Annual Recurring Revenue - What is It? How to Calculate?

What is Annual Recurring Revenue (ARR)?

Annual recurring revenue (ARR) is a metric often discussed in SaaS board meetings and serves as the foundation for most financial planning and analytics (FP&A) projections in the industry. However, it's easy to confuse ARR with other financial metrics like "annual run rate" and "accounting rate of return," so let's clarify its specific meaning in the SaaS context.

ARR represents the normalised recurring revenue from subscriptions over a year, capturing only the revenue from these recurring subscriptions. Understanding ARR is vital for SaaS companies, as it give a sound picture of financial health and growth potential.

Imagine you’re a seed-stage SaaS founder, planning your next steps. You might suddenly realize that not all revenue is the same. There’s recurring versus non-recurring revenue, subscription-based versus usage-based, and contracted versus billed and realised ARR. Knowing these distinctions is crucial. Incorrect reporting can jeopardize your next funding round, lead to unreliable insights, and give you a misleading picture of your business’s trajectory.

In this guidebook, we’ll explore why ARR is essential for SaaS companies, the different types of ARR, and how to calculate them. We’ll also examine how ARR differs from generally accepted accounting principles (GAAP) revenue. 

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Types of Annual Recurring Revenue (ARR)?

Let's start by understanding what these terms mean before diving into their implications.

1. Contracted ARR: This is the sum total value of the agreement / contract signed with a customer, indicating the amount the customer has committed to paying over a set period. This value is typically recorded and tracked in the Customer Relationship Management (CRM) system.
2. Invoiced ARR: Not all contracted ARR is invoiced immediately. Invoicing might be delayed by a couple of months, include discounts, or be based on actual usage. Sometimes, customers might pay for the entire year upfront.
3. Usage-Based ARR: This metric tracks the revenue that should be billed based on actual usage or consumption of the software or service within a given month.
4. Realised ARR: This is the revenue collected after it has been invoiced. Even after invoicing, there can be churn, leading to a difference between invoiced ARR and realized ARR.
5. Unbilled ARR: This occurs when the company has started providing services, but the invoice will be generated later, usually at the end of a specific period. This creates a temporary gap between revenue recognition and billing.
6. Unearned ARR: This is when the invoice has been generated, but the organisation has not yet started providing the services. This can happen due to delays in implementing or delivering the software or service.
7. New ARR: This ARR comes from new subscriptions and helps assess how well you’re developing new business. Also known as “New Logo ARR” or “New Business ARR,” it represents the total ARR from new customers.
8. Expansion ARR: This ARR is gained from subscription upgrades via upsells and cross-sells. It shows the impact of these efforts on revenue. Analyzing expansion ARR can help improve other metrics, such as lifetime value (LTV) and net retention rate (NRR), while also enhancing the LTV ratio, a key indicator of sales efficiency.
9. Renewal ARR: This ARR is generated from renewed subscriptions. It serves as a predictor of customer satisfaction and future growth, indicating your ability to deliver long-term value to customers without adding to your customer acquisition cost (CAC).
10. Churned ARR: This measures the revenue lost from customers canceling their subscriptions or choosing not to renew. An increase in churned ARR can signal customer dissatisfaction or the presence of cheaper alternatives.
11. Contraction ARR: This represents any reduction in what the customer was previously paying, such as plan downgrades, canceled licenses or seats, or usage-based reductions. It should not be confused with “Contracted ARR.
12. Resurrected ARR: This ARR comes from customers who canceled their subscriptions but signed back up within a certain period. Understanding why customers come back can provide valuable insights into how to win back previous customers.

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How do you calculate your startup's total ARR?

Calculating your company's total Annual Recurring Revenue (ARR) involves summing up the revenue earned from various sources and subtracting the revenue lost due to cancellations and downgrades. Here's a step-by-step breakdown:

1. Revenue earned from new subscriptions (New ARR)
2. Revenue earned from subscription upgrades (Expansion ARR)
3. Revenue earned from existing subscription renewals (Renewal ARR)
4. Subtract revenue lost from canceled subscriptions (Churned ARR)
5. Subtract revenue lost from downgraded subscriptions (Contraction ARR)

Let's walk through an example:

Example

Suppose your SaaS company has the following revenue data for the year:

• New ARR: $500,000
• Expansion ARR: $200,000
• Renewal ARR: $700,000
• Churned ARR: $100,000
• Contraction ARR: $50,000

To calculate the total ARR, follow these steps:

1. Sum the revenue earned:
   Total ARR from new, expansion, and renewal = New ARR + Expansion ARR + Renewal ARR
   Total ARR from new, expansion, and renewal = $500,000 + $200,000 + $700,000 = $1,400,000
2. Subtract the revenue lost:
   Total revenue lost = Churned ARR + Contraction ARR
   Total revenue lost = $100,000 + $50,000 = $150,000
3. Calculate the total ARR:
   Total ARR = Total ARR from new, expansion, and renewal - Total revenue lost
   Total ARR = $1,400,000 - $150,000 = $1,250,000

So, your company's total ARR would be $1,250,000. This calculation helps you understand the recurring revenue your business can expect over the next year.

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Why do you need to measure these metrics?

Understanding these terms gives you a clearer picture of your SaaS business's revenue dynamics. It helps you track invoicing, revenue recognition, and the timing of service delivery more effectively, leading to a more accurate assessment of your financial performance and future growth.

When there's a significant gap between contracted ARR and invoiced ARR, it can signal issues in your sales process. This might be due to delays in implementation or a long timeline for starting service delivery. It could also result from offering substantial discounts to customers. Both scenarios can have long-term effects on your business.

For example, imagine you announce a contracted ARR of $10 million with great enthusiasm. However, if only $2 million of that amount has been invoiced so far, it's essential to understand why there's such a gap. 

This discrepancy could reveal delays in service delivery, prolonged implementation times, or the impact of offering significant discounts. Understanding this journey from contract signing to invoicing is crucial for a realistic view of your financial health.

Delays in invoicing and lengthy collection cycles can directly impact cash flow, leading to potential challenges and increased risk of bad debts. Managing the collection cycle effectively is crucial for maintaining financial stability.

Grasping the complexities of go-live and invoicing processes allows for better cash flow management, risk reduction, and accurate revenue recognition. Streamlining these processes enhances financial stability and supports sustainable growth.

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What is a good SaaS ARR growth rate?

A good SaaS ARR growth rate varies depending on the stage of the company. For early-stage startups, a growth rate above 100% year-over-year (YoY) is often considered excellent. Mid-stage companies might aim for 50-100%, while mature companies might target 20-50% YoY growth. The key is to maintain a balance between rapid growth and sustainable business practices.

Real-time example: Outreach.io case study

Background: Outreach.io, a sales engagement platform, was founded in 2011 by Manny Medina and Andrew Kinzer. Initially, they created a recruitment platform, GroupTalent, but pivoted to developing software to improve sales productivity. This software evolved into Outreach.io.

ARR growth journey:

1. Early years: Outreach.io focused on solving their own sales problems, which led to creating a product that resonated with other sales teams. They ignored traditional marketing for the first 2-3 years, focusing instead on product development and direct sales.
2. Customer acquisition: The team closed their first 100 customers door-to-door, emphasizing the importance of personal engagement and understanding customer needs. This hands-on approach helped refine their product to better fit the market.
3. Growth strategy: Outreach.io implemented a high-velocity sales strategy, customized their outbound process based on industry and persona, and acquired Sales Hacker to boost their online presence. They also built a community to foster customer relationships and reduce churn.
4. Metrics: By continuously developing their product and maintaining a fast-paced release schedule, Outreach.io achieved significant ARR growth, eventually reaching over $60 million in revenues with a valuation of $1.3 billion.

Key takeaways:

• Product-Market Fit: Pivoting to a product that addresses a critical need can drive significant growth.
• Customer Focus: Direct engagement with early customers helps in building a product that truly meets market demands.
• Community Building: Setting up a community around your product can improve customer retention and reduce churn.
• Strategic Acquisitions: Acquiring platforms like Sales Hacker can enhance your market presence and growth potential.

Source: Outreach.io’s journey from a struggling startup to a billion-dollar company highlights the importance of focusing on product-market fit, engaging directly with customers, and strategically building a community and market presence. Their ARR growth showcases what is possible with a well-executed strategy and relentless focus on solving real customer problems​ (Startup Geek)​​ (Content Beta)​​ (The Next Scoop)​.

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ARR vs. Revenue

Annual Recurring Revenue (ARR) and Revenue are key financial metrics for SaaS companies but measure different aspects of financial performance.

ARR:

• Represents normalised recurring revenue from subscriptions over a year.
• Focuses on predictable, ongoing income.
• Key for subscription-based business models.
• Components: New ARR, Expansion ARR, Renewal ARR, Churned ARR, Contraction ARR.

Example calculation: If a company has:

• $500K from new subscriptions,
• $200K from upgrades,
• $700K from renewals,
• and loses $150K from churns and downgrades,

Total ARR = $1,250,000.

Revenue:

• Includes total income from all operational activities.
• Covers both recurring and one-time income.
• Measures overall financial performance.
• Components: Subscription Revenue, One-Time Sales, Professional Services, Other Income.

Example calculation: If a company generates:

• $1M from subscriptions,
• $200K from one-time sales,
• $100K from services,
• $50K from other income,

Total Revenue = $1,350,000.

Key differences

• Predictability: ARR is focused on recurring revenue, while Revenue includes all income types.
• Scope: ARR is for subscription income; Revenue covers all financial sources.

ARR is crucial for understanding the stability and growth of subscription revenue, while Revenue gives a comprehensive view of the company’s total financial health.

What is the formula for calculating ARR?

Annual Recurring Revenue (ARR) is a key metric for subscription-based businesses, particularly in the SaaS industry. It measures the revenue a company can expect to receive from its subscriptions over the next 12 months. The formula for calculating ARR is:

ARR = (Total Number of Subscriptions × Average Revenue per Subscription) + Expansion ARR − Churned ARR − Contraction ARR

Here's a breakdown of the components:

1. Total Number of Subscriptions: The total number of active, recurring subscriptions.
2. Average Revenue per Subscription (ARPS): The average amount of revenue generated from each subscription.
3. Expansion ARR: Additional revenue from existing customers through upgrades or add-ons.
4. Churned ARR: Revenue lost due to customers canceling their subscriptions.
5. Contraction ARR: Revenue lost due to customers downgrading their subscriptions.

ARR vs. MRR

Annual Recurring Revenue (ARR) and Monthly Recurring Revenue (MRR) are both important metrics for subscription-based businesses like SaaS companies, but they serve different purposes and provide different insights.

What they mean

ARR (Annual Recurring Revenue)

• What It Is: ARR is the value of your recurring revenue from subscriptions, normalized over a year. It shows you the predictable revenue you can expect annually from your subscriptions.
• How to calculate:some text
  • Multiply the total number of subscriptions by the average revenue per subscription.
  • Add any revenue from upgrades (Expansion ARR).
  • Subtract revenue lost from cancellations (Churned ARR) and downgrades (Contraction ARR).

MRR (Monthly recurring revenue)

• What It Is: MRR is the value of your recurring revenue from subscriptions, normalized over a month. It gives a more immediate snapshot of your revenue trends.
• How to calculate:some text
  • Multiply the total number of subscriptions by the average monthly revenue per subscription.
  • Add any revenue from upgrades (Expansion MRR).
  • Subtract revenue lost from cancellations (Churned MRR) and downgrades (Contraction MRR).

Key differences

1. Time frame:some text
   • ARR: Looks at revenue on an annual basis, helping with long-term planning and strategy.
   • MRR: Looks at revenue earned on a monthly basis, helping with short-term management and quick adjustments.
2. Use case:some text
   • ARR: Useful for annual budgeting, long-term financial planning, and reporting to investors.
   • MRR: Useful for tracking monthly performance, identifying immediate trends, and making tactical decisions.
3. Scope:some text
   • ARR: Provides a big-picture view of your business’s health over the year.
   • MRR: Offers a detailed, up-to-date view of monthly revenue changes.

Example

Let's say your company has:

• 1,000 active subscriptions
• Each subscription brings in $100 per month

Calculating MRR:

• MRR = 1,000 subscriptions * $100/month = $100,000

Calculating ARR:

• ARR = $100,000/month * 12 months = $1,200,000

This means your MRR is $100,000, showing your monthly recurring revenue, and your ARR is $1,200,000, showing your annualized recurring revenue.

When to use ARR and MRR

• Use ARR: For annual financial planning, budgeting, and reporting to stakeholders who are interested in the long-term health of the company.
• Use MRR: For monitoring monthly performance, making short-term decisions, and quickly identifying any issues or opportunities in your revenue stream.

Can I switch from MRR to ARR?

Switching from Monthly Recurring Revenue (MRR) to Annual Recurring Revenue (ARR) can be tricky, especially if your contracts are shorter than a year. Technically, you can convert these contracts to ARR, but it’s not practical. MRR is much better suited for shorter contract terms and is the preferred metric in such cases.

As your subscription business grows and you experiment with different pricing and packaging, you might introduce new contract terms. If you start to include more contracts that are less than a year in duration, it’s a good idea to use MRR as your standard revenue performance metric.

Switching from ARR to MRR can be a challenge. It requires changing your company’s communication, culture, measurement, and KPI reporting processes, which takes time and effort. However, if you’re seeing an increase in short-term contracts, making the switch is worth it. It’s important to note that companies rarely switch from MRR to ARR because MRR is more flexible and better suited for tracking shorter contracts.

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What should be included in ARR calculation?

Changes to key metrics can directly impact your ARR calculations. Here's how different factors play a role:

Customer revenue per Year:

• This forms the foundation of your ARR calculation. It includes the total revenue generated annually from subscriptions and renewals.

Product add-ons and account upgrades:

• When customers upgrade their plans or purchase additional features, it increases their annual subscription cost. Track these upgrade dollars carefully, as they represent increased revenue from existing customers who are expanding their use of your product.

Product and account downgrades:

• Downgrades decrease the annual subscription price. This includes the total dollar amount lost when customers move to a lower-tier plan. While these customers haven't churned, the reduced revenue still impacts your overall ARR.

Lost revenue from customer churn:

• Churned revenue represents the ARR/MRR lost when customers cancel their subscriptions. It's crucial to account for this loss, but remember that until their subscription period ends, there might still be opportunities to win them back or recover some of that revenue.

Understanding and tracking these factors helps in accurately calculating and projecting your ARR, ensuring a clear picture of your business's financial health.

What not to include in your ARR calculations?

When calculating ARR, focus only on the recurring aspects of your revenue model, such as subscriptions and the impact of churn and downgrades. It’s easy to accidentally include non-recurring items, which can skew your results. Here are some things you should exclude:

• Set-up fees: These are one-time charges and not part of the recurring revenue.
• Credit adjustments: Temporary credits or adjustments should not be included as they do not reflect ongoing revenue.
• Non-recurring add-ons: Any add-ons that are not billed regularly should be excluded.
• One-time charges: Any charges that occur only once should not be part of ARR.

By keeping these items out of your ARR calculations, you ensure a more accurate representation of your recurring revenue.

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Why understanding your ARR is so important?

Tracking the health of your subscription business over time requires a deep understanding of your company's current financial standing and progress towards your yearly growth goals. Whether you're assessing product-market fit, planning new features, or focusing on expansion revenue, knowing the real-world impact of your decisions is crucial.

Here’s why ARR is invaluable:

1. ARR measures tangible Growth:some text
   • ARR provides a clear, straightforward metric for annual recurring revenue, making it easy to track how your revenue compounds over time. Use ARR to map out the best path forward for your company and see the year-over-year impact of your decisions. It serves as a reliable compass for growth.
2. ARR helps forecast future revenue:some text
   • ARR is the foundation for more complex financial forecasts. By considering churn rates, acquisition goals, and potential pricing changes alongside ARR, you can build a realistic picture of future success. Without ARR, understanding the true impact of your business decisions on customer retention and revenue growth would be impossible.
3. ARR enables realistic goal-setting:some text
   • While you can’t predict the future, knowing your ARR gives you valuable insights for decision-making. It highlights opportunities within your current business model and guides actions that will have the most significant impact. Whether to focus on acquiring new customers or upselling existing ones, ARR helps you set achievable long-term and short-term goals.
4. ARR shows overall business health:some text
   • Subscriptions are the backbone of your business. Tracking the total annual revenue from these subscriptions is the best way to gauge your company’s financial health. By focusing on real subscription revenue, you get the most accurate picture of your business's success.

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How does customer acquisition, retention, and expansion affect your ARR?

1. Reducing customer acquisition costs (CAC):

• Implications: Lowering CAC means you spend less to gain each new customer. While this might not directly boost ARR, it frees up funds/earning that can be reinvested into areas like product development or marketing. This strategic cost management supports sustained growth, indirectly benefiting ARR by making the overall business more efficient.

2. Improving customer retention:

• Impact: Better retention means customers stay with your product longer, increasing their lifetime value. Satisfied, loyal customers are more likely to renew their subscriptions, directly increasing ARR. Retention efforts also reduce churn, which stabilises and grows your recurring revenue.

3. Increasing expansion revenue:

• Strategies: To boost revenue from existing customers, offer incentives for upgrading to higher-tier plans or additional services. This not only increases the perceived value of your product but also deepens customer engagement, directly contributing to ARR growth.

4. Boosting net customer acquisition:

• Impact: Bringing in more qualified leads increases both MRR and ARR by expanding your customer base. By making the acquisition process more efficient and reducing costs, you improve the lifetime value to customer acquisition cost (LTV/CAC) ratio, which positively impacts ARR.

Accounting basics and why they are required for founders.

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Restrictions of ARR as a financial metric

1. Short-term contracts:

• Limitation: ARR doesn’t work well for businesses with short-term contracts (less than a year). Converting monthly or quarterly contracts into an annual figure can distort your financial outlook.
• Impact: This can make it hard to see how your business is performing on a monthly basis and quickly adapt to changes.

2. Seasonal variations:

• Limitation: ARR might not accurately reflect seasonal revenue spikes or dips.
• Impact: You could miss important trends or make misguided decisions if you rely solely on ARR.

3. Revenue recognition issues:

• Limitation: ARR focuses on recurring revenue, ignoring one-time revenues like setup fees or special projects.
• Impact: This can lead to an incomplete picture of your company’s overall financial health.

4. Expansion and contraction:

• Limitation: ARR doesn’t always capture the full effect of customers upgrading (expansion) or downgrading (contraction) their subscriptions within a year.
• Impact: This might give you an inaccurate sense of growth or stability.

5. Customer churn:

• Limitation: ARR can mask the immediate impact of customers who cancel their subscriptions mid-year.
• Impact: You might not realise the extent of churn issues and could delay taking action to improve customer retention.

6. Complex calculations for hybrid models:

• Limitation: If your business model includes both subscriptions and one-time sales, calculating ARR can get complicated and less useful.
• Impact: The metric may become less clear and harder to interpret.

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How to optimise ARR for a tax automation and accounting platform?

1. Improve customer acquisition

• Targeted marketing: Focus your marketing on specific groups like small businesses, freelancers, or large enterprises. Use data to tailor your campaigns and reach the right audience.
• Free trials and demos: Offer free trials or personalised demos to show potential customers the value of your platform.
• Partnerships: Partner with accounting firms, financial advisors / industry influencers to expand your reach / build credibility.

2. Enhance customer retention

• Exceptional customer support: Provide top-notch customer support with knowledgeable staff who can help with tax and accounting questions.
• Regular updates: Keep your platform updated with the latest tax laws and accounting standards to ensure compliance and customer satisfaction.
• Customer engagement: Always stay in touch with your customers through newsletters, webinars, and tutorials that offer valuable tips and updates.

3. Increase expansion revenue

• Upselling and cross-selling: Offer additional features like advanced reporting, payroll management, or integrated financial planning tools. Show customers how these features can streamline their processes.
• Usage-based pricing: Implement a pricing model that scales with customer usage. Charge more as they add clients or process more transactions.
• Premium support packages: Provide premium support packages that include services like tax filing assistance, audit support, or dedicated account managers.

4. Reduce churn

• Customer feedback: Regularly collect feedback and make improvements based on what customers say.
• Churn prediction: Use analytics to identify customers who may be at risk of leaving / proactively engage them with support or special offers.
• Incentives for renewal: Offer discounts or added benefits for customers who renew their subscriptions early or for a longer term.

5. Optimize pricing strategy

• Value-based pricing: Make sure your pricing reflects the value your platform provides. Consider tiered pricing models that offer different levels of service.
• Freemium model: Offer a basic/sample version of your platform for free to attract small businesses and startups, with the option to upgrade as their needs grow.
• Regular review: Periodically review and adjust your pricing strategy based on market trends / consumer feedback, and what your competitors are doing.

6. Focus on product-market fit

• Continuous Improvement: Regularly update your platform to meet your users' evolving needs. Add features that address common pain points in tax and accounting.
• Industry compliance: Always stay ahead of regulatory changes and ensure your platform is always compliant with the latest tax laws and accounting standards.
• Custom solutions: Offer customisable solutions for specific industries or business sizes.

7. Leverage analytics

• Customer insights: Use analytics to understand how customers use your platform, what they like, and where they face challenges.
• Performance metrics: Track key performance indicators like Customer Lifetime Value (CLTV), Customer Acquisition Cost (CAC), and Net Promoter Score (NPS) to measure success and find areas for improvement.

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How can Inkle help in SaaS/ARR modelling?

Inkle provides robust financial modelling services tailored for SaaS companies, focusing on optimising Annual Recurring Revenue (ARR). Here’s how Inkle can support your business:

• Accurate financial projections: Inkle creates detailed financial models that forecast your company’s financial performance based on historical data and key financial drivers. This helps you plan for future growth and make informed strategic decisions.
• Scenario analysis: We perform sensitivity analysis to evaluate different scenarios (base case, worst case, and best case). This helps you understand potential risks and opportunities, ensuring your business is prepared for various outcomes.
• SaaS metrics calculation: Inkle calculates and analyses essential SaaS metrics, providing insights into your ARR and other critical performance indicators. This enables you to track and optimize your recurring revenue effectively.
• Segment analysis: Understanding the performance of different segments within your business is crucial. Inkle’s segment analysis helps identify areas of strength and opportunities for improvement.
• Liquidity and funding assessment: We conduct liquidity analysis to ensure your company can meet its short-term obligations and assess funding requirements to support sustainable growth.
• Profitability projections: Projecting the growth of profitability helps in setting achievable targets and aligning your business strategy with financial goals.
• Stakeholder communication: Inkle provides formal communication of vital metrics and financial line items, ensuring transparency and clarity for stakeholders.

For more details, you can contact Inkle at hello@inkle.io or visit our homepage at Inkle.

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