How to use the Rule of 40 calculator
Rule of 40 scores growth and profitability together:
- Choose the profit measure: free cash flow margin or EBITDA margin. Both are common; free cash flow is the stricter one.
- Enter revenue growth as a percentage, or switch to two revenue figures (the latest 12 months and the 12 months before) and let the calculator work out the rate. The income statement has both.
- Enter the margin for the same 12 months. Use a negative number if the company loses money or burns cash.
Magic number measures sales efficiency. Enter this quarter’s and last quarter’s revenue (or ARR), the sales and marketing spend from the previous quarter and, if you want the payback estimate, the gross margin.
The formulas
Gap = 40% − ScoreGrowth is year over year. The margin is free cash flow or EBITDA divided by revenue over the same 12 months.
ARR version = (ARRend of quarter − ARRstart of quarter) ÷ S&Mlast quarter
Payback in months ≈ 12 ÷ (Magic number × Gross margin)S&M is total sales and marketing expense. The previous quarter's spend is used because deals usually close some weeks after the money is spent.
A worked example
Rule of 40. Company A grew revenue 32% last year with a free cash flow margin of 5%. Its score is 37.0%, 3.0% below 40%. It could pass by lifting the margin to 8.0% at the same growth, or by growing 35.0% at the same margin.
Magic number. Quarterly revenue rose from $2,950,000 to $3,150,000, an increase of $200,000, or $800,000 annualized. The previous quarter’s sales and marketing spend was $1,000,000, so the magic number is 0.80. At a 75% gross margin, the new revenue takes about 20.0 months to pay back the spend.
Many ways to score 40
The rule’s appeal is that it accepts very different companies:
| Company profile | Growth | Margin | Score |
|---|---|---|---|
| Mature and profitable | 10% | 30% | 40.0% |
| The example | 32% | 5% | 37.0% |
| Fast growth, heavy burn | 70% | -35% | 35.0% |
The mature company passes with modest growth because it converts a large share of revenue into cash. The fast grower fails despite growing seven times as fast, because it spends heavily to do so. Investors use the rule to ask whether the losses are buying enough growth, and whether the profits come at the cost of a stalled business.
Two cautions apply. The score treats one point of growth and one point of margin as equal, while many investors weigh growth more heavily. And a company can pass for the wrong reasons: cutting sales spend sharply lifts the margin this year and lowers growth next year.
Reading the magic number
The magic number shows the cost of the growth behind the Rule of 40 score. Holding the example’s revenue gain fixed:
| Previous quarter S&M | Magic number |
|---|---|
| $700,000 | 1.14 |
| $1,000,000 | 0.80 |
| $2,000,000 | 0.40 |
A reading around 0.75 or higher is often cited as efficient, and above 1.0 as a sign that more spending could pay off. Below 0.5, each dollar of sales effort buys little revenue. These cut-offs are rules of thumb that vary; a company with high gross margins and low churn can justify a lower magic number than one with thin margins.
Because revenue is net of churn and contraction, a falling magic number can mean customers are leaving, not that sales got worse. Check it against net revenue retention and the customer acquisition cost.
What this calculator does not include
- One-time items. Services revenue, large one-off deals and restructuring costs distort both metrics. Use recurring revenue and adjusted margins when you can.
- Timing. The magic number assumes last quarter’s spend drove this quarter’s growth. Long enterprise sales cycles stretch that lag.
- Stock-based compensation. EBITDA and free cash flow both leave it out, which flatters the margin of companies that pay heavily in stock.