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  1. 018A software company grows recurring revenue at 35% a year with an EBITDA margin of minus 10%. What is its Rule of 40 score? If growth slows to 25%, what margin does it need to stay at 40?Mental mathsCoreVista Equity PartnersAustin · 2021

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    What margin keeps the score at 40 once growth is 25%?

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    The score is 25 today, and at 25% growth the margin must reach 15%. The Rule of 40 adds revenue growth and profit margin: 35 plus minus 10 is 25, well short of 40. If growth slows to 25%, the margin has to be 40 less 25, or 15%. That is a swing of 25 points of margin, from minus 10% to plus 15%, just to hold the bar.

    What is the Rule of 40 actually measuring?

    Think of a young restaurant that can either open new branches fast and lose money doing it, or open slowly and keep every branch profitable. Either can be healthy; losing money while also growing slowly is not. The Rule of 40 adds growth and margin so that a software company can trade one for the other, and treats a combined score of 40 or more as a sign of a healthy balance. Growth of 35% and a margin of minus 10% score 25, which says the company is spending more on growth than the growth is earning.

    The Rule of 40 is a trade-off line: slower growth must be bought back with margin-20%-10%0%10%20%30%40%0%10%20%30%40%50%Revenue growthEBITDA margin (vertical)growth + margin = 40today: 35 - 10 = 25slows, margin flat: 1525 + 15 = 40+25 points of marginScore now35 + (-10) = 25Margin at 25% growth40 - 25 = 15%
    A company growing 35% with a minus 10% margin scores 25, below the 40 line, and if growth slows to 25% it needs a 15% margin to reach 40, a climb of 25 points of margin.

    Why does slowing growth make the margin job so large?

    Because the score falls point for point. Losing 10 points of growth drops the score from 25 to 15 if nothing else moves, so the margin has to cover both the existing 15-point shortfall and the 10 points just lost. That is 25 points of margin. In practice it means cutting sales and marketing spend that was buying the growth, which is often exactly what happens when a buyout fund takes over a software business: growth slows by choice and margin is rebuilt.

    The relationship
    Score=g+m35+(−10)=25m=40−25=15%\text{Score} = g + m \qquad 35 + (-10) = 25 \qquad m = 40 - 25 = 15\%
    grevenue growth, usually recurring revenue, in per cent
    mprofit margin in per cent, often EBITDA or free cash flow margin
    What it says in wordsGrowth and margin trade one for one, so the margin needed is 40 less the growth rate.

    What should you say about the rule's limits?

    That it is a heuristic, not a law. Different investors use different margin definitions, EBITDA, operating or free cash flow, and the same company can pass on one and fail on another. The rule also treats a point of growth and a point of margin as equal, which is untrue for a small company where growth compounds into a much larger future business. Use it to frame the trade-off, then look at what is driving each side: retention, sales efficiency and gross margin.

    Where candidates lose it

    The common slip is with the sign: adding 35 and 10 to get 45 and declaring the company healthy. A negative margin subtracts.

    The second loss is giving 15% without noticing the size of the move. The interviewer wants to hear that going from minus 10% to plus 15% is a 25-point swing and what kind of cost cutting it implies.

    What the interviewer asks next

    • What growth rate would the company need to reach 40 at its current margin?
    • Which margin definition would you use, and why?
    • Why might a buyout fund accept a lower score at entry?

    Asked at Vista Equity Partners, Private Equity, Austin, 2021 (Wall Street Oasis): They asked mental math and asked about tech/saas-specific sector insights