The popular Rule of 40 principle states that, at scale, the combined growth rate and profit margin of a SaaS business should be equal to or larger than 40%.
The calculation is straightforward: the revenue growth rate is added to the EBITDA margin for a given time period (usually a year). By tying growth to a measure of profitability, namely the EBITDA margin, the Rule of 40 captures one business' operational efficiency, offering a better balance between revenue growth and cost-effectiveness.
Its typical components are:
Monthly Recurring Revenue (MRR) = Number of paying users * Average revenue per user (ARPU)
ARR = MRR x 12
ARR Growth Rate = (ARR Current Year / ARR Past Year) / ARR Past Year
EBITDA = Revenue - Operational Expenses
EBITDA Margin = EBITDA / Revenue
To calculate your Rule of 40's score using these components, the formula is:
Rule of 40 = Annual ARR Growth + EBITDA Margin
Generally, the Rule of 40 tends to be most reliable for mature, established companies, being a useful tool for late-stage growth investors.