Rule of 40

Every attempt to judge a subscription business on one number ran into the same wall. Look only at growth and the company burning cash to buy growth looks best of all — spend as much on advertising as you collect in revenue and you can manufacture almost any growth rate, so the figure alone can't tell you whether the business works. Look only at margin and first place goes to the company that stopped growing and squeezed its costs. Doing that while the market is still expanding means handing over ground, and the number still comes out looking good.

So putting two companies side by side stopped the conversation. One grows revenue 80 percent a year on an operating margin of negative 40 percent. The other grows 10 percent with a margin of 30 percent. Asked which is healthier, each side quoted the figure that favored it, and there was no way to weigh the two in the same unit.

The shortcut investors started using was simply to add them. Both companies above come to 40 and land in the same place. The approach treats growth and profit as substitutes for each other and holds that once the sum clears a threshold, it doesn't much matter which half produced it. The word "rule" is in the name, but this is an empirical benchmark that hardened over many deals, not an accounting standard.

Take the revenue growth rate over the last year and the profit margin over the same period as plain percentages and add them. Deciding what goes into each of the two values is the whole of the work.

1. Growth is revenue against the same period a year earlier. Subscription businesses usually measure it on annual recurring revenue (ARR) — recurring revenue expressed on a yearly basis — rather than total revenue, because one-off setup work mixed in makes the growth rate swing more than the business does.
2. For margin, decide which one first. Dividing operating profit by revenue is the most common choice; some companies use net margin or free cash flow margin instead. Without saying which was used, the comparison doesn't hold: the same company can move its sum by five or more points just by switching the basis.
3. Add the two. Growth of 35 percent with a 5 percent operating margin sums to 40. A negative margin subtracts, so growth of 60 percent with a margin of negative 25 percent sums to 35.

The period needs agreeing on as well. Calculated on a single quarter, one large contract or a month of delayed hiring moves the answer. The usual practice is to measure across the last four quarters and use quarterly figures only to read the trend.

Forty is the line, and a sum at or above it is taken to mean growth and profit together are sufficient. Between 30 and 40 is acceptable but wants an explanation. Below 20 reads as a signal that something structural needs fixing.

Two sums of 40 can carry very different risks depending on how they were built. A company at 70 growth and negative 30 margin and one at 20 growth and 20 margin have the same total and different options ahead of them. The first is buying growth with outside money, so a cooling funding market shows up in the growth rate first. The second feeds itself, but it's worth checking whether the market has already narrowed. That is why the sum never travels alone; both halves get written down next to it.

Which half carries the sum also shifts by stage. Below roughly $7,500,000 of ARR, growth supplies most of the total and a negative margin is normal. As a company gets larger the growth rate comes down on its own, so margin has to take up the slack to hold the sum. If a company doubled revenue while its sum slid from 45 to 25, profit failed to keep pace with growth cooling off.

This isn't a metric to use by itself. To find out why a sum came in low, look at the burn multiple for how much cash went out per unit of new revenue, and at CAC payback for how many months it takes to recover the cost of winning a customer. The rule of 40 is closer to a first number that tells you where to look.

"Thirty-five growth on a five percent operating margin, so we hit 40."

The two values add up past the line.

"We clear 40, but growth is only 15. That's a 40 built out of margin, and next year worries me."

The sum passes while growth has stalled, which makes the same sum hard to repeat.

"At our stage we look at burn multiple before the rule of 40."

Not yet the stage to produce profit, so the efficiency of the cash burned is the better read.

The first page of Pagedeck's board material carries this sum as one line. Revenue last year went from $2,250,000 to $3,000,000, up 33 percent, and the operating margin was 5 percent, so the sum is 38. Grace writes both values underneath it because there are two ways to turn 38 into 40 and they lead in opposite directions.

Cutting advertising to lift the margin to 7 percent produces a sum of 40 and a lower growth rate the following year. Pushing growth to 37 percent produces a sum of 40 even if the margin drops to 3 percent. The last board meeting chose the second, on the grounds that the market is still expanding.

The most common mistake is reading 40 as a pass mark that has to be cleared. The number is crisp and the name says rule, so it sounds like a regulation. But it is a benchmark derived by looking backwards at companies that grew, and applying it regardless of stage breaks quickly. A company at $750,000 of ARR that triples in a year has a growth rate of 200 percent, so even a margin of negative 150 percent leaves a sum of 50. That 50 doesn't mean healthy; it means the calculation has stopped meaning anything at that size. The test generally becomes useful somewhere past $7,500,000 of ARR.

The other belief is that growth and margin trade one for one. Because they get added, a point of growth and a point of margin look like they weigh the same. What it costs to produce them differs, though. A point of margin appears this quarter if costs come down by that much, while a point of growth requires money into advertising, sales, and product first and shows up months later. On top of that, growth raises next year's starting point, whereas costs saved this year are saved only this year. Being able to reach the same sum two ways does not make the two choices equivalent.