The Rule of Forty is often touted as a simple, go-to metric for evaluating the health of growing companies, particularly in the tech and SaaS sectors. The formula seems straightforward: add a company’s year-over-year revenue growth rate to its profit margin, and if the sum is 40% or higher, you’re in good shape. However, while the Rule of Forty offers a quick snapshot, many businesses and investors apply it without fully appreciating the nuance behind it.
One of the most overlooked aspects of the Rule of Forty is the quality of the revenue driving that growth. Sure, a company might hit 40% by stacking on service revenue or project-based income, but not all revenue is created equal. Buyers and investors are typically far more interested in recurring revenue—predictable, high-margin income streams—than in transactional or one-off sales. If the growth comes primarily from low-margin or unpredictable revenue sources, the Rule of Forty becomes less meaningful.
Another common misunderstanding is how profitability should play into the equation, especially for smaller companies. If your business is under $5 million in revenue, focusing too heavily on margin at the expense of growth can actually be detrimental. At this stage, growth is king. Investors want to see momentum and a path to scaling, not just a small, highly profitable business. Without significant revenue growth, a high margin doesn’t carry much weight—there’s no market traction to support a valuation lift.
On the other hand, for larger companies—those in the $20 million-plus range—the expectations shift. Growth still matters, but profitability starts to play a bigger role in how buyers view the business. If you’re growing fast but still burning through cash with no path to sustainable profits, the Rule of Forty won’t save you. Investors will question whether you’ve built a business that can stand on its own without external funding or constant reinvestment just to keep the lights on.
Moreover, it’s not uncommon for companies to inflate their Rule of Forty metrics by injecting one-off investments or cost-cutting measures that aren’t sustainable. Growth projections should be clean and based on standalone performance, without relying on temporary boosts. If your company only meets the Rule of Forty because you slashed expenses or received a major capital infusion, that’s a sign of deeper issues, not long-term health.
Ultimately, while the Rule of Forty can be a useful gauge, it’s not a one-size-fits-all solution. The real story lies in how your revenue is generated, whether you’re scaling sustainably, and how you’re balancing growth with profitability at different stages of your business. Without understanding these nuances, relying on the Rule of Forty alone can give a distorted picture of a company’s true financial health and future potential.
