Let me take you into a boardroom conversation from about a decade ago – not in our industry, but in Silicon Valley. A group of venture capitalists was reviewing one ‘software as a service’ (SaaS) company after another. Some were growing like wildfire but burning through cash; others were sitting on fat profit margins but barely moving. The frustrated venture capitalists soon realized they needed a better way to decide which firms were actually building real value.
That’s where the Rule of 40 originated—a shorthand, a back-of-the-envelope calculation, a simple yet powerful idea:
Add your Revenue Growth Rate to your EBITDA Margin.
If the result is > 40, you’re on solid ground.
Today, this same rule is applied across a wide range of industries where investors are actively exploring opportunities—including RIA firms with recurring revenue, enterprise ambitions, and investors at the table. If you ignore it, you overlook a critical measure of your organization’s health and value creation.
So, let’s take a closer look at exactly how the Rule of 40 works, where it falls short (if used incorrectly), and how to wield it as a strategic leadership tool in your firm.
HOW THE RULE OF 40 WORKS
As referenced above, the formula for calculating your Rule of 40 is: Revenue Growth Rate (%) + EBITDA Margin (%) = Your Rule of 40 Score.
For the Revenue Growth Rate, use your trailing 12-month revenue compared to the prior 12 months (e.g., $10 million in 2023 vs. $11.5 million in 2024 = a 15% growth rate).
To calculate your EBITDA margin, use normalized EBITDA adjusted for one-time expenses and true owner compensation. For instance, a $2.875M EBITDA on $11.5M in revenue results in a 25% margin.
If the total is ≥ 40, consider your firm financially healthy – generating value either through strong growth, strong profit, or a combination of both. The 40% threshold isn’t magic – it’s just practical. A company growing at 30% with a 10% margin is strong. Similarly, a company growing at 15% with a 25% margin would also be attractive, especially RIA firms, which typically enjoy the benefit of:
WHY IT MATTERS IN THE RIA WORLD
Let me offer my observations from the firms I coach and the deals I see being completed. Private equity groups, strategic buyers, and even internal successors are no longer focusing solely on AUM or headcount when valuing an advisory business. They want to know: Are you creating sustainable, profitable growth?
One of our newer clients (I’ll call them Firm A) came to us with a solid 18% year-over-year growth rate. Not bad. However, their EBITDA margin was only 19%. Why? They had added two new offices, made key hires, and upgraded their technology, but they hadn’t refined the firm’s pricing or focused on new client acquisition. This led to a Rule of 40 score of 37.
Another firm (Firm B) experienced a much slower 9% growth rate but achieved a 36% EBITDA margin, resulting in a Rule of 40 score of 45. Both firms believed they were performing well. However, only the second firm, with half the growth rate but nearly double the EBITDA margin, had true clarity. Why? Because they were honest with themselves and focused solely on counting organic growth.
Here’s the all-too-common problem: Roughly 70% of reported growth in the RIA market is driven by capital markets. It's primarily from passive lift. It has little to do with strategy or business development. Another significant portion stems from M&A activity (inorganic acquisitive growth). This leaves very little of the pie for genuine organic growth.
So, if you’re using the Rule of 40 and counting capital market appreciation or acquired AUM as ‘growth,’ you’re creating a misleading narrative. The true test is this: What’s your Rule of 40 when you isolate organic growth?
When you isolate for that, the Rule of 40 tends to become a lot less comfortable (and much more revealing). That’s why it matters so much – because it forces you to engage in a conversation about what is and isn’t driving your business.
Increasingly, institutional buyers and PE-backed consolidators are using the Rule of 40 to identify high-potential investment opportunities. Therefore, take the time to actively track this metric quarterly and on a rolling 12-month basis, as well as after any significant leadership or organizational changes. Perhaps most importantly, segment your analysis:
This is where you start leading like a CEO rather than merely operating as your firm’s lead advisor.
START LEADING SMARTER
The Rule of 40 isn’t merely a scoreboard – it’s a strategic lens that an increasing number of elite firms are utilizing in new and innovative ways to help inform:
If you’re pursuing growth while neglecting margins—or focusing on margins at the expense of growth—this score highlights the issue. There’s no hiding from it. Ultimately, it serves as a check to help you maintain balance and sustainability, fostering leadership maturity.
Coaching Questions From This Article
About ClientWise LLC
ClientWise is the premier business and executive coaching firm working exclusively with financial professionals. We specialize in helping clients optimize growth and maximize revenue by engaging as a knowledgeable partner in accomplishing specific and significant business results. Our full-service coaching program empowers financial advisors, wholesalers, managers and executives to enhance performance through customized, action-oriented solutions based on each client’s specific vision and situation.
Our certified coaches are members of the International Coach Federation (ICF). They adhere to ICF’s strict code of ethics and have the experience and insight to work with you on the unique challenges and opportunities you face each day.
Drawing from an in-depth knowledge of the financial industry, ClientWise’s mission is to professionally develop industry leaders and consistently raise the bar for industry service, commitment and integrity. Simply put, our singular focus is to help you get clear, get focused, and get results.