Glossary · Metrics · Updated
The Rule of 40 adds a software company's annual growth rate to its operating margin. If the sum reaches 40 or more, the company is considered properly balanced between growth and profitability, whatever the split between the two.
The value of the rule is that it refuses a simplistic trade-off. A company can grow very fast while losing money, or grow slowly while profitable: both profiles are acceptable as long as the sum holds. What is not acceptable is growing slowly while losing money.
It became a common benchmark after the 2022 market turn, when investors stopped funding growth at any price. Before that, 150% growth justified almost any negative margin; today the path to breakeven is part of the conversation from Series B onward.
It does not apply at early stages. A seed-stage company has statistically meaningless growth and a deeply negative margin by construction: the calculation would produce nonsense. The rule becomes meaningful from several million euros of ARR, once growth is measurable as a stable percentage.
Example: three companies through the filter
Three software companies at the same ARR level with very different profiles.
| Company A, annual growth | 80% |
|---|---|
| Company A, operating margin | −30% |
| Company A, score | 80 − 30 = 50, above the threshold |
| Company B, annual growth | 20% |
| Company B, operating margin | +25% |
| Company B, score | 20 + 25 = 45, above the threshold |
| Company C, annual growth | 35% |
| Company C, operating margin | −10% |
| Company C, score | 35 − 10 = 25, below the threshold |
Company C is the worrying one, even though it loses less than A and grows faster than B. It is stuck in the middle: too slow to justify its losses, not profitable enough to do without them.
The common mistake
Applying the rule too early. At pre-seed or seed it measures nothing usable and pushes teams to sacrifice growth to improve a margin that does not matter yet. It becomes relevant once ARR is counted in millions.
Frequently asked questions
How do you calculate the Rule of 40?+
Add the annual ARR growth rate, as a percentage, to the operating margin, also as a percentage and with its sign. Sixty percent growth with a −25% margin gives a score of 35, slightly below the threshold of 40.
From what stage does the Rule of 40 apply?+
In practice from Series B, once ARR is in the millions and growth settles into a stable percentage. Before that, growth is too volatile and margin too negative by construction for the calculation to say anything useful.
Related terms
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