Cash burn and capital spending are inevitable when trying to scale a SaaS venture, especially in the early stages. Recurring revenue allows SaaS businesses to generate consistent revenue month over month, keep up with capital spending, and scale their way to a successful merger, acquisition, or IPO. In short, recurring revenue fuels growth in a subscription-based revenue model like SaaS.
Recurring revenue is commonly measured as either monthly recurring revenue (MRR) or annual recurring revenue (ARR). In relation to a SaaS business, this is usually made up of income from monthly or yearly subscriptions to cloud-based software.
Why is recurring revenue important for SaaS businesses?
In the early days of tech, software was bought and sold like any other product via a single purchase. This was mostly due to the fact that software wasn’t yet available on the cloud. Now, software has become easily accessible to anyone with an internet connection and the buying process has changed as a result.
A subscription-based recurring revenue model gives SaaS companies the flexibility to meet changing customer expectations, and make rapid changes to their pricing and packaging.
Recurring revenue can also be utilized as a metric to forecast short-term and long-term growth. Based on historical data, SaaS companies can predict future recurring revenue and optimize their internal processes to increase their MRR expansion rate.
Differences of a SaaS business model
Software as a Service (SaaS) businesses typically use a recurring revenue business model, which means most of their revenue comes from customer subscriptions.
This translates to a constant fluctuation in customers and revenue, so it’s essential to keep track of these changes. The success of a SaaS revenue model can be measured in part by two critical factors which both affect recurring revenue:
1. Customer acquisition rate (CAC)
Customer acquisition is measured by the number of new customers that signup for your SaaS in a given period of time. Customer acquisition is a vital metric for early-stage SaaS companies and can be improved by developing an effective customer acquisition strategy.
2. Customer Retention Rate
Customer retention is measured by the number of customers that renew their subscriptions in a given period of time. Customer retention and renewal rates reveal whether or not a SaaS company has a sustainable business model. If customers start to churn at increasing rates, your revenue could start to plateau or decline at an alarming rate.
What is monthly recurring revenue (MRR) in SaaS?
Monthly recurring revenue is often cited as one of the most critical metrics for a SaaS business, particularly when used by C-level execs as a measure of company performance. Within the subscription industry, it’s essential to track MRR because it accounts for the vast majority of total revenue and is a strong indicator of future growth.
Committed monthly recurring revenue (CMRR) is the total value of the recurring portion of subscription revenue. In a term-based SaaS business, this means the portion of subscription revenue that is recognized each month; it should not be confused with contracted MRR, which is the value of the contracted recurring portion of subscription revenue. In many businesses, the values of these two metrics will often overlap, but the figures could differ significantly depending on your billing and pricing models.
There are several different ways to measure MRR, and each can be used to discover new business insights and improve your recurring revenue model.
What are the different types of SaaS MRR?
SaaS companies that use MRR to measure revenue predictability will typically focus on one or more individual components that apply to their business. These can include the following:
MRR from new or reactivated subscriptions
This is all the revenue generated from newly acquired or returning customers. While both of these metrics are calculated similarly, revenue generated from returning customers should be calculated separately as reactivation MRR.
MRR from customer renewals
This is revenue that already exists from customers with ongoing subscriptions and can change month to month as users cancel, upgrade, or downgrade their subscriptions.
MRR from upgraded subscriptions and add-ons
MRR from subscription upgrades includes any additional revenue made from add-ons, upselling, and cross-selling. This is often calculated under the umbrella term of expansion MRR and is a good indicator of customer satisfaction and loyalty.
It’s equally important to take into account MRR losses, also known as contraction MRR. They include:
MRR losses from canceled subscriptions
Revenue loss incurred from canceled subscriptions is also commonly referred to as churn. Calculating churn gives SaaS businesses insights into what factors contribute the most to lost revenue.
MRR losses from downgraded subscriptions
Downgraded subscriptions account for lost revenue each month and should be added together for a monthly total. When calculated together with churn MRR, you get your total contraction MRR, indicating your total monthly revenue loss from downgraded subscriptions.
How to calculate monthly recurring revenue (MRR)
In its simplest form, MRR can be calculated as:
MRR = (new MRR + expansion MRR) – (churn + contraction MRR)
Here’s a closer look at each of these separate revenue variables:
New MRR and expansion MRR
New MRR can be calculated simply as the number of new subscribers multiplied by the subscription fee. For example, 12 new subscribers at $50 per subscription = $600 in new MRR.
Renewed subscriptions can be calculated as ongoing subscribers multiplied by the subscription fee. For example, 100 ongoing subscribers at $50 per subscription = $5000 in renewed MRR.
MRR from upgraded subscriptions and add-ons (expansion MRR) can be calculated and added together individually. For example, four $20 subscription upgrades and two $30 subscription add-ons = $140
Churn and contraction MRR
Churn MRR is calculated by multiplying the number of canceled subscriptions by the subscription fee. For example, if 20 customers canceled their $50 subscriptions, that’s $1,000 in churn MRR.
Contraction MRR is calculated by adding the total cost of all subscription downgrades together. For example, 3 downgrades of $20 + 1 downgrade of $50 = $110.
What is annual recurring revenue (ARR) for SaaS?
Annual recurring revenue (ARR) is the same as MRR, only calculated on a yearly basis. It’s used more commonly by SaaS or subscription businesses with longer-term subscriptions, but it can also be useful in end-of-year calculations. ARR is equal to the value of your term subscription’s contracted recurring revenue components, normalized to a one-year period.
How to calculate annual recurring revenue (ARR)
To calculate your SaaS ARR, you can do the same calculations as MRR using figures over a 12-month period. However, several ARR components must be taken into account when making your ARR calculations to ensure accuracy and validate your financial metrics.