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Annual Recurring Revenue (ARR)

What is ARR?

Annual Recurring Revenue ARR is a key metric used by subscription-based SaaS companies using term-based agreements. ARR normalizes the contracted recurring revenue components of term subscriptions to a one-year period. An alternative to monthly recurring revenue MRR, ARR is used almost exclusively in B2B subscription businesses with multi-year agreements to help financial leaders understand their annual revenue and visualize company growth year over year.

How do I calculate ARR?

An ARR formula typically includes only contractually committed, fixed subscription fees for an annual contract. Most businesses calculate ARR like this:

ARR = Total revenue of yearly subscriptions + Total revenue gained from add-ons and upgrades + Total revenue lost due to downgrades, cancellations, and churn

Since one-time fees are by definition non-recurring, they are almost always excluded from ARR calculations.

Subscription consumption fees and variable fees are usually excluded from ARR calculations. However, an argument can be made to include predictable consumption fees, or at least the contracted minimal committed consumption fees.

Unlike MRR, which can vary dramatically from GAAP revenue due to the variance in days in the month, ARR correlates well with GAAP revenue if your subscriptions are in annual or true multi-year intervals.

Related: see the difference in calculating MRR and ARR.

However, you can experience an “MRR-like” jitter issue if your term subscriptions run for non-standard lengths, such as 15 months or 30 months and eight days.

In the end, you should have a clear definition of annual recurring revenue and how it’s calculated for your organization. The most important thing is to be consistent in the calculation, and communication of metrics within your organization.

What is a good ARR growth rate?

According to a recent study of 439 SaaS companies, the median ARR growth rate for companies ranged between 40% and 60%. However, average growth rates vary widely based on a business’s current growth stage.

The survey showed that:

  • Early-stage businesses (earning $1-3m ARR) will experience higher growth rates than late-stage ($15m+ ARR) businesses

  • As ARR climbs, year-over-year growth often slows

  • Top businesses can experience faster growth by upselling to existing customers

Finally, according to the survey, businesses must achieve and sustain a growth rate above 100% to be in the top 25% of company growth worldwide. To get to this level, many later-stage companies utilize a top-down ARR model in their growth strategy.

Why is ARR important for SaaS?

ARR is an invaluable metric for measuring the success of your SaaS business. In addition to calculating revenue for a one-year period, it also helps predict future growth and revenue based on the value of renewals and cost of churn, allowing you to manage expenses more easily. Knowing your ARR can even increase revenue by providing insight into what is and isn’t working for customers, which guides upselling and cross-selling.

ARR also provides a picture of your company’s overall health by showing where it’s performing well and where it isn’t, helping you strategize ways to improve your bottom line. Furthermore, ARR indicates the momentum you can expect from revenue sources such as renewals, sales, and upgrades, all of which are useful in developing a growth strategy for the next year.

The predictability of subscription services compared to one-time sales is highly attractive to investors, allowing ARR to assess your relationships with customers. Customers who are willing to pay a regular subscription fee demonstrate confidence and trust in a brand, especially when they choose long-term contracts.

SaaS businesses should make the calculation of their ARR a priority despite the greater difficulty in doing so as compared to a one-time sales model. However, many SaaS companies calculate their ARR incorrectly, as shown by this poll of 50 SaaS companies. The results indicate that 40 percent of these companies exclude required items or include the wrong items in their ARR calculations, providing a false picture of their business health.

ARR vs revenue vs annual profit

While ARR, total revenue, and annual profit all speak to a company’s growth and profitability, they’re very different metrics.

ARR is a revenue-based metric that measures predictable revenue. It’s the income from subscription fees over a year, which you can then use to forecast revenue for the next year.

Revenue for SaaS companies refers to the aggregate income generated from all revenue streams including predictable annual subscription fees as well as additional add-on services or any other sources of revenue, before subtracting expenses or costs. It represents the total amount of money received by the SaaS company from its customers over a defined period.

Annual profit is a profitability-based metric, referring to the net income earned after deducting all expenses and costs from the total revenue generated over a year. It represents the financial gain or profit realized by the SaaS company during that period.

To illustrate the differences, let’s consider the finances of a fictional company:

  • ARR: The company generates $1 million in revenue annually from existing subscription contracts and recurring revenue, and uses this number to forecast future revenues.

  • Total Revenue: The company earned $1.5 million in total revenue, including the $1m in contract value as well as $500,000 in set-up fees, add-ons, and upgrades.

  • Annual Profit: The company has an annual profit of $700,000 after deducting $800,000 in expenses for employee salaries, marketing expenses, infrastructure costs, etc.

ARR momentum

The most important components of your company’s ARR are:

  • ARR from new customers

  • ARR from existing customers who renew

  • Incremental increases or expansion in ARR from upgrades and add-ons

  • Incremental decreases or contractions in ARR from downgrades

  • ARR losses, or revenue churn

ARR for each of these components is often measured and reported in absolute value, relative value, and incremental changes from period to period.These components help you develop a full picture of what “direction” your company’s revenue is moving and why. This way, you can make informed decisions about how to best apply your efforts for growth. At Maxio, we measure the different components of annual recurring revenue in a report called the subscription momentum report.

What is the difference between ARR and MRR?

Very simply, ARR is 12 x MRR. That’s all there is to it.

So why use ARR vs. MRR?

Unfortunately, there aren’t great answers to common questions, like why to use one metric over the other. It often comes down to preference.

Annual recurring revenue is often used in B2B subscription business when the minimum subscription term is one year. It also tends to be used by businesses with multi-year terms, and those with lower transaction volume and higher transaction value. While MRR is typically preferred by B2B businesses with monthly subscriptions (as well as B2C subscription businesses), it’s not uncommon for companies to use both metrics to represent their revenue.

One trend we’ve observed in companies using both MRR and ARR: they tend to think of ARR as a valuation metric and MRR as an operating metric. 

You would probably reference your ARR metric in board meetings or conversations with management, but your MRR metric is often more useful in the day-to-day operations of the business. Because expenses tend to be fairly stable month-over-month in a SaaS business, MRR can be a useful shorthand metric, even if you and your management team tend to think in terms of ARR.

Say, for example, your marketing team asks for an incremental budget increase one month. You can make a quick, back-of-the-envelope decision based on your MRR metric minus your typical monthly spend. 

If you’re comfortable with the runway you’d be leaving yourself, you can go ahead and greenlight the budget increase. 

ARR does have one big benefit—it aligns well with your GAAP revenue. While MRR and monthly GAAP revenue can differ significantly in any given month due to the amount of revenue spread and fluctuating days in the month, ARR is going to be roughly equal to the GAAP revenue for your recurring revenues over a one-year term.

Switching from MRR to ARR

There’s really only one issue with adopting ARR as your standard “normalized” revenue performance  metric: it’s difficult to apply to contract terms under a year in duration. Technically, you can do it, but MRR is much better. The use of annual recurring revenue for contracts less than a year in duration is rarely seen in practice.

As a subscription business grows and experiments with pricing and packaging, it’s common to introduce new contract terms.

If you end up including contracts with term lengths of less than a year, we suggest using MRR as your normalized recurring revenue performance metric.

It can be painful to switch your company’s vernacular from ARR to MRR. Changing communications, culture, measurement, and KPI reporting processes consumes valuable energy and time. But if the volume of new short-term contracts is growing, it’s worth it. (And it’s worth noting that companies rarely change from MRR to ARR.)

ARR and GAAP revenue

In most situations, the annual recurring revenue ascribed to a contract element will be roughly equal to the GAAP revenue associated with that contract element.

However, while ARR is representative of GAAP revenue, it’s an imprecise financial expression and should never be confused with “reportable GAAP revenue.”

For most efficient business discussions, consider adopting the term “GAAP pervenue” for discussions relating to accounting and income statement/P&L performance, and “ARR” or “MRR” for subscription metrics and analytics. Stay on the same page by ensuring everyone should have a clear understanding of the terminology, as well as the rules for the generation of the underlying numbers.

Finance professionals, specifically CPAs, rarely need education on GAAP revenue, but many are new to the subscription business and need to understand how annual recurring revenue differs from GAAP revenue. If your finance person is a bookkeeper (as is common in early-stage businesses), they will likely need education on both topics, as will managers in sales, marketing, and product functions.

ARR's restrictions as a financial metric

While ARR is one of the best financial metrics for SaaS companies, it’s only as useful as the context surrounding it. It doesn’t provide clear insight into retention by itself, despite including revenue from renewals and upsells. You should consider ARR in relation to your data on churn and net revenue retention to get a clearer picture of your business’s momentum.

In addition, ARR doesn’t account for revenue recognition, meaning your picture of revenue growth is incomplete even when you know your ARR. Deeper insight into billing and collections efficiency is needed to obtain accurate revenue recognition.

But ARR’s biggest downside as a SaaS metric is that GAAP standards don’t provide guidance on reporting it. While private SaaS companies can use ARR to attract investors, public companies should use stricter GAAP reporting structures.

How do I use ARR?

In the finance function, ARR is used in or to:

  • Report on growth from new contracts, including those with different term lengths

  • Report on net & gross expansion and contraction from existing customers

  • Assess trends in ASP (average selling price)

  • Report on Cohorts (typically by customer start month, quarter, or year)

  • Estimate future GAAP revenue

Is there a CARR equivalent to CMRR?

Contracted Monthly Recurring Revenue (CMRR) is the value of the contracted MRR from the booking date through the subscription end date. It’s often used by term subscription businesses with gaps between order date and subscription go-live dates (due to onboarding or simply contract language).

Is there a CARR metric equivalent? There is no reason you can’t track and measure CARR, but it is not a common term. A Google search for CMRR shows plenty of relevant hits, but if you try CARR or “CARR Subscription Metric,” you won’t find much.

ARR reporting in spreadsheets

While ARR does approximate revenue, it is still a normalization value, so you’ll be hard-pressed to find an ARR data field or function in any GL or finance system. 

Few billing platforms include ARR, favoring MRR if they have either (though Maxio maintains both MRR and ARR).

Unless your finance system has a rev rec module, it won’t have a Contract Object, and will likely not track subscription start and end dates. This means “cancellation” actions and churn are challenging to report on in your finance system.

Without support for ARR and cancellations in your finance system, most turn to Excel to track and measure ARR and churn. 

To perform core ARR calculations, it is easiest to start with a simple “status” or state spreadsheet including the basic information needed to report on the present state of each contract or subscription. This approach works well for a few dozen customers, but its value quickly evaporates as a company grows.

If you’re interested in setting up quick ARR and reports for your business, Maxio’s free downloadable metrics template is a great place to start. 

Get Your Free SaaS Metrics Template

Ultimately, this approach doesn’t provide information to report on changes, and what is fundamentally interesting about a subscription company is the change or rate of change.

Using spreadsheets to track subscription actions 

Most organizations move to a transaction or subscription ledger approach in very short order. This approach mimics a simple database that captures each subscription action (new booking, upgrade, renewal) as a record in the spreadsheet. 

To calculate ARR churn, you also need to report on cancellations (essentially the absence of a renewal). However, measuring a cancellation using an “absence of data” is extremely difficult in Excel. In other words, you need some form of measurable cancellation record. 

You can either tag transactions to indicate the transaction did not renew or add a cancellation transaction with a value (for bookings loss) and an ARR value.

The best-practice approach to create cancellation records is to record the cancellation in the same period as you would record it if it were a renewal. Doing so enables you to consistently measure renewals and churn, a mathematical must since churn is simply (1 – renewal rate).

Cancellation example

Let’s say a subscription ends on July 31. If it renews, the new term’s start date is August 1, therefore the renewal date for ARR calculations is August 1. If it cancels, you may be tempted to report the cancellation as the date of cancellation. However, in doing so, you’re reporting the cancellation in a different period. The cancellation should be recorded on Aug 1, the end date of the subscription (i.e. the renewal period).

A typical ARR performance report includes ARR totals broken out by the following classes: New, Renewal, Expansion/Upgrade, Contraction/Downgrade, and Lost, as shown in the Maxio ARR Momentum Report above. 

While the data management and .xls formulas become increasingly complicated as your business and reporting needs grow, calculation of New and Lost are typically the easiest and can usually be calculated using a data field or flag to indicate the class of a record.

In early-stage subscription model businesses, you can also use data fields/flags to indicate the class of a transaction. However, as the volume of data grows and the complexity of transactions increases, this becomes increasingly complicated. 

Mid-term subscription changes for quantity, products, value, and term-end dates all create immediate havoc with the formulas used to calculate Expansion, Contraction, and Renewals in Excel. 

Maxio’s subscription management function was designed to handle these complicated scenarios with ease and accuracy.

Your Plug-and-Play SaaS Metrics Dashboard

In this template, you’ll find a comprehensive set of pre-built SaaS metrics (that you can trust) to wow investors and make key business decisions with confidence.

Chart your path to profitability with metrics like:

  • Subscription Momentum (ARR, customer count, average ARR)

  • Churn & Retention (churn rate, renewal rate, net revenue retention)

  • Customer Lifetime Value (CLV)

Get the template