The Rule of 40 – what is it, and why does it matter?

Hypergrowth remains the primary goal of most SaaS businesses. However, what defines growth? Even more importantly, what is a realistic growth rate to target? In recent years, the Rule of 40 has been a standard benchmark used to define a healthy SaaS company. This rule states that the sum of a company’s percent ARR (Annual Recurring Revenue) growth and its margins (free cash flow) should be greater than or equal to 40 percentage points. Several factors can contribute to each growth variable:

1. ARR growth: There are multiple ways to achieve ARR growth – whether it be through organic growth (customer acquisition, customer retention, cross-selling, up-selling, etc.), new product development, or pricing.
2. Margins: Factors here are not mutually exclusive of those contributing to ARR growth but can include other cost improvements across non-essential activities such as travel costs or essential activities like service quality and R&D…