Annual recurring revenue – an introduction
Annual recurring revenue (ARR) is a valuable metric to measure revenue of a SaaS or other subscription business to determine performance. It gives an understanding for management and potential investors about the business’ revenue stream and helps predict future revenue, creating some certainly for the year ahead.
What is ARR?
ARR is the annualised value of current recurring revenue for SaaS or any other subscription-type businesses.
It tells you how much your current base of customers will be worth over a whole year. For businesses with an annual subscription model, ARR is more reliable than one with a monthly rolling contract model as customers are tied in.
ARR is used by B2B SaaS companies selling subscriptions greater than one year but it’s also used by businesses selling monthly subscriptions showing an annualised view of their MRR.
Why is ARR so important?
SaaS companies typically spend significant amounts to win new customers and the return on that spend is seen over a longer period of time.
When you combine ARR with net churn (the number of customers acquired and churned), you get a good picture of the future revenue profile of a SaaS company which is sometimes hard to see when simply looking at the monthly financial results.
All recurring elements should be considered to calculate ARR; new customers, renewals, upgrades, downgrades and churn. This information helps you understand areas of the revenue profile that are performing well or poorly.
ARR is also used to assess the value of a business. Potential investors or buyers may use a multiple of ARR to determine a valuation.
What is a good ARR?
Monitoring the ARR trend over time shows how the business is growing revenue. Early-stage SaaS companies should be targeting significant (more than 100%) year-on-year ARR growth. However, the right growth rate can be balanced with EBITDA % using the Rule of 40.
Often the right strategy, particularly for an early-stage SaaS company, is to focus heavily on ARR growth. The “speculate to accumulate” adage is never truer than in a young business, so you can expect to be spending a lot of money on sales and marketing.
When businesses are seeking investment, potential investors often prefer a demonstrable ARR. A good ARR can then be interpreted by investors as systematic and predictable and could generate a larger valuation. However, not all ARR is the same. ARR with multi-year contracts which are paid in advance should drive a premium valuation when compared to a monthly recurring contract with no contractual commitment.
What does ARR look like?
How do you calculate ARR?
Assuming you are tracking MRR, annual recurring revenue (ARR) is relatively straightforward to calculate as it’s just annualising your MRR at that point in time. If you’re a business with monthly subscriptions, you will normally be tracking MRR.
The formula to calculate ARR is:
ARR = MRR x 12 months
ARR = (opening MRR + new revenue – lost revenue + upsells – downgrades) x 12 months
- Opening MRR: last month's closing MR
- New: revenue from new customers
- Churn: lost revenue from churned customers
- Expansion: increasing value of revenue to existing customers
- Contraction: a contraction of revenue to the existing customer base
ARR worked example
If a company has ARR at the end of January of £1,200,000 (MRR of £100,000 x 12 months). During February the following revenue movements happened:
- New: £20,000
- Churn: £5,000
- Expansion: £2,000
- Contraction: £3,000
February ARR = (100,000 + 20,000 – 5,000 + 2,000 – 3,000) x 12 months = £1,368,000
ARR demonstrates the health of a SaaS or subscription-type business. Its individual components allow a business to assess the impact of actions, identify opportunities and provide a key metric to investors. Management teams and (potential) investors will be focused on ARR and ARR growth to have confidence in the stability and growth of the business.