Rule of 40 for Private SaaS: Formula, Inputs and Trade-Offs

Add two percentages:

1. Growth: year-over-year ARR growth for subscription companies, or revenue growth if you don't track ARR. Use the same measure every period.
2. Profit margin: EBITDA margin or free cash flow margin. Free cash flow margin includes working capital and capex, so it's stricter for companies that collect annual payments up front.
3. Add them: growth plus margin equals your score.

Say ARR grew 25 percent and EBITDA margin was 10 percent. In this example, the score is 35, five points short. For example, a company growing 60 percent while losing 30 percent scores 30, and one growing 5 percent with a 35 percent margin scores 40. Same rule, very different businesses.

Choose your margin definition once, label it (Rule of 40 on EBITDA or on free cash flow) and don't switch to whichever looks better.

Use benchmarks as context, not targets. SaaS Capital's research found median ARR growth of 25 percent among private B2B SaaS companies in 2024¹. If you grew at that median rate, you'd need a margin of about 15 percent to hit a score of 40.

For margins, Damodaran's US industry data list an average EBITDA margin of 35.93 percent for the software (systems and applications) group². That figure covers established companies across the industry, so it isn't a fair benchmark for a young private SaaS business that's investing in growth.

Because the rule was popularized for larger companies, its usefulness is limited at very early stages, where growth is volatile and margins are negative by design. It becomes more informative when revenue is large enough that margin is a choice.

Compare your score with your goals and the trade-offs:

• Below 40 with high growth: check the burn multiple and CAC payback before pulling back. Investing ahead of revenue can be right if unit economics are sound.
• Below 40 with slow growth: the issue is usually retention or sales capacity, not cost.
• Above 40 with slowing growth: you may be under-investing, so ask what extra spend would earn a return.
• Score improving: check whether improvement comes from growth, margin or both.

Check your burn multiple and CAC payback for the efficiency numbers behind the score.

The score is most useful for comparing your own choices. Say you're deciding whether to add five sales reps. In this example, the hires cost about 6 points of margin this year and you expect them to add about 8 points of growth once ramped. The score rises only after the ramp, so the decision depends on whether you can fund the gap and whether the growth is likely to hold. Put the trade-off in writing before you commit, and revisit it after two quarters of actual results. Also compare valuation expectations in private SaaS valuation multiples.

Watch for these:

• Mixing growth measures: quoting ARR growth in one period and revenue growth in the next.
• Adjusting margin with generous add-backs that a buyer would reject.
• Ignoring the timing of annual prepayments, which can inflate free cash flow in a strong billing quarter.
• Comparing a trailing figure with a forecast without labeling which is which.
• Treating 40 as a pass mark for every stage.

Keep a simple table by quarter with growth, margin definition, score and notes about one-off items. If you're planning cash or a fundraising, connect the score to your cash runway and to going-concern considerations covered in ASC 205-40 evaluations.

There are two levers, and they interact. Improve growth through better retention, expansion, pricing and sales capacity. Improve margin through gross margin improvements, efficient hiring and lower cloud and software costs. Small changes to both are usually easier than a big push on one.

Say you have a $6,000,000 ARR business growing 20 percent with a 5 percent margin. In this example, lifting net revenue retention by 5 points might add about 5 points of growth without new sales spend, and trimming a few costs might lift margin by 5 points, taking the score from 25 to 35. Compare tools that support the planning in Jirav, Cube and Mosaic and Cube versus Mosaic for B2B SaaS.