Rule of 40 in SaaS: What a Good Score Actually Means in M&A
The Rule of 40 has become shorthand for SaaS company health. The formula is simple: add your revenue growth rate to your EBITDA margin. If the sum exceeds 40%, the conventional wisdom says, you are doing well. Below that threshold, something needs fixing.
The simplicity is seductive but misleading. In M&A contexts, acquirers apply the Rule of 40 with far more nuance than the binary pass/fail interpretation suggests. Understanding how buyers actually use this metric, and what constitutes a "good" score for different business profiles, separates founders who can articulate their value from those who cannot.
The Formula and Its Components
The Rule of 40 captures the trade-off between growth and profitability:
Rule of 40 = Revenue Growth Rate (%) + EBITDA Margin (%)
A company growing at 50% annually with negative 5% EBITDA margin scores 45, beating the threshold. A company growing at 15% with 30% EBITDA margin also scores 45. Both achieve the same Rule of 40 score through different paths, and both represent viable business models depending on context.
The metric emerged because traditional financial analysis struggled with SaaS economics. High-growth software companies typically operate at losses that would concern investors in traditional industries. The Rule of 40 provides a framework for evaluating whether those losses are justified by growth, or whether the business simply has poor economics.
Bain notes that venture capitalists popularised the Rule of 40 around 2015 as a high-level health check for SaaS businesses, but the metric applies broadly to most software companies. It captures the fundamental trade-off between investing in growth and short-term profitability in a single number.
What the Research Actually Shows
The valuation premium for Rule of 40 performance is well documented, but the scale of the difference is often understated.
McKinsey's research found that companies achieving the Rule of 40 generate enterprise value to revenue multiples nearly three times higher than bottom-quartile performers. This is not a marginal premium. It represents the difference between a $3M ARR business valued at $9M versus $27M on identical revenue.
The scarcity of consistent performance makes this premium meaningful. Analysing more than 200 software companies over a decade, McKinsey found that businesses exceeded Rule of 40 performance only 16% of the time. The median public SaaS company in their sample grew at just 22%, far below the hypergrowth narrative that dominates industry discussion.
Bain's data reinforces the point. Of 86 companies studied from 2013 to 2017, only 25% exceeded the Rule of 40 for three or more years. Just 16% maintained outperformance across all five years. Consistent Rule of 40 performance is the exception, not the norm.
How Acquirers Apply the Metric
In M&A contexts, buyers use the Rule of 40 as a starting point for analysis, not a final verdict. Several dimensions matter beyond the headline number.
The Path to 40 Matters
A 60% growth company with -20% margins achieves the same score as a 10% growth company with 30% margins. But these businesses face very different acquirer scrutiny.
High-growth, negative-margin businesses raise questions about sustainability. Can growth continue at these rates? Will margins improve as scale increases, or are the economics structurally broken? What happens if growth slows before profitability arrives?
Moderate-growth, high-margin businesses raise different questions. Is growth capped by market size or competitive position? Can margins be sustained, or do they reflect underinvestment? Is there upside potential, or has the business optimised for current performance at the expense of future opportunity?
Neither profile is inherently better. The questions simply differ, and founders who understand their profile can anticipate and address acquirer concerns proactively.
Trajectory Trumps Snapshot
A company scoring 35 today with improving trajectory may be more attractive than one scoring 45 with declining trajectory. Acquirers model forward performance, not historical snapshots.
Bain found that among firms achieving Rule of 40 performance, 50% did so through balanced growth between 10% and 30% revenue growth, not hypergrowth. Large, established companies like VMware, Adobe, and Salesforce navigated technology transitions and adjacent market expansion to sustain growth over time. The path matters more than the peak.
Companies whose growth slows without corresponding profitability improvement often become targets of activist investors and private equity acquirers looking to implement operational changes. This is not necessarily a bad outcome, but it affects valuation and deal structure significantly.
Component Quality Varies
Not all growth is equal. Revenue driven by aggressive discounting, short-term contracts, or customers with high churn probability contributes to the headline number but degrades underlying value. Acquirers will decompose growth into its sources and assess sustainability.
Similarly, not all profitability is equal. Margins achieved by starving R&D may look attractive today but create product obsolescence risk. Margins from eliminating customer success may boost short-term numbers while accelerating churn. Acquirers look beyond the EBITDA margin to understand whether profitability is sustainable.
The Four Metrics That Correlate with Value
McKinsey's research identified four operational metrics with high correlation to enterprise value multiples. These are the measures that sophisticated acquirers track beyond the Rule of 40 headline.
Annual Recurring Revenue Growth: The ability to drive topline growth remains crucial. McKinsey's top-quartile SaaS companies achieved 45% ARR growth versus 14% for bottom quartile. This metric reflects market opportunity, competitive position, and sales effectiveness combined.
Net Retention Rate: This measures growth efficiency within the existing customer base. Top-quartile companies achieved 130% NRR versus 104% for bottom quartile. A company with 120% NRR delivers 20% growth annually without adding a single new customer, fundamentally changing the economics of expansion.
Payback Period: This reveals sales and marketing efficiency. Top-quartile companies recovered customer acquisition costs in 16 months. Bottom-quartile companies took 47 months, nearly four years. That difference represents capital efficiency that compounds over time.
Free Cash Flow Margin: For larger, more mature SaaS companies, FCF margin correlates strongly with valuation. Top-quartile moderate-growth companies achieved 31% FCF margin versus 15% for bottom quartile. Even fast-growing companies showed dispersion, with top quartile at 26% versus 10% for bottom.
These metrics collectively tell the story that the Rule of 40 summarises. Acquirers who understand the components can assess whether the summary score reflects genuine business quality or accounting artefacts.
What "Good" Looks Like by Stage
Rule of 40 expectations vary by company maturity. Applying the same standard across stages misses important context.
Early Stage ($500K to $1M ARR): Companies at this stage are typically investing heavily in product and initial market penetration. Negative scores are normal and expected. The question is whether the underlying metrics, retention, payback period, unit economics, suggest the business will achieve Rule of 40 performance at scale.
Growth Stage ($1M to $5M ARR): By this point, the core model should be proven. Rule of 40 scores between 20 and 40 are acceptable if trajectory is improving. Scores below 20 raise questions about whether the business model works. Scores above 40 with improving trajectory attract premium interest.
Scale Stage ($5M+ ARR): Mature businesses should consistently achieve or approach Rule of 40 performance. The mix between growth and profitability will shift as the business matures, with profitability contributing more as growth naturally decelerates. Sustained Rule of 40 performance at this stage commands meaningful valuation premiums.
The Retention Foundation
The single most powerful lever for improving Rule of 40 performance, and the metric that most strongly correlates with valuation multiples, is net retention.
McKinsey's analysis of 40 public B2B SaaS companies found those with NRR of 120% or higher achieved median enterprise value to revenue multiples of 21x versus 9x for those below. The premium is substantial because retention drives both growth efficiency and long-term profitability.
Consider the arithmetic. A business with 120% NRR grows its existing customer base by 20% annually without spending on new customer acquisition. That expansion revenue flows directly to the Rule of 40 calculation at high margin. Meanwhile, new customer acquisition can focus on growth rather than replacement, improving both the numerator and denominator of efficiency metrics.
Top performers like Twilio, CrowdStrike, and Elastic achieve NRR above 125% by investing heavily in customer success, cross-sell, and product expansion. They treat existing customers as growth engines rather than maintenance obligations.
Preparing Your Rule of 40 Story
Before entering a sale process, founders should be prepared to discuss their Rule of 40 performance with nuance.
Know your score and its components. Be able to articulate not just the headline number but how growth and profitability contribute, how those contributions have evolved over time, and where they are headed.
Understand your path. Which of Bain's three archetypes fits your business: hypergrowth (above 30% revenue growth), balanced growth (10% to 30%), or profitability-led (below 10% growth with strong margins)? Each path is valid but implies different buyer profiles and valuation frameworks.
Address weaknesses proactively. If your score is below 40, explain why and what you are doing about it. If specific components drag performance, acknowledge them and demonstrate improvement trajectory. Sophisticated acquirers will find the weaknesses; better for you to frame them first.
Connect to value drivers. The Rule of 40 summarises underlying operational performance. Be prepared to discuss the metrics that drive your score: retention, payback, ARR growth, margin structure. The conversation will inevitably go deeper than the headline.
Beyond the Rule
The Rule of 40 is a useful heuristic, not a comprehensive valuation methodology. Businesses that achieve the threshold have demonstrated the ability to balance growth and profitability, which correlates with long-term value creation. But the metric cannot capture strategic fit, competitive positioning, technology differentiation, or the many qualitative factors that influence M&A outcomes.
What the Rule of 40 does provide is a common language for discussing operational performance. Founders who can speak fluently about their score, explain its components, acknowledge its limitations, and connect it to their broader business narrative demonstrate the operational sophistication that acquirers value.
For businesses in the lower middle market, where every negotiating advantage matters, that sophistication translates directly into better outcomes.
If you want to discuss how your Rule of 40 performance might position you in the current market, we would be glad to share our perspective.