Recurring revenue is the beating heart of your SaaS company. As a metric, known as ARR, this revenue helps you work towards increasing your subscriber base, compounding your growth, and developing a better product over time.
Read on as we take a look at ARR and discuss why it’s important for SaaS companies to track, providing a clear definition, the formula, and a review of some calculation examples.
ARR Definition
Annual recurring revenue (ARR), sometimes referred to as annual run rate, is the normalized annual revenue from your existing subscriptions. It gives you an overview of how your business is performing year on year and enables you to more accurately forecast your growth. ARR tends to go hand in hand with MRR (monthly recurring revenue) for both SaaS startups and more mature tech businesses.
How to Calculate Your Startup's ARR
The ARR formula takes into account all of the recurring revenue within your business.
To calculate ARR, simply add the dollar amount of yearly subscription revenue with the dollar amount gained from expansion revenue, and then subtract the dollar amount lost from churn.
ARR formula:
ARR = (total subscription revenue per year + recurring expansion revenue) – revenue lost from churned customers
Expansion revenue (from recurring fees related to upgrades, upsells, add-ons) affects the yearly subscription price of customers, so it must be included.
Despite the relative simplicity of this calculation, many SaaS startups still get ARR wrong. That's because they include or omit revenue that shouldn’t be part of the equation.
SaaS ARR: Best Practices for Subscription-Based Businesses
What you should include in ARR calculations
Any recurring subscriptions
Upgraded accounts
Downgraded accounts
Lost revenue from churned customers
What you shouldn’t include in ARR calculations
Set-up fees
Account adjustments
Discounts
One-off upgrades
Any other non-recurring charges
Another common mistake companies make when calculating ARR is taking their MRR figure and multiplying it by 12, as there are 12 months in a year. Seems logical.
The problem with this method lies in the volatility of SaaS sales cycles, due to seasonality or other factors, which can impact acquisition and churn over a short period of time. For example, if you have an unusually good month or close your first enterprise deal, those outliers can inflate your ARR – it won't be indicative of what your yearly business typically looks like.
Why it's important for SaaS startups to get ARR right
Incorrect calculations mean you’ll get the wrong picture about your company’s health and growth. It also means reports for your stakeholders and potential investors will be misleading, which can lead to even bigger problems down the road.
It’s important to be as honest and transparent as possible with your ARR methodology so you can get an accurate read on your company’s health, and when the time comes, so you can present achievable forecasts to interested investors.
ARR Calculation Examples
If all your subscriptions are annual, your ARR will be relatively simple to calculate. However, when you’re taking monthly and multi-year subscriptions into account, plus one-off fees and discounts, things can get a little trickier.
Let's go through a few examples so you can see how the ARR calculations differ:
Example 1
If a customer signs up for your product for 4 years, at a total cost of $40,000, plus a cost for sign-up and training fees of $8,000, the calculation should be:
ARR: $40,000 / 4 years = $10,000
The $8,000 is not included in this calculation, as it’s non-recurring revenue.
Example 2
A customer signs up for your annual plan for $100,000 which is made up of the main subscription fee, plus two other subscription components. They’ve also paid your set up fee of $2,500.
ARR: $100,000
Your total subscription revenue from this customer is the sum of their annual plan. The set-up fee is a single payment, so isn’t included in the calculation.
Example 3
A customer signs up for a 15-month term at $150,000.
ARR: $150,000 x (12/15) = $120,000
Example 4
You have a customer that signs up to your monthly plan, and uses your product for 18 months before deciding they won’t renew their plan.
ARR: $0
The customer is paying monthly and hasn’t signed up for an annual subscription, so you should not include this in your annual recurring revenue calculation.
These are just a few examples you might come across in your business. Calculating your ARR accurately can take a little extra thought and consideration in these situations, but the payoff in getting things right is worth it over the long term.
The Benefits of Tracking Annual Recurring Revenue
Annual recurring revenue is a critical metric for SaaS businesses, and it’s fairly simple to measure. This KPI provides a number of benefits to business leaders, which include:
Helps you forecast revenue for the coming year
Gives you better insights into your startup's growth potential
Surfaces how customer churn is affecting your business
Tracking your ARR over time can also help you plan SaaS growth strategies for product development, as well as sales and marketing, so you can decide when the time is right to raise capital for funding bigger growth initiatives.
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