Technology · Software
Rule of 40: Which Margin Goes In
Growth plus margin depends on which margin you choose: FCF, FCF after stock pay, or operating margin. The 40% bar is shown on a fictional company.
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Educational analysis. This guide is not investment advice or a recommendation to buy or sell any security, and it is not personalised.
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The Sum Changes When the Margin Changes
The Rule of 40 adds revenue growth to a profit margin and asks whether the total clears a rough 40% bar. Brad Feld published the formulation in February 2015: growth rate plus profit should add up to 40%. He left “profit” undefined. That gap is the whole problem. Free cash flow margin, free cash flow after stock pay, GAAP operating margin and adjusted operating margin each produce a different sum from the same year of filings.
This page shows the filed arithmetic for five software companies on those bases. It does not put any of the five filers against the 40% bar. That comparison sits only on a fictional example at the end.
Filed Sums on Free Cash Flow Bases
Free cash flow here means operating cash flow less capital expenditure, as a percentage of revenue. “After stock pay” subtracts stock-based compensation from that free cash flow. Growth is each filer’s stated revenue growth for the year shown.
| Company | Fiscal year | Revenue growth | FCF margin | Growth + FCF | FCF margin after stock pay | Growth + FCF after stock pay |
|---|---|---|---|---|---|---|
| ServiceNow | FY2025 | 20.9% | 34.5% | 55.4 | 19.7% | 40.6 |
| Snowflake | FY2026 | 29.2% | 23.9% | 53.1 | -10.2% | 19.0 |
| Salesforce | FY2026 | 9.6% | 34.7% | 44.3 | 26.2% | 35.8 |
| Microsoft | FY2026 | 17.8% | 20.2% | 38.0 | 16.4% | 34.2 |
| SAP | FY2025 | 7.7% | 22.9% | 30.6 | 18.3% | 26.0 |
Constellation Software is omitted: FY2025 revenue grew 15.5%, of which organic growth was 4%, so most of the growth was bought.
The gap between the two FCF columns is stock pay as a share of revenue. Snowflake’s stock pay was 34.1% of FY2026 revenue; Microsoft’s was 3.7%.
Filed Sums on Operating Margin Bases
GAAP operating margin already expenses stock-based compensation under ASC 718. Adjusted operating margin, the company’s own non-GAAP figure, adds stock pay and other items back. Only ServiceNow’s and Salesforce’s are used here. Growth plus each margin is a third and fourth reading of the same year.
| Company | Fiscal year | Revenue growth | GAAP operating margin | Growth + GAAP op. margin | Adjusted operating margin | Growth + adjusted op. margin |
|---|---|---|---|---|---|---|
| Microsoft | FY2026 | 17.8% | 46.8% | 64.6 | not used | not used |
| ServiceNow | FY2025 | 20.9% | 13.7% | 34.6 | 31.2% | 52.1 |
| SAP | FY2025 | 7.7% | 26.1% | 33.8 | not used | not used |
| Salesforce | FY2026 | 9.6% | 20.1% | 29.7 | 34.1% | 43.7 |
| Snowflake | FY2026 | 29.2% | -30.6% | -1.4 | not used | not used |
For ServiceNow and Salesforce, adjusted operating income (31.2% and 34.1% of revenue) puts the adjusted sums far above the GAAP ones, because stock pay is large relative to GAAP operating profit. FCF before versus after stock pay works the cash-flow version of the same point.
A Fictional Company on Two Bases
Take a fictional subscription company growing revenue at 25% with a reported free cash flow margin of 18% and stock-based compensation of 12% of revenue. Growth plus reported FCF is 43. Growth plus FCF after stock pay is 31 (25 + 18 − 12). On the first basis the sum is above 40; on the second it is not. Nothing about the business changed except which margin entered the sum.
That is the only place on this page the 40% line appears.
How to Use the Rule Without Letting It Use You
Pick the margin that matches the question you are asking, state it, and recompute peers on the same basis. For cash generation before equity compensation, use reported FCF; for cash after treating stock pay as a cost, subtract it. Accounting profit calls for GAAP operating margin, never mixed with an adjusted peer figure.
A reverse DCF still starts from a price and solves for growth; the Rule of 40 does not replace that work. It is a one-line screen whose answer depends on the line you chose.
The Rule of 40 is a screen, not a valuation; the primer shows growth plus free cash flow before and after stock pay beside the multi-period DCF.
- 17 sections, from the recurring-revenue roll-forward and retention disclosure to stock pay, the Rule of 40, usage pricing, the licence-to-cloud transition and serial acquirers
- 42 pages
- a seat SaaS grower, a usage-priced platform, a licence-to-cloud platform and a vertical-software acquirer, all fictional
- 4 worked valuations
- listed software companies on filed margins, stock pay, free cash flow and backlog, each with its fiscal year
- 6-company screen
The Excel model is the primer's recurring-revenue DCF live across 13 sheets: a seat SaaS grower, a usage-priced platform, a licence-to-cloud platform and a vertical-software acquirer, all fictional, plus a column for a company of your own in any of the four business models. Revenue rolls forward from gross and net retention and new-customer revenue, fading to terminal levels that set perpetual growth. Margins move in a straight line to year 10, and stock pay is charged as a cost or counted through dilution. A licence base migrates to the cloud at a conversion ratio you set, and an acquirer's deals earn their own margin. A reverse DCF reads the growth a price requires, and the sensitivity grids re-run the model in every cell.
See what's in the Software Sector Primer →£25 PDF · £59 with the Excel model · £159 for all three Technology industries
Frequently Asked Questions
- What is the Rule of 40 for software companies?
- Brad Feld first published the rule in February 2015: growth rate plus profit should add up to 40%. Feld left the profit measure open. Common practice uses free cash flow margin, GAAP operating margin, or an adjusted operating margin; each produces a different sum from the same filing.
- Does the Rule of 40 use free cash flow or operating margin?
- Either, and the choice changes the answer. Free cash flow margin (operating cash flow less capex) is one common choice; GAAP operating margin and company-adjusted operating margin are others. Stock-based compensation sits inside GAAP operating profit and is added back in reported free cash flow, so charging it as a cash cost moves the sum again.
- Should stock-based compensation be deducted in a Rule of 40 sum?
- If the margin is free cash flow as commonly reported, stock pay has already been added back. A second sum that subtracts stock pay shows growth plus free cash flow after stock pay. The 40% threshold is illustrated only on a fictional company.
- Why is Constellation Software left out of the Rule of 40 table?
- Most of its FY2025 revenue growth was acquired (organic growth 4% against total growth of 15.5%). A Rule of 40 sum that treats bought growth as organic growth misstates the trade-off the rule was meant to describe.
Read next
Stock Pay as a Share of Revenue in Software
Stock-based compensation is a real operating cost under ASC 718. Across six filers it ranges from nil to over a third of revenue.
Software FCF Before vs After Stock Pay
Reported free cash flow adds stock pay back. A consistent valuation either charges that cost or counts the dilution, never neither.
Reverse DCF for Software Stocks
Start from a price and solve for the growth it implies. Worked on a fictional SaaS company; most sensitive to terminal margin and retention.
See it applied
These company profiles apply the concepts from this guide to real public companies.
Also in Software
- Net Revenue Retention: How Filers Define It
- Gross vs Net Revenue Retention
- Usage-Based Pricing and Net Retention
- Rule of 40: Which Margin Goes In
- Stock Pay as a Share of Revenue in Software
- Software FCF Before vs After Stock Pay
- RPO and cRPO in Software
- Current Share of RPO by Software Company
- Licence-to-Cloud Transitions and the Revenue Dip
- Reverse DCF for Software Stocks
- Vertical Software Acquirers: Return on Acquired Capital