Just like people, companies go through many stages of life 👶👨‍🎓👴

This can make it hard to compare them against each other, as they may be in different stages.

Luckily, investors have developed a cool trick called the “Rule of 40” to specifically assess a software company's performance – regardless of what stage it's at 📏

The formula for the Rule of 40 is simple: a “strong” software company’s revenue growth rate added to its profit margin should be greater than 40% 🚀

💡 profit margin is net income ➗ revenue, used to measure how profitable (or not) a company is

💡 Revenue growth rate is how much a company’s revenue grew over the last year

Try it yourself: a company grew their revenue 70% in the last year, but operated at a -20% profit margin.

Does it satisfy the Rule of 40? 🤔

Yes, it does!

70% + (-20%) = 50%, which is greater than 40%

Investors may consider this a strong software company, assuming it can continue growing fast.

For younger, earlier-stage software companies, growth is more important than profitability.

They often invest lots of money into growth in order to grow fast, but operate with negative profit margins! 🌱

But as companies mature and get big, their focus usually shifts towards profitability 💵

The bigger a company is, the harder it is to grow fast, so it becomes more important to have high profit margins!

For example, a company growing revenue 20% per year, but operating at a 25% profit margin would also satisfy the Rule of 40.

20% + 25% = 45%, which is greater than 40%

In short, the Rule of 40 states that a strong software company should be either growing fast, highly profitable, or a health balance of both! 🥤