The formula is one addition. The definitions decide the answer, and the same company can pass by five points or fail by fifteen.
The Rule of 40 is revenue growth plus profit margin, both in per cent, and a score of 40 or more passes. The formula is trivial; the definitions are not. The same illustrative software company scores 45.0 on ARR growth plus adjusted EBITDA margin and 24.6 on revenue growth plus free cash flow margin after stock-based compensation. A growth equity investor should underwrite the second.
Worked in full in The Growth Equity Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The rule is a shorthand for the trade-off every growth company makes: burn cash to grow faster, or grow slower and make money. Investors use it to compare companies at different points on that curve. It only works if everyone measures both halves the same way, and in practice the two halves come from whichever figures the management presentation prefers.
| Input | Value |
|---|---|
| Revenue, prior year | 46.0 |
| Revenue, current year | 60.0 |
| ARR, opening | 50.0 |
| ARR, closing | 70.0 |
| Reported EBITDA (after stock-based compensation) | −3.0 |
| Stock-based compensation | 6.0 |
| Increase in deferred revenue (annual billing in advance) | 5.0 |
| Other working capital | −0.5 |
| Capitalised development costs | 4.0 |
| Other capital expenditure | 1.0 |
Rule of 40 score = growth rate (%) + margin (%)
In Excel: =(C2/B2-1)+C7/C2, formatted as a percentage; the score is that percentage read as
a plain number.
| Definition | Growth | Margin | Score |
|---|---|---|---|
| ARR growth + adjusted EBITDA margin | 40.0% | 5.0% | 45.0 |
| Revenue growth + adjusted EBITDA margin | 30.4% | 5.0% | 35.4 |
| Revenue growth + free cash flow margin | 30.4% | 4.2% | 34.6 |
| Revenue growth + reported EBITDA margin | 30.4% | −5.0% | 25.4 |
| Revenue growth + FCF margin after SBC | 30.4% | −5.8% | 24.6 |
A spread of 20.4 points on identical facts. The top row passes with room to spare; the bottom row misses by 15.4 points. Neither is a lie. Each choice inflates the score in a specific, recognisable way:
The version to underwrite is revenue growth plus free cash flow margin after stock-based compensation: one base for both halves, every cost counted. On that basis this company scores 24.6, and the investment case has to explain why the growth will accelerate or the margin will widen.
Turn the rule round. For this company to reach 40 on the strict definition, how fast must revenue grow at each margin?
| FCF margin after SBC | Growth needed for 40 | Next-year revenue needed |
|---|---|---|
| −10.0% | 50.0% | 90.0 |
| −5.8% | 45.8% | 87.5 |
| 0.0% | 40.0% | 84.0 |
| 10.0% | 30.0% | 78.0 |
| 20.0% | 20.0% | 72.0 |
At its current margin the company must grow 45.8 per cent, to 87.5 of revenue, to score 40. Every point of margin bought with slower hiring lowers the bar by one point of growth, which is the trade-off the rule was designed to expose.
The first is annualising a quarter. A company that grew 9 per cent last quarter is not growing 36 per cent a year, and it is not growing 41.2 per cent either, which is what compounding the quarter gives. Use trailing twelve months against the prior twelve months, or say clearly that the figure is a run rate.
The second is comparing scores computed on different definitions. A benchmark that quotes a peer's 45 on ARR and adjusted EBITDA tells you nothing about a target's 25 on revenue and free cash flow. Before any comparison, restate both on the same basis.
The third is treating 40 as a pass mark for the price. The rule says the business is balanced; it says nothing about what to pay for it. A company scoring 45 can still be an expensive entry.
The free workbook for this book at the companion page also recomputes the example company the book uses for this metric, and the result is lower than the figure printed. For how growth rounds then shape the return, see what a pro rata cheque actually costs.
Free cash flow margin after stock-based compensation is the strictest and most comparable. Adjusted EBITDA adds back share-based pay, which is a real cost paid through dilution. In an illustrative company the adjusted EBITDA margin is 5.0 per cent while free cash flow after stock-based compensation is minus 5.8 per cent, a difference of almost eleven points of score.
Revenue growth, unless the margin is also computed on ARR. ARR is a year-end run rate and grows faster than recognised revenue in an accelerating company: 40.0 per cent against 30.4 per cent in the illustrative case. Adding ARR growth to a revenue-based margin mixes two bases and flatters the score.
Growth must equal 40 minus the margin. At a free cash flow margin of minus 10.0 per cent a company needs 50.0 per cent growth; at minus 5.8 per cent it needs 45.8 per cent, taking revenue from 60.0 to 87.5 in the illustrative case. Each point of margin gained lowers the growth requirement by one point.
This article is one calculation from The Growth Equity Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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