The Rule of 40: The “Are You Okay?” Test for SaaS Companies

If you’ve ever looked at a SaaS company’s financials and wondered, “Is this thing a business or a very expensive hobby?” — congratulations, you’re ready for the Rule of 40.

This delightfully simple formula tells you whether a SaaS company is “healthy,” “survivable,” or “should probably stop burning investor money like it’s firewood in Manali.”

So… What’s the Rule of 40?

It’s basically SaaS yoga: Growth rate + Profit margin ≥ 40%.

That’s it.If the total hits 40 or more, the company gets a gold star and everyone pretends things are under control.

Examples:

• 40% growth + 0% profit → still passes.

• 20% growth + 20% margin → balanced, adulting.

• 50% growth with a 10% loss → technically passes, emotionally questionable.

  
  

It's the industry’s favorite shortcut because it balances two things founders struggle with:

Growing fast and not going broke.

Why Do I Love This Rule So Much?

Because it's a clean, cheat-sheet metric in a messy world.

• Investors get to judge companies with one number.

• Founders get to defend their existence with one number. Or get a chance to give more useful insights

• CFOs finally have something to talk about at parties.

  
  

It’s also great for deciding when to switch gears:

• Early stage? Chase growth like a sugar-high teenager. ----> Initial 3-6 months

• Later stage? Maybe try this magical thing called “profit.” --> Always remember SAAS will run out of money before projected dates.

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If a company hits the Rule of 40, it suggests they can grow without destroying the company in the process. Always nice.

Why the Rule of 40 actually makes sense? (Mostly for investors but sometimes for founders)

The Rule of 40 works because it forces SaaS companies to balance the two things they love messing up: growing fast and not blowing up.

SaaS businesses have high upfront costs and long payback cycles, so focusing only on growth turns them into cash-incinerating machines, and focusing only on profit turns them into turtles running a sprint.

The Rule of 40 blends both sides into one clean signal:

Are you scaling without setting yourself on fire? It’s not perfect, but it captures the essential truth of SaaS — growth without efficiency is chaos, and efficiency without growth is a slow death.

And as a founder, I’ve even used it to sanity-check and tune my pricing so I wasn’t undercharging myself into oblivion.

But Let’s Be Honest… It Has Problems

The Rule of 40 is basically the “BMI of SaaS.”Useful, but absolutely capable of lying to your face.

Here’s where it goes off the rails:

1. It’s a Snapshot, Not a Diagnosis

A company can pass the Rule of 40 and still be bleeding cash faster than a startup giving away free credits.

2. Early-Stage Startups? Forget it.

At that point, revenue is a rounding error, profit margins are imaginary, and applying the Rule of 40 is like judging a toddler for not having a job. Focus on growing revenue

3. It Can Easily Be Faked

A company might show good numbers by:

• Slashing prices

• Burning more on marketing

• Ignoring churn

• Summoning demons (unconfirmed)

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Passing doesn’t always mean it’s healthy — sometimes it just means it’s creative.

4. “Which Profit Margin?” is A Trick Question

EBITDA? Operating margin? Free cash flow?Everyone uses a different number.It's basically financial astrology with better spreadsheets.

A Simple Example (Because Blogs Need Examples)

Take a SaaS company:

• Revenue grew from ₹10M to ₹12M → 20% growth

• EBITDA margin is: 30%

Add them up → 50% Boom. Rule of 40 crushed—Confetti time.

Does that mean it’s a great business? Maybe .Or maybe that 30% margin came from firing half the support team and charging for phone calls.

My Honest Take (The Part Founders (including me)Hate)

The Rule of 40 is a decent first date metric. Great vibes. Some clarity. Looks neat on paper.

But would I marry the business based on this number?Absolutely not.

Use it as:

• A quick sniff test

• A comparison tool

• A sanity check when founders send “We are killing it” investor updates

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But always dig deeper.Churn, CAC/LTV , cash flow, runway, and customer quality matter far more than a cute formula.

Final Word

The Rule of 40 won’t tell you everything. But it will tell you something — and in SaaS, “something” is often a luxury.

And founders… come closer. No, really, closer.

Stop stressing about hitting 40% when you’re still wrestling with product–market fit.

At that stage, the Rule of 40 means about as much as a gym membership you bought in January — nice in theory, completely useless if you don’t actually show up.

The biggest early-stage mistake?

Throwing away your own product intuition just to manufacture “pretty numbers” for investors.

Congratulations, you hit 42%! Meanwhile, your product is still held together with duct tape and hopes(And hopes are stronger than Duct tape)

Build the product first. Make something people want. (Read Paul Graham)

The numbers will show up later, usually wearing sunglasses and acting like they knew you all along.

If you want, You can check 10 real SaaS companies and see:

• who passes,

• who fails,

• and who passes just because their CFO is exceptionally good with Excel sorcery.

As George Box said

All models are wrong, but some are useful — especially the ones that stop you from confidently driving off a cliff. 

Models or rules aren’t reality; they’re just reality with better lighting. The trick is to use them as guides, not commandments. They won’t save you from every mistake, but they’ll help you avoid the really stupid ones.