The startup world is full of acronyms, but one that many people seem to misunderstand is Annual Recurring Revenue (ARR). Despite having the word “revenue” in it, ARR is a little more nuanced.
If you’re in the B2B SaaS space, ARR is a valuable metric for measuring the performance and value of your business. For startup founders in particular, knowing how to calculate ARR can give you a better idea of the overall health of your business and allow you to properly communicate key metrics with your team and your investors.
The Basics of ARR
Understood in its simplest terms, ARR is a subscription economy metric used almost exclusively in B2B subscription businesses. ARR is the value of contracted recurring revenue of a business’s term subscriptions normalized for one calendar year. In other words, tt shows the money that is coming in every year for the life of a subscription or contract.
For example, if someone were to purchase a two-year subscription for your software for $10,000, the AAR would be $5,000 each year.
Subscriptions are based on on-going relationships, so for SaaS startups using the subscription model, ARR helps to track how these relationships change over time—be it renewals, upgrades, or lost customers.
How to Calculate ARR
Unfortunately, there are no defined rules when it comes to calculating ARR. Typically, ARR excludes any one-time or variable fees and includes just committed and fixed subscription or recurring fees.
Therefore, you can calculate ARR by simply dividing the total contract value by the number of relative years.
To better demonstrate how to calculate ARR, let’s take an example. Say that a customer agrees to a 2-year subscription cost of $24,000. To calculate the ARR, you would take $24,000 and divide by 2 years. The result would be an ARR of $12,000.
From the above, it may seem like ARR is simply a fancy way of dividing contract value by years, but if you are using this metric correctly there are a few additional things to keep in mind:
- ARR only includes fixed contract fees, meaning any one-time charges or variable fees are not included.
- ARR should only be used to calculate contracts that have terms of one year or more.
- Billing cycles don’t affect how ARR is recorded, so it doesn’t matter if a client pays monthly, quarterly, or everything up front.
Why Startups Need to Track ARR
This probably all sounds simple enough, so now you’re likely wondering what all this means to you as the founder of a SaaS startup. While ARR can be a useful metric for a lot of reasons, the primary benefit is that it can be used to gauge the health of your business. Since ARR is the amount of revenue that is expected to repeat, it can be used to track a company’s progress and predict future growth. More specifically, ARR can be instrumental in:
1. Illustrating Company Health
- ARR reveals where revenue is growing and where it’s being lost, which is a powerful indicator of a company’s performance. Armed with this knowledge, you can make better decisions when it comes to hiring, compensation, financing, and more.
2. Measuring Momentum
- ARR can reveal momentum (or a loss of momentum) in areas such as new sales, renewals, and upgrades.
3. Increasing Revenue
- Tracking changes in ARR can shed light on what customers are looking for and what they need. In turn, this information can help you upsell or cross-sell your services.
4. Predicting Revenue
- By tracking the value of renewals and the cost of lost clients, you can better predict the duration and revenue of subscriptions from potential clients.
5. Attracting Investors
- Investors and lenders like to see contractually-obligated and accurate revenue forecasting. Therefore, ARR can help you demonstrate both predictability and sustainability.
ARR vs. MRR
In order to use ARR as a metric for your business, you’ll need to have Term Agreements of at least one year or more.
For subscriptions that have terms of less than one year, or if customers have the ability to cancel at any time with notice (usually 30 days), ARR is a misleading calculation. In these cases, you would want to calculate monthly recurring revenue (MRR).