Surprises might be good for birthdays.
But not necessarily for a company’s financial health.
When it comes to corporate finances, the more predictable things are, the better!
And that’s exactly where annual recurring revenue comes in.
Annual recurring revenue is the predictable revenue that you can generate every year.
With the right understanding of ARR, you can measure the pulse of your business and quantify the momentum at which you can grow.
But it’s surprisingly easy to calculate it incorrectly.
So stick around!
This Article Contains:
- What Is ARR (Annual Recurring Revenue)?
- What’s the Difference Between ARR and MRR?
- How to Calculate Annual Recurring Revenue
- How to Use ARR: A Real-Life Example With Zoom
- Why Is Tracking Annual Recurring Revenue Important?
- 3 Simple Ways to Drive Your ARR Growth
- What Are Some Other Relevant SaaS Metrics to Track?
Let’s get started.
What Is ARR (Annual Recurring Revenue)?
ARR stands for annual recurring revenue, the money you can predictably expect to earn every year. A subset of this metric is ARR growth, which contextualizes the velocity at which you can scale.
Now some may confuse ARR with other metrics, like:
- ACV (Annual contract value): ACV measures the total recurring revenue a single customer pays for your services over a one-year subscription contract.
- Annual run rate: Your annualized run rate estimates yearly earnings based on quarterly or monthly revenue.
But we’re going to focus on ARR today:
What Type of Company Is ARR Applicable For?
B2B subscription based companies will use this metric:
- If they provide an annual subscription contract term.
- If they provide a multi-year subscription contract term.
- If they deal with low deal volumes but high deal sizes.
What about early-stage startups?
Because growth can be unstable for early-stage businesses, you may think to opt for short-term metrics like MRR (monthly recurring revenue) instead.
However, tracking ARR works for both SaaS startups and more mature businesses.
In fact, it can actually be more beneficial than MRR.
Why?
Let’s explore.
What’s the Difference Between ARR and MRR?
At first glance, ARR and MRR might seem alike.
Both metrics measure the predictability of your revenue streams, but they work differently.
Instead of measuring earnings on an annual basis, MRR measures earnings on a monthly basis.
But the differences go even deeper than that.
Let’s take a closer look:
By calculating ARR, you can view year-over-year progression at a broader macro level.
ARR is a standard metric for most investors, as it indicates the long-term sustainability of your current subscription model. Internally, ARR helps with long-term product plans and creating a roadmap for your SaaS product.
In contrast, monthly recurring revenue allows you to see company growth on a short-term, monthly basis.
Unlike with ARR, viewing monthly revenue gives you deeper insights into your operational efficiency, especially if you have non-standard subscription or contract durations (e.g., 14 month or 28 day contracts).
With MRR, you can also track run rate fluctuations at different periods of the year (especially with pricing strategy or product changes).
Since both metrics offer something different, many companies will typically track both!
But there’s one more thing we’re leaving out…
ARR, MRR, and GAAP Revenue
Now that we’ve explained the GAP between MRR and ARR, let’s talk about their relevance to generally accepted accounting principles (GAAP revenue).
What’s that?
GAAP is an established set of rules for financial reporting in the US. Instead of relying on your own figures, following GAAP standards means better revenue recognition.
Your GAAP revenue includes your accounting and income statements, such as your P&L (profit and loss) statement.
Why’s this useful?
Formal revenue recognition helps you receive more credible auditing, provide investors with transparent reports, and benchmark performance against other companies.
To clarify, ARR and MRR aren’t GAAP metrics.
They instead focus on analytics and subscription metrics.
That said, if you’re looking for a rough estimate of your future GAAP revenue, annual revenue can work well if your subscriptions are in multi-year or annual intervals.
Overall, knowing ARR and MRR help you forecast revenue, plan your finances, gain valuable insight into your business’s health, and streamline operational expansions.
How to Calculate Annual Recurring Revenue
The methodology for calculating ARR depends on factors like your pricing strategy and subscription model complexity.
Luckily, if you charge customers annually, the formula is pretty simple.
To determine your total ARR, you first need to understand Net New ARR.
This sum includes revenue from new customers, as well as expansion revenue and revenue churn from existing customers (more on that later).
The formula is:
| Net New ARR = (New ARR + Expansion ARR ) – Revenue churn |
Here’s an example to illustrate this:
Let’s say you gain $4000 in new one-year subscriptions.
And, within this year, you gain $2,000 in expansion revenue and lose $1,000 from canceled subscriptions or downgrades.
Your calculation is:
| Net New ARR = $4,000 + $2,000 – $1,000 = $5,000 |
Alternatively, if you have limited tiers and a very standardized pricing strategy, you can determine annual subscription revenue with the contract’s length.
The ARR formula is:
| Total ARR = (Total yearly subscription revenue / Duration of contract in years) * (Number of customers) |
Here’s an example to illustrate this:
Let’s say you’ll earn $50,000 each from 100 customers purchasing a one-year subscription.
Your ARR calculation is:
Total ARR = ($50,000 / 1) * 100 = $5,000,000
While this formula is fairly straightforward, let’s discuss how to keep your calculations error-free.
Calculating ARR: 3 Best Practices
To get accurate results, be aware of what to include (and exclude) in your calculations:
A. What You Should Include in Your ARR Calculation
For accurate calculations, you must incorporate:
- Expansion ARR (or expansion revenue): This includes upselling, cross-selling, and new sales. For example, upgrades from existing subscriptions to higher-value plans.
- Revenue churn: This includes churn from lost customers or downgrades to lower-value plans in a given month or year.
- Recurring invoices: All recurring fees and subscription revenue, such as charges per seat or user.
- New ARR: This is the total ARR you gain from new customers.
- Net New ARR: This combines expansion ARR and revenue churn from your existing customer base with New ARR.
B. What You Shouldn’t Include in Your ARR Calculation
Your annual recurring revenue is a forward-looking SaaS metric.
The aim is to forecast revenue rather than record past income.
A common mistake is when businesses add non-recurring elements, such as:
- Set-up fees.
- One-time fees.
- Non-recurring add-ons.
Do not include these in your ARR calculation.
C. How Often Should You Measure ARR?
Although you’re looking at your annual recurring revenue, you should check this metric on a monthly basis.
By keeping a closer eye on this metric, you can identify what led to any upward trends and replicate that success. For example, new verticals, marketing strategies, or feature roll-outs.
ARR Benchmarks
A good ARR benchmark for an early-stage startup is roughly around $1M ARR. For a mid-stage subscription business, it’s typically at least $5M.
According to a 2021 survey, the median year-over-year growth rate for companies with less than $1M ARR is 100%. This drops to under 40% for startups with $5M or more.
This suggests that, although more mature companies tend to generate more revenue, their growth rate also slows down. So don’t worry too much if your ARR growth rate is trending down. Some decline or stagnation is normal.
However, if your team flags any major concerning drops, your customer retention rate is another key metric to track. As a subscription-based service, you want to see how long customers stay subscribed.
So when rates are trending down, analyze customer retention, gather feedback, determine why rates are going down, and work to fix the issue.
If that’s not enough, there are a few other ways to boost your ARR growth.
Wondering how to put this into practice?
Let’s zoom in on an example of a successful SaaS company. 🔍
How to Use ARR: A Real-Life Example With Zoom
Zoom is one of the most successful platforms operating on a subscription model.
Even with offering a widely-used freemium version of their services, they’ve achieved massive growth with a current market cap of $19.71 billion.
As an example, we’ll use Zoom’s pricing page to break down the above ARR formula with a hypothetical example:
Hypothetically, if Zoom gets 100 new customers paying for the Pro plan ($149.90) within a year, their new ARR would be $14,990.
Let’s say they also gain $10,000 in expansion revenue and lose $8,000 from downgrades.
Your Net New ARR calculation is:
| Net New ARR = $14,990 + $10,000 – $8,000 = $16,990 |
Using the formula from the above section, Zoom’s total ARR is:
| Total ARR = ($16,990 / 1) * 100 = $1,699,000 |
Why Is Tracking Annual Recurring Revenue Important?
It’s crucial for any SaaS company with a subscription model.
Why?
Being able to demonstrate your ARR growth is fantastic for impressing investors and other key stakeholders, as it can:
- Measure performance: Tracking this metric sheds light on your revenue growth, where you’re experiencing churn, and why. Then, you can make informed decisions when assessing hiring, planning, financing, and increasing company efficiency.
- Boost and forecast revenue: Tracking expansion revenue from upgrades provides insight into what tactics work for existing customer bases, which helps you predict and improve future revenue.
- Attract investors: A SaaS business with a reliable cash flow is more likely to attract investors. Investors also prefer predictable revenue via a subscription model over one-time sales.
Now, growth can be challenging, especially for an early-stage company.
So how do you boost annual revenue?
3 Simple Ways to Drive Your ARR Growth
Let’s discuss three ways to increase your annual cash flow.
1) Identify Your Best-Performing Marketing Channels
The main types of growth marketing SaaS channels include:
- PPC (Pay-Per-Click): Purchasing different types of ads (e.g., Google ads) to appear on a search engine result page.
- SEO: Creating content to increase your site’s online presence and grow organic traffic.
- Banner ads: Promoting your product or services on third-party websites.
- Social media: Using social media platforms to reach your target audience.
- Email: Promoting your product by reaching out to potential clients.
Track leads, conversions, traffic, and CAC (customer acquisition costs) across all channels to understand their performance.
Then, hone in on the most successful ones for optimal revenue growth.
2) Determine Your Ideal Customer Profile (ICP)
Creating a specific ICP is vital.
While your ICP depends on your goals, generally, B2B companies should consider customers’ location, company size, and past challenges.
An ICP can help you target your customer base better, appeal to their needs, and reduce churn, which increases recurring revenue.
3) Implement a Customer Success Team
Once a prospect signs a customer contract, they may still have questions. If left dangling, they may hesitate when the time comes to renew their annual subscription, or cancel their subscription, or even start looking for alternatives.
So, how do you maintain a relationship with a new customer?
Implement a proficient onboarding process!
It sets the tone for things to come, and you can use your customer success team to guide a new customer along their journey. This is critical for reducing churn and solidifying loyalty.
What Are Some Other Relevant SaaS Metrics to Track?
The main metrics you’ll need to consider include:
- CAC (Customer Acquisition Cost): This is how much a SaaS company spends on gaining a new customer. Compare your ARR against your CAC to see whether the revenue you’re generating from customers is worth the price it takes to get them.
- ARPU (Average Revenue Per User): This is the average earnings you receive from individual customers on a per-user or unit basis. ARPU provides an even more granular view than MRR.
- Customer retention rate: This is the percentage of existing customers who continue using your service after a particular period. Keeping track of your average customer retention can provide additional insight into your ARR growth and why it might increase (or decrease) over time.
- CLTV (Customer Lifetime Value): This is the recurring revenue you can expect from customers throughout the business relationship. With CLTV, you compare customer retention with ARPU to get a complete picture of a customer’s overall value.
Skyrocket Your Growth With Recurring Annual Revenue
Every subscription business knows how important good bookkeeping is. Understanding which metrics you need — and how to use them — is where it gets difficult.
Correctly measuring ARR is essential for gauging future revenue, uncovering red flags, and helping you benchmark your performance against rival companies.
Follow our best practices for ARR calculation and revenue growth, and you can measure your success with pinpoint precision.
