ARR Annual Recurring Revenue explained for SaaS startups

ARR, an acronym for Annual Recurring Revenue, is revenue a startup can anticipate in an annual period. It is the value of the recurring revenue of a startup’s term subscriptions which are normalized to a year. It is a common term used in the SaaS and subscription world.

ARR meaning is also known as Annualized Run Rate since ARR is a close cousin of MRR.

Whilst ARR also is an acronym for Accounting Rate of Return, in SaaS land, that’s not the term you would assume one says their ARR is $1m.

The key points about ARR are:

• It is subscription-based and it is recurring
• It is expressed as a $ amount (or whatever your currency is). Read: Use Dollars in your startup
• The components of term recurring revenue may be paid in different terms, monthly, semi-annual, annually or multi-year, but they are all converted into an annual amount
• It does not include one-off transactions
• It is a key metric that all investors expect founders to know and track
• It’s used for startup valuations
• It is not the same thing as accounting revenue

ARR is basically MRR but bigger

There are very few blogs that go into a lot of detail on ARR, as in many ways, it’s just not that interesting a number and there isn’t all that much to say.

The annual recurring revenue formula is simple. ARR is your MRR, or Monthly Recurring Revenue (the monthly recurring revenue formula is simply your users times by monthly fee), times by 12 (You are assuming yearly subscriptions). There are 12 months in a year, you figure out a monthly equivalent and then turn it into an annual number.

What you are effectively saying though, is that ARR is your run rate revenue. It gives you an idea of your revenue on a rolling annual basis assuming that nothing changes.

Yup, that’s right. There is no growth, no churn (recurring revenuelost), no account expansion, no nothing.

If you are worried about how to calculate annual recurring revenue, don’t worry, you are in good company (and that’s why you are here!). A lot of SaaS companies are calculating their metrics like their MRR incorrectly. In fact, Profitwell found in a poll of 50 SaaS companies that 2 out of 5 were including or discluding something they shouldn’t be in their calculations.

“…most enterprise SaaS companies should use annual recurring revenue (ARR), not monthly recurring revenue (MRR), because most enterprise companies are doing annual, not monthly, contracts…” Dave Kellog

Calendar and run rate

There are a few ways one can think about ARR though so we will cover how to calculate ARR for subscription businesses. One is the run rate and the second is the calendar year (ARR vs revenue).

If you say in any given month that your ARR is $1m, then you are saying that based on the last month, you are generating ARR of $1m assuming the company’s recurring revenue remains constant.

If you are an enterprise company or an SME with a lot of lumpy multi-year or annual contracts, then your run-rate ARR can be pretty misleading.

What if last month has a lot of seasonality and is your best month, or that you have been working for a year on a huge contract? Well, your run rate ARR this month will be huge, and it is going to slump the next month.

You, therefore, can talk about ARR on a calendar basis. In 2018 our ARR was $1m. In 2019, on a run rate basis, it will be $3m.

Once you start talking on a calendar basis, you might be more inclined to use numbers such as bookings and billings though. When I was working with an enterprise SaaS company, I never talked about MRR or ARR.

When I worked at Salesforce, Marc Benioff understood that the only metric that mattered to describe growth was bookings. ARR was not a number that was ever discussed with employees. Most employees did not even know the ARR of the company. But, everyone knew the bookings goal for the year. We all knew what we had to achieve.

Villi Iltchev, Partner, August Capital

To understand all these terms, you can get a free tool and read all about them  here: Decipher key top line SaaS revenue terms like bookings, billings and revenue

Ultimately, with ARR context matters a lot more than when one is talking about MRR. MRR is now and certain. ARR is not certain as it assumes the world looks exactly as it does today, which clearly doesn’t really make sense.

Why do people use ARR?

MRR is a far more operational number than ARR is, but ARR does have its use cases.

People like to think about financial numbers on an annual basis. It seems to give them a better sense of the size of your business. When you say you are doing $100k MRR, I automatically times by 12 and think or say, so you are doing $1.2m a year (ARR). A $60m a year business feels larger than a $5m a month business.

Next, especially when you are a larger SaaS or subscription businesses, churning out then money, you can start to think about valuations more smartly. One of the main, and easiest ways to value a company is from public comparable companies. The data, unlike with comparable transactions is publicly available. You can go to company websites and click on investor relations and download their financial statements. If you are good with numbers, you can make some comps and multiply their metrics against your ARR to get an idea of what you would be valued in the public market.

Nerd note- you would typically decrease your valuation by 25% since you are in the private market and therefore have a ‘liquidity discount’. Ironically these days though, a lot of companies seem to be valued more highly in the private markets! That’s a function of low-interest rates and too much money in funds waiting for a home.

What companies have ARR?

If you are in any way tech-savvy and have a business, you are paying for a SaaS company already so understand the subscription model. Almost every software service imaginable has been turned into a SaaS offering, all of which generate ARR.

• LeadPages: They make it easy to set up landing pages, particularly useful for making custom pages for lots of advertising campaigns
• Xero: If you need to manage your accounting, this is one of the best accounting platforms around
• Slack: Team communication with a lot of APIs built-in
• Salesforce: Manage your sales team

How do I calculate ARR?

The simplest ARR calculation

You have one client who purchases a one-year contract (annual subscription) for $9000 generating you recurring fees.

Your company’s ARR is $9000, the same number.

To turn that into MRR, you divide $9000 by 12 which is $750.

A simple calculation of ARR based on a multi-year contract

You sell multi-year contracts and bill one year up-front in your enterprise SaaS startup. The client buys a 3 year contract for $27000.

The ARR is $27000 (Bookings) divided by three years, so $9000 (Billings).

The MRR is $750.

A simple calculation of ARR based on MRR

MRR = ARPU x Number of customers

• ARPA: Average Revenue per User is the average of the monthly fees you charge customers
• Number of customers: How many customers you have in a time period

Let’s assume you have two pricing packages:

• Basic: $50 recurring revenue per month
• Premium: $100 recurring revenue per month

And you have 10 customers, 50% subscribing to each package:

• Basic: 5
• Premium: 5

5 x $50 plus 5 x $100 = $250 + $500 = $750

You have an MRR of $750.

To turn this into ARR you simply multiply $750 by 12 which is $9000.

Introducing contracts

Your calculations will get more complicated if you have a startup which offers multi-year term subscriptions.

If you offer lots of different packages, then you will need to do a little bit of math, right? With an annual package, you will book one year of revenue. That’s ARR (Annual Recurring Revenue). But for everything else, you will need to normalize for ARR. This is easy though in theory (With a big business it can get a little funky!).

Let’s cover all the contract terms to make sure you are clear that these aren’t complicated calculations:

• 3 year: divide by 3
• 2 year: divide by 2
• Annual: nothing
• Semi-annual: Multiply by 2
• Quarterly: Multiply by 4

Let’s do another example.

• 3 year: One customer paying $9000
• 2 year: One customer paying $6000
• Annual: 5 customers paying $3000 each
• Semi-annual: One customer paying $1000
• Quarterly: Two customers paying $1000
• Monthly: Ten customers paying $100

These normalize into ARR as follows:

• 3 year: One customer is $9000/3 = $3000
• 2 year: One customer is $6000/2 = $3000
• Annual: 5 customers paying $3000 each is 5 x $3000 = $15000
• Semi-annual: One customer paying $1000 is 2 x $1000 = $2000
• Quarterly: Two customers paying $1000 is 2 x $1000 x 4 = $8000
• Monthly: Ten customers paying $100 is 10 x $100 x 12 = $12000

The total revenue is $43000 ARR

That’s $3583 MRR.

Exclude one-off fees in the annual subscription

Next, ARR, like MRR (Since they are the same numbers) excludes one-time or adjustable fees, as well as one-time product sales. Remember, ARR is about recurring, right?

Professional services, support, and maintenance contracts are only MRR if they recur. If they are one-offs they are not recurring.

Let’s do another example, the same as above but the customer with the 3-year contract is new and paid a one-off customer onboarding fee of $10000.

The total is still $43000 ARR. It’s the same. You just ignore the one-off $10k. If during the year, nothing changed, then your future revenue for the year would be $43k + $10 = $53k.

Understanding how complicated it all can get

There are some key concepts we haven’t talked about here. These are bookings, billings, and deferred revenue.

If you only have a monthly offering, then this is all simple as cake. MRR, bookings, billings, revenue, and deferred revenue are all the same.

The moment you have a contract length longer than a month, or offer other services, suddenly the pain is brought and it’s not simple anymore.

You need to understand these to be a SaaS master. You can get a free tool and read all about it here: Decipher key top line SaaS revenue terms like bookings, billings and revenue

Mistakes in calculating ARR

We covered how to calculate ARR, here are some things to avoid messing up when calculating the ARR metric. Note that you will likely calculate on an MRR basis and then convert to the annual basis.

Include discounts

If you have special offers of 50% in the first year, then your customers are not paying full price. You add in ARR of $500 per year, not $1000. Only when they start paying the full price do you get to add in the full value.

Don’t include trials

Ahrefs, for example, has a special offer of $7 for a week. That is not recurring revenue, it is a one-off.  If you were to include it, you would see a minor increase in ARR, a large increase in customers and high churn a week later.

No professional services and other one-off revenue

We went through this already. You only include recurring revenue in Annual Recurring revenue. Duh

Normalize different contract lengths

You know this already. If a 3- year contract is closed, you only note one year of it. Make sure everything is apples to apples. You want to think about bookings and billings when you are dealing with multi-year contracts.

Include late payments

If you have ‘delinquent’ payments, you should have a dunning process to get the client back on track (Typically their credit card expires). The client hasn’t churned yet, so don’t treat them like as churned customers.

Don’t include fees like transaction costs

Payment processing fees go in COGS not revenue.

How do you break ARR down?

Yes, ARR is composed of a number of numbers contributing to it, but it’s not normal to calculate ARR as one would with MRR. Of course, if you are an enterprise business, then you look down on the piddly monthly contracts and revenue minions have. But that’s you. So assuming you are an enterprise like subscription company and don’t do monthly contracts, you are going to do the same thing as you would with MRR.

Since I wrote this all out on the MRR blog, I’m going to basically shamelessly repurpose it for you now. Just pretend the MRR numbers are ARR in charts.

I have built an enterprise SaaS model and to be honest, with enterprise, MRR and ARR are not really concepts that I think of much. It’s all about the bookings and billings since it’s a sales game with a sales cycle.

Here is a graph from the SaaS financial model breaking down what MRR looks like for a subscription business I made up. You can see things going up and down from the baseline.

Note: I’m going to include a few details here which aren’t typically mentioned, being the basis upon which pricing affects new and lost revenue. Note the ‘original pricing’ and ‘new pricing’.

Ok, now here are the numbers behind the graph (Well, a few months anyway). This spells out exactly what happens numerically, which is more useful for comprehension in this key metric.

Note: This is for the BASIC plan, which is the lowest pricing plan.

The starting ARR in the next period is just the ending ARR in the prior year period.

• ARR – Start of month: This is the ARR you start off with. If you are just starting, then the ARR is zero

Here we have new customers and lost customers

• New ARR:  This is new customer money. You have added new customers
• Churn: Customers have left with their money. You have lost clients

This section is what I call package switching. The sum is the net change.

• ADD: Downgrade from Premium: You increase your revenue in the basic plan (But you lose overall) as a client downgraded from the premium to basic
• ADD: Downgrade from Pro: Same as above, but a downgrade from pro
• LESS: Upgrade to Premium: You lose money from basic ARR but you increase overall ARR as the client upgrades to premium
• LESS: Upgrade to Pro: Same as above, but to pro

Here we have more money from existing customers. In my SaaS model for ARR calculations, I assume customers expand only and don’t contract. It’s too hard to assume contraction without a trading history. And you would like to be a little optimistic, though reasoned!

• Plus: Expansion revenue (From new modules): Existing clients buy more services from you to expand. This can include adding new seats. These may or may not be set out in an enterprise contract.

The ending ARR is a sum of all the other numbers.

• Starting ARR
• PLUS new ARR
• LESS churn
• Plue net package switching
• Plus expansion revenue generated
• = Total / Ending ARR

ARR – End of month: This is the ARR you have at the end of a month

In the screenshot, you can see that I have modelled three packages in their business model: Basic, premium, and pro. Then at the end, you determine the total. The total ARR you have is a sum of your three packages. The three packages could be your bronze, silver and gold customers, or it could be 3 avatars you have which numerically characterize them.

Impact of changes in prices

I mentioned the pricing before. I’m going to explain these now.

The easiest way to increase your ARR and profitability is to increase pricing. When you are dealing with annual or multi-year contracts, the model gets really complicated fast, if you sweat the details. You are going to have customers paying you different prices over time and when it comes to churning, they won’t be churning at the current price. They will be churning on an older price, which could be from 12 months, or even years prior when it comes to their renewal.

Less: Churn based on original pricing

If you have an annual customer churn at the end of their term, then you will lose ARR equal to the pricing they were paying when they entered the contract, not the price you may have increased (or decreased) a year later.

Users churn at the price at which they joined. Since you are more likely to increase your pricing, not decrease it, the $ churn will be less than your current pricing. You need to know what they were paying and deduct the dollar churn on that number.

New customers – based on new pricing

New customers join or renew (on say an annual basis), at your new or current pricing.

For annual customers, they will renew at your new price and not their old price (Unless you agree to do so, for some reason). For more complicated deals, you may negotiate this, but you will always (or should be!) asking for a higher price, since inflation, better product, that you need to make rent, whatevs.

How do you increase ARR?

If you want to make more money, you need to increase your ARR. But how do you do that? Well, there are more levers than you might think. Let’s run through them all.

Increase your pricing

Increasing your ARPU is the most obvious way to increase your ARR. The truth though, is that most SaaS startups are underpricing their product. The only downside you need to consider is the potential number of clients who will churn due to the price increase. If the price increase is minimal, you are unlikely to lose many customers, and larger companies can be pretty price insensitive. If you have a lot of customers the net new increase in recurring revenue generated should easily offset the loss of customers.

If you’re pricing is very low compared to value, it may still make sense to dramatically increase your price even if you will lose a number of customers as you will come out net positive. Since you more than likely have a sales team, you should be able to ascertain a better feel of the clients’ willingness to pay more. Listen!

Increase number of customers

It’s easier to make more money by keeping your customers, but you need more customers to grow. Research has shown though, that the top-performing SaaS companies have more account expansion than those that don’t. Also, larger companies rely more on expansion than smaller companies. See this research report on page 26.

Get your customers back

For companies that are large, losing clients can be a big deal (See Twilio and Uber). If you lose customers, feel free to reach out and get them back! That of course can be easier said than done if you are in enterprise land.

Expand the amount one customer pays through expansion revenue

Increasing your price is a no-brainer if you can. What’s even better is to get more money out of every customer, but increasing their share of wallet allocated to you.

You can make more money by:

• Selling more modules: Get them to buy another service. Some other features you have released
• Increasing the number of seats: Get them to add more users from their company. Maybe execs get a dashboard, you add a new department or a new country from a client.

There are variable fees you might charge customers, say via API calls. Yes, that will increase your revenue, but it won’t increase your MRR as it’s not recurring.

Get the client to pay for a more expensive package

If you have most of your clients on the Basic package, get them to the Premium or Pro one! They pay more money that way. Similarly, make sure that clients aren’t downgrading to lower-priced packages.

You will likely see this if clients start seeing little difference between the packages you offer. Maybe basic does most of what premium does, and they can live without the features premium affords? They’ll downgrade. You want to upgrade them.

Offer differentiated prices to price discriminate

Price discrimination is charging different amounts to different people. The simplest example is having pricing tiers on your site. Different prices for different levels of features.

The more advanced application is having enterprise pricing and not listing the price on the website. Then the sales guys will figure out how much flesh they can extract one-on-one. Field and phone sales come at a higher cost, though.

Reduce churn

If you have a monthly churn rate of 3%, that might not sound that much, but if you understand the ARR formula, you are losing 36% of your entire customer base each year! That’s huge! The lower your churn rate, the faster you will be able to grow your ARR.

Multi-year contracts will not increase your ARR. You will only increase your bookings and billings (If you charge upfront). It’s only when you increase how much they are actually spending on an annual or normalized monthly basis will your ARR increase.

Offer contracts

The longer the contract, the more certainty you have on revenue. Because they are stuck with you! If they start losing the loving feeling, they still can’t churn and leave you.

Why do startups like ARR?

Everyone uses ARR. Talk to anyone in SaaS and they will ask you what your ARR is to get a feeling for how large you are. Investors will ask the same. Journalists will ask too, perhaps to see if you are worth writing about?

Here are more reasons to like ARR:

• Normalize: Normalize for subscription terms of different lengths to an annual basis
• Forecasts: ARR is an easy way for you to forecast your future cash flow, make an annual budget and forecast revenue. ARR allows you to plan and control your growth because it is predictable revenue. You can measure new contract growth and churn when a customer signs
• Clients pay on time: It’s not variable, and you don’t have to bill customers each month. As opposed to offering consulting services by the hour, you don’t have to fill in timesheets, invoice the customer and hope to heck they actually pay on time. If customers don’t pay, they don’t get to use your service. Simple.

Why do investors like ARR?

Investors like predictability so this is a critical metric. Subscription business typically doesn’t suffer from seasonality and a lot of operational headaches as one has in ecommerce.

ARR tells investors a lot about your business, especially if you break it down. Investors are more likely to use MRR when thinking about a business operationally unless they are an enterprise company.

Investors use ARR to compare you to other subscription businesses when valuing you. It’s a great leveler. And frankly, venture capitalists love the idea of ARR because it makes it much easier to value a business. A multiple of ARR is a great yardstick.

What is the difference between MRR and ARR?

ARR is sort of the same concept as MRR. It’s just the total amount of money we get per year from our MRR. That’s 12 x monthly revenue. We talked about this above.

Is ARR a KPI?

ARR is a KPI for all SaaS businesses. It should be constantly tracked and will need to be communicated to investors when raising new money or reporting.

How is ARR different to accounting revenue?

It’s not the same thing. As far as anyone other than you and investors, ARR is made up as ACSOI was with Groupon.

ARR is not recognized by the Financial Accounting Standards Board (FASB) or the U.S Securities and Exchange Commission (SEC). It is not reportable GAAP revenue, and should not be confused with or incorporated into revenue recognition. In other words, ARR can’t be reported to anyone legally.

Accounting revenue is a lot about revenue recognition. When you have longer contracts, everything gets harder for accounting purposes. ARR is a more relevant metric than GAAP revenue to describe the size of a SaaS business

Revenue is backward-looking and, for SaaS, a terrible metric. It is inept at describing the past because of the waterfall nature of how subscription revenue gets recognized.

Since ARR is calculated by taking the latest month’s Monthly Recurring Revenue (MRR) and multiplying it by 12, it describes the present, but not the future. It’s a point in time like cash on your balance sheet. It’s just where you are today, not where you might be.

Whilst, ARR is better than GAAP revenue, it’s not the best either. It provides little insight into your performance, growth, or execution.

Understand all the key top-line SaaS metrics

If you want to understand all the key revenue terms in SaaS, you can download a free Excel model and see how all the numbers are calculated, as seen below.