What Is Annual Recurring Revenue (ARR)?
Annual recurring revenue (ARR) is a metric used to measure the total revenue that a SaaS company expects to generate from its subscriptions normalised over a one-year period.
ARR is used mostly by B2B businesses with multi-year subscription models to help leadership understand their annual revenue better and visualise the year-on-year growth of the company.
How Annual Recurring Revenue Is Calculated
For SaaS companies, ARR = MRRx12, which means adding up the monthly recurring revenue (MRR) of all active customers and multiplying it by 12. Since most contracts are on an annual basis, ARR can also be calculated as (the sum total of annual subscriptions + recurring revenue from add-ons and upgrades) – loss of revenue from cancellations/downgrades.
As ARR represents the amount a SaaS company can expect to generate from its recurring billing for a span of 12 months, one-time fees or non-recurring/non-core revenues are not included in the calculation.
Also, the right way of calculating ARR may be more complex than it seems. Many a time, companies fail to distinguish annualised run rate from annual recurring revenue. For context, the annualised run rate is nothing more than a given month’s revenue multiplied by 12. However, these estimates may or may not be supported by a reliable subscription pool in the coming months.
In contrast, annual recurring revenue should represent a steady earning potential based on trusted subscriptions and extended business relationships with valuable customers. Without such backing, the annualised run rate is just a number and does not accurately project what the ARR should be.
Getting ARR wrong is possible due to inconsistent pricing and discounts, incomplete data and tweaks in calculation. Consider this. The ARR calculation is straightforward when a SaaS player charges a $100 monthly subscription fee and a one-time implementation fee of $100.
If the implementation fee is waived later as a discount, will the same $100 be split proportionately under both heads per the GAAP guide and impact subscription? Alternatively, the company may put the one-time implementation fee as $0 without hurting the ARR part.
Again, if the new subscription of $100 gets activated on the last day of a financial year, should we add the entire contract value for that month or annualise it? If annualised, the recurring revenue will be split and the rest of the amount will be pushed to the next fiscal.
The nuances of SaaS ARR calculation could be mind-boggling, but a near-accurate ARR calculation serves its broad purpose. This key performance indicator enables SaaS companies to monitor growth, make financial projections, set sales goals and go for informed decision-making.
What A High ARR Means For SaaS Companies
The annual recurring revenue (ARR) is a benchmark metric for measuring the success of a subscription-based SaaS business. A rapidly rising ARR indicates positive momentum, driven by the growing number of active customers and an increase in the monthly recurring revenue (MRR) per customer. In fact, the higher the upsell and product expansion rates, the better it is for a SaaS player.
As a SaaS company with a high ARR indicates a large and dedicated customer base, this is bound to drive its enterprise value of the business and kindle investor interest. Interestingly, the powerful and long-term growth metric also plays a significant role in determining a company’s valuation.
Going by the 5.5x ARR valuation multiple seen in 2023, a SaaS company with an ARR of $10 Mn may see a valuation of $55 Mn.
How SaaS Companies Can Boost ARR
SaaS companies can increase their annual recurring revenue through various strategies such as aggressively pushing marketing and sales, expanding their product and service offerings and improving customer retention rates. Here is how to go about it:
- More customer acquisition through outbound and inbound marketing, word-of-mouth promotion and long-term business partnerships
- Increasing MRR per customer through upselling and cross-selling
- Reducing customer churn through excellent support, customised experiences, and product-related training and hand-holding
- Product & service expansion through new launches tailored to industry trends, new features and functionality, and enhanced offerings through mergers and acquisitions
