Rule of 40:

The Rule of 40 is a SaaS metric in which the growth rate of the revenue of a company + the profit margin (usually EBITDA margin) must be equal to or greater than 40% to show a healthy, sustainable business model. It balances growth and profitability, and it is an important benchmark for venture capitalists and investors to determine whether a SaaS company is financially healthy, though it should be combined with other metrics for a detailed analysis.
How it Works
Find the metrics: You require the company’s annual revenue growth rate and its profit margin.
Add the numbers together: Add the two percentages together.
Look for the threshold: If the result is 40% or more, the company passes the Rule of 40.
Example
Scenario 1 (Passes the rule):
A business with 30% revenue growth and a 15% profit margin (EBITDA margin) has a Rule of 40 score of 45%.
Scenario 2 (Below the threshold):
A company with 12% revenue growth and an 18% profit margin has a score of 30%, which is below the 40% mark and might be a cause for concern to investors.

Why it’s Important:
The Rule of 40 makes a huge difference in SaaS valuations because it gives investors and analysts an easy reference point to determine whether a SaaS business is achieving growth and profitability in a manner that will create long-term value. Here’s how the Rule of 40 affects SaaS valuations:

Investor Indicator: SaaS businesses that hit or surpass the Rule of 40 (i.e., profit margin plus EBITDA growth ≥ 40%) are typically viewed as more attractive assets. This performance indicator shows that a business is able to grow its operations sustainably or is already profitable, and both of these are desirable characteristics from the perspective of investors and acquisition prospects.

Valuation Multiples: Businesses with or above the Rule of 40 generally have higher valuation multiples (e.g., greater revenue or EBITDA multiples) than those with lower performance. Investors are willing to pay a premium for businesses that exhibit a sound mix of growth and profitability since they are considered less risky and offer a more certain financial future.

Stage Relevance: The Rule of 40 is most relevant to mature or post–product-market fit SaaS businesses as opposed to extremely early-stage ventures. Early-stage ventures can still be justified on high valuations primarily based on high growth, but for mature SaaS companies, the onus grows to balance profitability as well.

Strategic Management: Businesses with a Rule of 40 value close to or greater than it are well-managed and have more strategic choices. They have the luxury of reinvesting to grow further, accelerating margin improvement, or positioning themselves for exit (like IPO or acquisition) at a good valuation.

Overall, surpassing the Rule of 40 can have a significant positive impact on SaaS valuation, serve as an investor validator, and facilitate long-term sustainability. Below it, particularly for more established companies, usually dampens valuation multiples and could signal operational issues to potential investors.