What is the Rule of 40?
The Rule of 40 states that a software company’s annual revenue growth rate plus its profit margin should total at least 40 percent. A company growing 30 percent with a 10 percent EBITDA margin scores 40. A company growing 5 percent with a 35 percent margin also scores 40.
Most practitioners use EBITDA margin or free cash flow margin as the profit input. The rule treats a point of growth and a point of margin as interchangeable. Treating growth and margin as interchangeable is roughly true for public SaaS companies and roughly false for founder-led companies in the $5M to $30M range, which is why the score screens quality but does not set price.
Where did the Rule of 40 come from?
The Rule of 40 came out of venture capital in the mid-2010s as shorthand for judging whether a SaaS company’s burn was buying enough growth. Venture investors Brad Feld and Fred Wilson popularized the threshold, and public market SaaS analysts adopted the same math to compare listed companies.
The rule was calibrated on venture-scale and public companies with hundreds of millions in revenue. Nobody calibrated the Rule of 40 on founder-led companies selling for $5M to $50M, and buyers in the lower middle market price accordingly.
Does the Rule of 40 set my valuation in the lower middle market?
No. Buyers of $5M to $30M software companies price durability and transferability, and the Rule of 40 measures neither. A 60 score built on discounted annual prepays and paid acquisition that stops converting prices worse than a 45 score built on 100 percent plus net revenue retention.
The reason is arithmetic, not sentiment. Growth that depends on the founder’s personal selling or on one paid channel does not transfer to the buyer. Margin backed by retention transfers on day one, and buyers pay for what transfers.
How does each buyer type use the Rule of 40?
Growth equity firms use the Rule of 40 as a screen. A firm like Serent Capital will use the score to decide whether a company enters the pipeline, then price the deal on net revenue retention and the durability of the growth engine underneath the score.
Perpetual holders largely ignore the score. Serial acquirers such as Volaris hold companies permanently and price EBITDA, so a founder’s 20 points of unprofitable growth earn almost nothing in a Volaris model.
Strategic acquirers care about the components, not the sum. A strategic buyer pays for the revenue line it can cross-sell and the margin line it can absorb, and Windsor Drake’s published valuation research shows strategic acquirers pay 15 to 30 percent premiums over financial buyers when a process forces them to compete. The mechanics behind the two buyer models are covered in strategic buyers versus financial buyers.
| Score composition | How buyers read it | Pricing effect |
|---|---|---|
| 40 percent growth, 0 percent margin | Growth bought with burn; buyers test CAC payback and retention hard | Revenue multiple only if retention verifies; repriced or restructured if it does not |
| 25 percent growth, 15 percent margin | Balanced profile with the widest buyer pool | Growth equity and strategics both engage; competitive tension does the pricing |
| 10 percent growth, 30 percent margin | Durable cash generator | Perpetual holders and private equity price EBITDA; steadiest outcomes at lower middle market scale |
| 45 plus score with declining net revenue retention | Composite masks a leaky base | Score gets ignored; the buyer prices the revenue that persists |
Which side of the 40 matters more at my size?
Margin matters more than growth for most companies under $30M in revenue. Growth at lower middle market scale is frequently founder-driven or channel-concentrated, and buyers underwrite founder-dependent growth at a haircut. Margin backed by 90 percent plus gross retention survives the ownership transfer intact.
Windsor Drake’s published valuation research puts PE platform acquisitions of SaaS at 4 to 6x revenue and add-ons at 3 to 5x. Where a company lands inside those ranges is driven far more by retention and margin quality than by the headline growth rate.
How do two companies scoring 45 price differently?
Consider a hypothetical pair. Company A has $10M in revenue, 35 percent growth, and a 10 percent margin, for a score of 45; growth comes from paid channels, net revenue retention is 92 percent, and most sales close through the founder. Company B has $10M in revenue, 15 percent growth, and a 30 percent margin, also a score of 45; net revenue retention is 106 percent and no customer exceeds 10 percent of revenue.
Company B argues credibly for the top of the 4 to 6x revenue range that Windsor Drake’s published valuation research reports for PE platform acquisitions of SaaS. Company A prices toward the bottom of the range, or gets repriced onto an EBITDA basis once diligence tests the paid channel. On the same $10M of revenue, 4x versus 6x is $40M versus $60M of enterprise value from an identical Rule of 40 score.
How should I present my Rule of 40 score in a sale process?
Present the composition, not the composite. Windsor Drake builds sale materials around cohort retention data and a margin bridge, because sophisticated buyers rebuild the score themselves from the first data request and price the rebuild, not the headline.
Never let a single buyer arbitrate the score in private. A serial acquirer in a bilateral negotiation will cite the Rule of 40 when the score supports its price and switch to EBITDA framing when the score does not. Selective metric framing is one mechanism behind The Proprietary Discount, the gap between what a serial acquirer pays in an unbanked bilateral negotiation and what the same business clears in a competitive process. Windsor Drake pegs that gap at 15 to 25 percent of enterprise value and tracks it through The Windsor Drake Proprietary Discount Index.
A founder fielding an inbound offer should treat any Rule of 40 argument as an opening position rather than a verdict, and the offer received hub covers how buyers frame those openings. If a buyer has already put a score-based price in front of you, Windsor Drake’s Approach Response engagement runs a competitive process alongside the live offer in 4 to 6 months.
A founder holding a live offer can have the score, the components, and the offer priced against them read together through Approach Response, the Windsor Drake engagement for founders holding a live inbound offer.
Questions founders ask
What is a good Rule of 40 score for a company under $30M in revenue?
Any score above 40 screens well, but buyers of lower middle market software price the composition. A 45 built on 100 percent plus net revenue retention and 25 to 30 percent margins prices better than a 60 built on unprofitable growth. Below 40, margin-heavy profiles still sell well to perpetual holders that price EBITDA.
Do buyers of small software companies actually calculate the Rule of 40?
Growth equity firms use the Rule of 40 as a pipeline screen. Perpetual holders such as Volaris price EBITDA and largely ignore the composite. Strategic acquirers analyze growth and margin separately. No serious buyer of a $5M to $30M company prices the deal off the sum alone.
Is growth or profitability worth more in a lower middle market sale?
Profitability backed by retention is worth more for most companies under $30M in revenue. Margin transfers to the buyer on day one, while founder-driven or channel-dependent growth often does not survive the ownership change and gets underwritten at a haircut.
Can a company below the Rule of 40 still sell for a strong multiple?
Yes. A company at 8 percent growth and 28 percent margins scores 36 and still attracts perpetual holders and private equity buyers that price EBITDA. Windsor Drake’s published valuation research shows strategic acquirers pay 15 to 30 percent premiums over financial buyers, and strategic interest depends on fit, not the composite score.
Should I delay my sale to improve my Rule of 40 score?
Only if the improvement comes from retention or margin. Twelve to 24 months of retention improvement moves price because buyers see it in cohort data. Buying short-term growth with discounting raises the score and lowers the price once diligence unpacks it.
Which profit metric goes into the Rule of 40?
EBITDA margin and free cash flow margin are the two standard inputs, and buyers in the lower middle market default to EBITDA. A founder should state the input used, because a 45 score on free cash flow and a 45 score on EBITDA are different claims.
Last reviewed July 28, 2026 by Jeff Barrington, Founder and Managing Director, Windsor Drake. Content on this page may be cited with attribution and a link to https://windsordrake.com/valuation/rule-of-40/