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Fundamental analysis · Small caps

Rule of 40

Growth (%) + margin (%) ≥ 40

A software company growing 50% with a −10% margin scores 40. One growing 15% with a +25% margin scores the same. The metric says: both are healthy, in different ways.

Which margin is meant is usually not stated. More on that shortly.

Why it is needed at all

A growing software company spends money today to have revenue in three years' time: sales, engineering, customer acquisition. Those costs run straight through the profit and loss account; the benefit arrives later.

The result: the faster a healthy company grows, the worse its profit looks. A price/earnings ratio then penalises precisely what creates value. Conversely, a company can flatter its profit in the short run by ceasing to invest — and sell its future in the process.

The Rule of 40 makes the two paths comparable. That is its achievement, and it is not a small one.

Where it comes from

It is usually attributed to Brad Feld. Strictly speaking, the venture capitalist merely made it public on 3 February 2015: in his post he explicitly credits an unnamed late-stage investor. Fred Wilson was writing about the same rule of thumb at around the same time. It has no author.

And Feld wrote "profit". Not free cash flow margin. The version in common use today, built on cash flow, is a later mutation of practice rather than part of the original formulation. Analyst reports now put EBITDA margin, adjusted EBITDA margin or operating margin in the same slot.

So the most-cited metric in software valuation has neither an author nor a settled definition of its second term. That is not a footnote anecdote.

The cases in which it misleads

1 · The second term is not defined. Between free cash flow margin and adjusted EBITDA margin there can easily be ten points or more at a growing software company — working capital, capitalised development costs and share-based compensation land quite differently in the two. Two houses can report 33 and 45 for the same company, and both are calculating correctly. Without a statement of which margin was used, the number cannot be read.

2 · One-off effects in the margin. Prepayments from annual customers, a tax refund, a divested business line. The margin jumps; the business has not changed. A Rule of 40 built on a single quarter says little.

3 · Share-based compensation. It weighs on profit but not on cash flow. A company paying a large share of salaries in stock looks considerably better on free cash flow margin than the dilution warrants. We do not strip it out — but we do disclose it.

4 · Very small companies. At €8m of revenue a single large customer can move the growth rate by 15 points. The metric is then closer to an accident than to a property of the business.

Hence the rule: what matters is not whether 40 is reached, but how — and on what basis it was calculated.

What counts alongside it

Metric What it says Orientation
Net revenue retention (NRR) Do existing customers grow on their own? Only readable within a segment → its own page
Gross margin Is this software at all? In practice 70% is treated as the dividing line
Burn multiple How expensive is a euro of new business? Rule of thumb: below 1.5 good, above 3 critical

None of these thresholds is prescribed. They are conventions of market practice, formed around large American cloud providers — apply them unexamined to a German small cap and you are measuring with someone else's yardstick.

Net revenue retention is the most informative of the three: above 100%, the company grows even if it wins no new customers at all. A blanket threshold is of little use, however, because the typical value depends heavily on the customer segment.

Gross margin is a switch. Below 70% the business is usually a services business with a software veneer — and that is to be valued on services multiples, not software multiples. The difference is a factor of three or more.

The small cap special case

A large share of technology small caps are not SaaS businesses at all: hardware, semiconductors, project work. The Rule of 40 does not apply there. Calculate it anyway and you get a number without meaning.

How we use the number

We always state which margin sits in the second term, and we calculate over twelve months rather than a quarter. Share-based compensation we disclose separately instead of stripping it out. And we apply the rule only to companies whose business model rests on recurring software revenue — for all others it simply does not feature.

The full framework: How we value technology companies

Sources

As of: 11 August 2026 · Version 2