What is ARR?
Annual Recurring Revenue (ARR) is a financial metric used by SaaS (Software as a Service) companies to measure the annualized, predictable and recurring portion of their revenue that is generated from subscription-based products or services. It is calculated by multiplying the Monthly Recurring Revenue (MRR) by the number of months in a year. This is NOT a metric recognized by GAAP, so this means that there are a few different flavors of how it is calculated among the SaaS and VC communities.
Tracking ARR is important for SaaS companies because it provides a clear picture of the company’s revenue growth over time and helps to predict future revenue. Subscription companies recognize revenue over a period of time, but ARR helps showcase the scale of the business by taking into account the annualized run rate of the business. It is also a key metric for evaluating the financial performance of a SaaS company, as it reflects the stability and predictability of the company’s revenue stream. This predictability is a big reason why many SaaS businesses are so highly valued.
How to calculate ARR (for a SaaS company)
ARR only includes revenue from recurring sources, such as monthly or annual subscriptions. It excludes any one-time or non-recurring revenue, such as professional services or consulting fees.
Some examples of revenue sources that would be included in ARR for a SaaS company are:
- Monthly or annual subscriptions to a software product or service
- Recurring revenue from upgrades or add-ons to a software product or service
- Recurring revenue from maintenance or support contracts
Examples of revenue sources that would not be included in ARR are:
- One-time fees for professional services or consulting
- One-time fees for custom development or integration work
- Sales of physical products or non-recurring services
- One off overage charges
And, now for a rather common grey area:
Are recurring services ARR?
Some SaaS or subscription businesses have recurring services - services that the client has subscribed to, and receives the benefit from every month. Are these recurring services counted in the ARR calculation? Maybe. Since there is no GAAP definition of ARR, the decision is up to management and the investors. It’s important to be transparent that this is a different service line to a software subscription. I recommend having these actual recurring services broken out as a separate revenue line on the detailed income statement, and also breaking out the cost of goods sold into multiple lines as well.
I would say that a startup could take the position that this is annual recurring revenue if the revenue item is truly recurring - that the customer has contracted to pay a set amount every period. Services revenue that changes based on usage, the whims of the client, etc. should probably not be included in ARR.
To calculate ARR, add up the monthly recognized revenue that includes the sources listed above (subscription, recurring upgrades, recurring maintenance), but excludes the sources that are one-time. This produces a MRR number, which is then multiplied by 12.
ARR formula
ARR = MRR * 12
Vs MRR
When should a startup use ARR vs MRR? Traditionally, some of the best SaaS investors suggest using ARR if a company has annual contracts, and MRR if a company has clients paying month to month. (Read the section called “Two Kinds of SaaS Businesses,” where David Skok, one of the OG SaaS investors, and a partner at Matrix, explains when he suggests MRR.)
However, these days, founders and investors tend to love the bigger number, opting to go with ARR over MRR. It’s probably totally fine to use either one in most situations.
ARR vs Recognized Revenue
The most common difference between Annual Recurring Revenue and GAAP recognized revenue is that ARR may exclude certain revenue items, such as implementation fees, one time development work, sales of physical goods, non-recurring services, etc. GAAP’s goal is to recognize as the service is delivered to the end client, regardless of the type of service or the timing of the cash collection, which is why certain revenue items may be excluded from the annual recurring revenue calculation. The other most common difference is if a SaaS company uses bookings to calculate ARR, which we will discuss now:
Why does ARR matter to SaaS founders and VCs?
ARR is important because it measures the run rate scale of a SaaS or subscription business.
It can be challenging to understand the scale and momentum of a subscription business because revenue is recognized over time (rather than upfront, as is the case with traditional businesses that sell products or services on a one-time basis). This can make it difficult to get a clear picture of the company’s financial performance and growth potential.
How NDR boosts ARR
Net Dollar Retention (NDR) and Annual Recurring Revenue are closely intertwined in a subscription business. NDR measures the growth or contraction of revenue from an existing customer base, taking into account upgrades (expansions), downgrades (contractions), and lost customers (churn). When NDR increases, it signifies that the revenue from existing customers is growing.
An increase in NDR can boost ARR in two main ways. First, when existing customers upgrade their services (upselling or cross-selling), this expands the revenue gained from each customer. These expansions contribute to higher NDR and directly increase in annualized revenue.
Second, when the churn rate is low (few customers are canceling or downgrading their subscriptions), it means the company is effectively retaining its existing revenue. Maintaining or growing the existing revenue base, alongside bringing in new customers, leads to an increase in revenue.
Therefore, NDR acts as a lever for ARR growth. By focusing on activities that improve NDR (like enhancing customer satisfaction, providing valuable product features, or offering excellent customer service), a company can increase its ARR.
One way to address this challenge is to use annual recurring revenue (ARR) as a metric for understanding the scale and momentum of a subscription business. This is because this metric shows the amount of revenue that a company expects to receive on a recurring basis over the course of a year, and it includes revenue from subscriptions to the company’s software or services, as well as any other recurring revenue streams.
By tracking the growth of their ARR over time, subscription businesses can get a sense of how quickly they are expanding and how well they are positioned to generate long-term value for their shareholders. This can help to provide a more complete picture of the company’s financial performance and growth potential, even though revenue is recognized over time rather than upfront. Some VCs use a SaaS burn multiple, which compares the growth in recurring revenue vs. the company’s overall burn.
Recognized revenue vs. bookings for calculating ARR
For most SaaS companies, recognized revenue is the only metric that should be used to calculate ARR. Recognized revenue is the revenue that has been earned and is recognized on the company’s financial statements. This means that the company has delivered the product or service and is entitled to receive payment. Your fearless SaaS accountant should produce this recognized number for you every month.
However, for some enterprise B2B (business-to-business) SaaS companies, it may be more appropriate to track booking ARR instead of recognized ARR. Booking ARR is the value of new annual contracts that are booked in a given period, regardless of when the revenue is recognized. This metric is useful for enterprise B2B SaaS companies because the sales cycle is often longer and the revenue may not be recognized until later.
Tracking booking ARR can provide a more real-time view of the company’s revenue growth and sales performance. In particular, if a SaaS startup has a long implementation period, this metric can do a much better job showing how the sales team is doing and when calculating sales and marketing efficiency. Basically, if it takes a while for the signed contract to turn into recognized revenue, then the metrics used to showcase the marketing spend and sales efficiency may be unfairly penalized, so bookings can be the right method to produce ARR.
It is important to note that booking ARR may not always be a reliable indicator of the company’s financial performance, as it does not take into account any cancellations or churn that may occur. (This is where a book to bill ratio comes in, which tracks the booked revenue vs the actual recognized revenue).
Just as importantly, if your SaaS startup is going to report out a booked ARR number to investors, it is VERY important to clearly state to VCs that you are going to use a bookings number. While it’s often the investor who asks for the number to be reported on as a booked number, that does not absolve the startup founder from making sure the bookings method is clearly disclosed. Additionally, there may be a need to write down the ARR recognition policy, including defining what constitutes a signed contract that is included in a bookings calculation.
Annual Recurring Revenue vs. Annualized Run Rate
Some founders (and lazy VCs, tbh), have started using the abbreviation ARR to mean “annualized run rate” - as in, the current month’s revenue multiplied by 12. The idea is that this represents the amount of revenue the company would earn annually based on the most recent month’s numbers. For a high-growth company, this is tempting, as recognized revenue for a 12 month period will be a lot lower than the most recent month’s number times 12.
However, in our opinion this is a misuse of the term ARR. If you want to show your most recent run rate, go for it, but don’t call it ARR, call it something that’s not easy to confuse with a standardized(ish) SaaS metric.
How cash collections impact the calculation
The short of it is that cash collections should not impact the way that recurring revenue is calculated. Subscription businesses should use either bookings or recognized MRR to drive the annual rev. calculation, and when cash is collected is not part of the calculation. However, the one time that cash can begin to influence the metric is if the end client becomes a credit risk, and they may not actually pay their bill. In that case, it makes sense to speak with your accounting team to see if revenue needs to be impaired. This can, in fact, impact historical numbers as well.
ARR FAQ
- Definition of ARR
- What is the Meaning of ARR?
- Can you use GAAP revenue to calculate annual recurring revenue?
- Can professional services be included in ARR?
Definition of ARR
Annual recurring revenue (ARR) refers to revenue, normalized on an annual basis, that a SaaS business has contracted with customers, that it expects to receive and deliver to those customers. This metric shows contracted, predictable, recurring revenue expected to be received over a 12 month period, and is calculated by multiplying monthly recurring revenue (MRR) by 12.
What is the Meaning of ARR?
ARR is a SaaS metric designed to help measure the yearly, recurring revenue run rate that a subscription business has contracted and expects to deliver and receive. It is calculated by multiplying MRR by 12. The metric should exclude one-off income, such as product sales, one-time professional services fees, custom development work, or usage/overage charges.
Can you use GAAP revenue to calculate annual recurring revenue?
A company may be able to use GAAP recognized rev to calculate annual recurring revenue, if the company does not have any non-subscription income, and if the business has decided to use recognized revenue (vs. bookings) to drive the calculation.
Can professional services be included in ARR?
Since there is no GAAP definition of annual recurring revenue, a SaaS business could make an honest case to include recurring professional services in its ARR calculation.
If the professional services are an integral part of the company’s core offering and are delivered on a recurring basis as part of a subscription model, a founder could make the legitimate case to include them in the calculation. For example, if a SaaS company offers a subscription service that includes ongoing support and maintenance services provided by a team of professionals, paid for as part of the subscription, the income generated from those services could potentially be included in the company’s ARR.
One off professional services, such as implementation, consulting, one time development, etc. should be excluded.
It may make sense to split out the revenue into multiple categories, since professional services typically have a lower gross margin than software services. This will help explain how the software profitability differs from the services revenue, and make sure potential investors understand that the core, software revenue is highly profitable. Additionally, if a SaaS startup is going to include professional services in its ARR calculation, splitting it out in a stand alone line item is more transparent to investors, as professional services usually merit a lower valuation multiple. It’s best to be honest about these things!
Kruze - we are recurring revenue experts
At Kruze Consulting, our dedicated team of certified public accountants and financial experts at recurring revenue recognition. Leveraging years of expertise, we devise strategic plans to account for annual recurring revenue. Whether you are selling to consumers through app store subscriptions or to large enterprises, our team can assist in driving predictable revenue models and understanding unit economics. Kruze is the recognized expert on recurring revenue accounting - reach out to us today to start your journey toward great subscription accounting.