Discover why the Rule of 40 is crucial for evaluating high-growth companies in today’s volatile market.
Sectors & Industries
April 24, 2025
Table of Contents
The Rule of 40 has become a go-to metric for evaluating high-growth companies—especially in the tech and SaaS world. While traditional valuation tools like P/E ratios may fall short when a company is reinvesting heavily into growth, the Rule of 40 offers a fast, clear way to judge whether a business is scaling efficiently.
So, what exactly is the Rule of 40? And how do investors use it to evaluate stock potential?
Let’s break it down—starting with the basics, how to calculate it, why it matters, and which companies are currently outperforming on this metric.
At its core, the Rule of 40 is a simple formula that balances revenue growth with profitability. The idea is that a healthy company should be growing fast—but not at the cost of burning unsustainable amounts of cash.
The Rule of 40 = Revenue Growth % + EBIDTA Margin %
If the result is 40% or higher, the company is considered operationally efficient—even if it’s not yet profitable.
Traditional metrics like net income or earnings per share (EPS)EPS don’t always reflect the health of early-stage growth companies, especially in sectors like software, biotech, or AI infrastructure. These firms often reinvest revenue aggressively into R&D, hiring, and customer acquisition.
The Rule of 40 gives investors a quick way to see whether the trade-off between growth and profit makes sense.
Let’s say a company has:
Rule of 40 = 35 + 10 = 45 → Meets the threshold.
Now take another:
Rule of 40 = 60 + (-30) = 30 → Below the threshold.
Even though the second company is growing faster, its profitability drag makes it less efficient from a capital deployment standpoint.
Investors don’t expect early-stage disruptors to be profitable—but they do expect them to show operating leverage over time.
This rule is especially relevant in SaaS (Software-as-a-Service), where companies often report negative earnings while pouring capital into sales teams and product development.
What separates the best from the rest isn’t just growth—it’s efficiency. The Rule of 40 rewards companies that can grow fast while keeping their margins in check.
Some investors tweak the formula using free cash flow margin instead of net profit. This gives a different picture of the company’s ability to fund its own growth.
Adjusted Rule of 40 = Revenue Growth + Free Cash Flow Margin
This version is especially useful for companies that may not be GAAP-profitable but still have strong cash reserves and capital discipline.
Wall Street loves efficiency. When a company nails the Rule of 40, it signals that it can grow without endlessly raising capital or issuing shares. This is especially important in a higher interest rate environment where money isn’t free.
A high Rule of 40 score often results in:
The Rule of 40 is used by investors to identify companies that strike the right balance between growth and profitability. Below are four companies from different sectors that exceeded the Rule of 40 threshold, based on actual financial data from late 2024 to early 2025.
1. Astera Labs (ALAB)
Why it stands out: Astera Labs is scaling rapidly due to high demand for its AI-focused connectivity chips. Despite being in a hypergrowth phase, the company is already profitable—a rare and powerful combination in the hardware space.
Why it stands out: Micron is benefiting from the rising need for AI-driven memory solutions. It has significantly improved its operating efficiency and has returned to profitability while maintaining high revenue growth, qualifying easily under the Rule of 40 framework.
Why it stands out: Qualcomm demonstrates that even mature companies can meet the Rule of 40 by maintaining strong profitability. While its growth is modest compared to high-growth startups, its operating margins remain consistently high, keeping it in the efficient-growth category.
Why it stands out: Palantir is now generating positive net income while still growing revenue at a healthy rate. This performance shows improving operational maturity, with growing contributions from commercial contracts and AI-driven solutions.
Companies that grow fast but fail the Rule of 40 often rely on frequent capital raises, which dilute shareholders. If capital markets tighten, those companies are the first to get hit.
Red flags include:
As more companies shift into AI, cloud, and data infrastructure, the Rule of 40 remains a reliable signal of which players are scaling sustainably. Investors increasingly apply it to AI startups, cybersecurity firms, and fintech disruptors to assess whether the underlying model is viable—or just hype.
Absolutely. In fact, it may be more relevant than ever. As investors move past “growth at all costs” and look for signs of durable business models, the Rule of 40 offers a quick and reliable lens to sort real contenders from pretenders.
It’s not a magic number—but it’s a powerful filter in the hands of investors who understand how growth and margin interplay.
Watch the video here:
The “magic” Rule of 40 is a simple financial benchmark used to evaluate the efficiency of growth-stage companies—especially in SaaS and tech. If a company’s revenue growth rate + profit margin adds up to 40% or more, it’s considered to be growing responsibly. The magic lies in the balance—it rewards both fast growth and profitability, helping investors identify companies that scale efficiently without burning unsustainable amounts of cash.
Example: A company growing at 30% with a 10% profit margin passes the Rule of 40 with a score of 40—indicating strong fundamentals.
The Bessemer Rule of 40 comes from Bessemer Venture Partners, a top VC firm that coined the metric to evaluate cloud and SaaS startups. Bessemer’s version focuses on ARR growth (Annual Recurring Revenue) combined with free cash flow margin—offering a more cash-focused version of the Rule. This adaptation helps investors prioritize startups with recurring revenue and efficient operations over those growing recklessly.
Why it matters: It’s now a go-to metric for VCs and institutional investors analyzing software businesses.
In Palantir’s case, the Rule of 40 helps investors measure how efficiently it’s scaling its data analytics business. As of 2024, Palantir often scores well above the 40% threshold due to high year over year revenue growth and improving margins, especially in government and commercial contracts. Investors use the Rule to track whether Palantir is balancing growth with bottom-line strength as it matures.
Pro tip: Always check Palantir’s latest earnings call for its operating margin and revenue growth to calculate its Rule of 40 score.
Yes—40% year-over-year growth is exceptional, especially if it’s paired with a healthy profit margin. Hitting 40% growth alone shows strong demand, effective product-market fit, and expansion capability. But remember, growth without profitability can be risky. That’s why the Rule of 40 combines growth with efficiency, helping you see the full picture.
Key takeaway: If a company is growing 40% annually and breaking even or better—it’s usually worth a closer look.
Here’s the simplest way to explain it:
Take the company’s revenue growth % and add its EBIDTA margin %. If the result is 40 or more, the business is doing well.
It’s like checking if a company is running fast (growth) without running out of gas (profitability). This rule makes it easy to screen for strong businesses, especially in fast-moving industries like tech and AI.
In marketing, “Rule of 40” isn’t a standard term—but some professionals apply a similar logic. For instance, marketers may track whether 40% of revenue comes from repeat customers or if 40% of pipeline is tied to high-intent leads. However, these uses are more situational. In finance, Rule of 40 always refers to the growth + margin equation used for evaluating companies.
Clarification: Unless otherwise stated, Rule of 40 refers to business financials, not marketing performance.
Rule of 40 primarily applies to:
It’s not a good fit for industries with low margins or slow growth (like utilities or manufacturing). It’s best used when comparing tech-focused, high-growth firms that may not yet be profitable but aim to be.
Absolutely. In fact, it’s become more important in today’s environment of rising interest rates and tighter capital. Investors are now favoring companies that grow efficiently, not just fast. The Rule of 40 helps filter out companies that are scaling recklessly and highlights those with disciplined execution.
In a market where cash efficiency and resilience matter more than hype, the Rule of 40 remains one of the most relevant and powerful tools for growth investors.
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