline, then back tested with the other margin percentages.
