The Rule of 40: What It Tells You About a Company and What It Doesn't

The One Number That Changed How We Evaluate Growth Companies

In early 2015, venture capitalist Brad Feld published a blog post titled "The 40% Rule for a Healthy Software Company." He didn't invent the concept — he credited an unnamed late-stage investor he'd overheard at a board meeting. But by writing it down, he sparked one of the most widely adopted mental models in growth investing.

The premise is deceptively simple: take a company's revenue growth rate, add its profit margin, and if the sum is 40 or above, the business is healthy.

Rule of 40 = Revenue Growth (YoY %) + Profit Margin (%)

Fred Wilson, another prominent VC, independently wrote about the same idea around the same time. The concept resonated because it solved a persistent tension in evaluating growth companies: how do you compare a company growing at 80% with -30% margins against one growing at 15% with 30% margins? The Rule of 40 says both score 50 — both are healthy, just following different strategies.

Why It Exists

The traditional debate in growth investing is binary: growth or profitability. Pick one. The Rule of 40 rejects this framing. It recognizes that growth and profitability exist on a spectrum, and what matters is their combined output.

A company burning cash to grow at 100% YoY is making a bet. A company with 40% margins and 5% growth is harvesting. The Rule of 40 treats both as potentially valid strategies, as long as the total clears the bar.

This is why it became the lingua franca of SaaS investing. Software companies, with their high gross margins and recurring revenue models, are uniquely suited to this kind of analysis. They can choose where to sit on the growth-profitability curve, and the Rule of 40 measures whether they're doing it well.

The Advocates

Brad Feld (Foundry Group / Techstars) popularized the rule and continues to reference it as a quick health check for software companies.

Bessemer Venture Partners adopted it into their widely-followed Cloud Index, tracking public SaaS companies against the Rule of 40 benchmark.

McKinsey & Company published research validating the rule, finding that companies exceeding 40 traded at significantly higher revenue multiples than those below it. Their data showed that companies scoring above 40 generated total shareholder returns that were double those of companies scoring between 20 and 40.

Alex Karp (Palantir CEO) explicitly celebrates it on earnings calls, calling their Rule of 40 performance "iconic" — and the numbers back it up.

How It's Calculated

There are two common formulations, and they lead to meaningfully different numbers:

The classic version uses EBITDA margin:

Rule of 40 = Revenue Growth (YoY %) + EBITDA Margin (%)

The cash-focused version uses free cash flow margin:

Rule of 40 = Revenue Growth (YoY %) + FCF Margin (%)

We use the FCF-based version on R40 because free cash flow is harder to manipulate and better reflects the actual cash a business generates. EBITDA can be flattering — it ignores stock-based compensation, capital expenditures, and working capital changes. FCF does not.

The choice matters. A company with heavy stock-based compensation (common in tech) might look great on EBITDA but mediocre on FCF. When evaluating with the Rule of 40, you should know which version you're looking at.

Palantir: Rule of 40 as a Competitive Weapon

Palantir has turned the Rule of 40 into a headline metric. In their Q4 2024 earnings, the numbers were staggering:

That's not just passing — it's nearly 2.5x the threshold. CEO Alex Karp called it "one of the truly iconic performances in the history of corporate America." On their Q3 call, they had already posted a score of 68 and were expanding margins for the eighth consecutive quarter.

For the full year 2024, Palantir's Rule of 40 score exceeded 100, driven by the AI platform (AIP) tailwinds accelerating both U.S. government and commercial revenue.

What makes Palantir's score notable is the composition: it's not just growth subsidized by losses, or margins from stagnation. It's both — substantial growth and massive cash generation simultaneously. That combination is rare and explains much of the market premium on the stock.

View Palantir's indicator history →

Upstart: What the Rule of 40 Reveals in a Turnaround

Upstart offers a completely different case study. As an AI-powered lending platform, it's been through a brutal cycle: pandemic boom, rate-shock bust, and now recovery.

Their Q4 2024 results showed real momentum:

The revenue growth is impressive — 56% year-over-year — but Upstart has historically struggled with profitability. They came "within a whisker" of GAAP profitability in Q4 (their words), with Adjusted EBITDA at levels not seen since Q1 2022.

This is where the Rule of 40 tells an interesting story: Upstart's top-line growth alone nearly clears the bar. If they can reach even modest FCF margins as the lending environment normalizes, the composite score moves into healthy territory fast. The Rule of 40 framework captures this optionality — it shows that a high-growth company doesn't need to be profitable yet to be on a good trajectory, as long as the growth rate is strong enough.

View Upstart's indicator history →

What the Rule of 40 Doesn't Tell You

Here's where intellectual honesty matters. The Rule of 40 is a useful heuristic, not a valuation model. It has real blind spots:

It ignores valuation entirely. A company scoring 80 on the Rule of 40 trading at 50x revenue is a very different proposition from one scoring 45 at 8x revenue. The rule tells you nothing about whether you're overpaying.

It doesn't distinguish revenue quality. Recurring subscription revenue and one-time services revenue score the same. A SaaS company with 95% net revenue retention is fundamentally different from one with 80%, even at identical Rule of 40 scores.

It's easy to game in a single quarter. Companies can pull forward revenue, delay spending, or juice FCF through working capital timing. One quarter's score is a snapshot, not a verdict.

It penalizes heavy investment. A company deliberately investing in a massive new market will score poorly even if the investment is brilliant. Amazon in 2014 would have failed the Rule of 40 miserably — and you know how that turned out.

It's sector-specific. The rule was designed for software companies with 70-80%+ gross margins. Applying it to hardware companies, banks, or retailers is meaningless. Even Upstart — a fintech with lending exposure — requires context that the raw number doesn't provide.

Stock-based compensation is invisible in the EBITDA version. A company paying 30% of revenue in SBC looks profitable on EBITDA but is diluting shareholders heavily. The FCF version partially captures this, but not perfectly.

How the Rule of 40 Is Evolving

The original Rule of 40 is increasingly seen as a floor, not a ceiling. The "Rule of X" — a weighted version proposed by Bessemer — gives more credit to growth than to profitability, arguing that a dollar of growth is worth more than a dollar of margin when it comes to enterprise value creation.

McKinsey's research supports this asymmetry: in their analysis, growth contributed roughly twice as much to shareholder value as profitability for high-growth software companies. Their proposed evolution weighs the revenue growth component more heavily.

There's also a push toward trailing-twelve-month (TTM) calculations rather than quarterly, which smooths out seasonality and one-time events. And some analysts now track the trend of the Rule of 40 score — is it improving or deteriorating quarter over quarter? — rather than the absolute number.

For platforms like ours, the future is clear: composite indicators like the Rule of 40 are a starting point. They're most powerful when layered with other metrics — net revenue retention, FCF conversion, capital efficiency, and competitive positioning — to build a complete picture.

The Bottom Line

The Rule of 40 endures because it's simple, directional, and captures the fundamental tension in growth investing. It won't tell you whether to buy or sell. It won't predict the future. But it will tell you whether a company is creating value efficiently — or burning cash without enough growth to show for it.

Use it as a filter, not a final answer. And always ask: what's the score composed of, and where is it heading?