Software and internet platforms
Rule of 40
A software company's growth rate plus its profit margin should add up to at least 40 percent.
Facts checked against sources onWhat does Rule of 40 mean?
The rule of 40 is a quick health check for software companies: revenue growth rate plus profit margin should be at least 40 percent. The profit measure varies; many investors use free cash flow margin, others EBITDA margin. Example: a company growing 30 percent with a 12 percent free cash flow margin scores 42 and passes, while one growing 50 percent with a margin of minus 20 percent scores 30 and fails. It lets investors compare a fast-growing, loss-making company with a slower, profitable one. McKinsey research has found that only a minority of software companies reach it. It is a rule of thumb, not a law.
Where does it come up in case interview prep?
- How software and SaaS companies workLesson in Software and SaaS
- SaaS unit economics: ARR bridge, NRR, CAC payback, and rule of 40Lesson in Software and SaaS
- Software and SaaS: players, trends, regulation, and how to crack the casesLesson in Software and SaaS
- Cybersecurity: players, trends, rules and casesLesson in Cybersecurity
Related terms
- Annual recurring revenue (ARR)The yearly value of all active subscription contracts at a point in time.
- Free cash flowCash from operations minus capital expenditure.
- EBITDAEarnings before interest, taxes, depreciation and amortization.
- Net revenue retention (NRR)How much recurring revenue a group of existing customers brings in a year later.
- CAC payback periodHow many months of gross profit it takes to earn back the cost of winning a customer.
- Gross merchandise value (GMV)The total value of goods or services sold through a platform.
- CPM (cost per thousand impressions)The price an advertiser pays for 1,000 views of an ad.
- CPC (cost per click)The price an advertiser pays each time someone clicks an ad.
Learn it in context
See Rule of 40 at work in a lesson from Software and SaaS, with checks as you go.
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