Annual Recurring Revenue

by Adarsh Raj Bhatt in
1 U.S. dollar banknote

Key Takeaways 

  • Annual recurring revenue or ARR is equal to the revenue amount that a startup anticipates receiving from its customers, normalized to a one-year term.
  • The method you use to determine ARR will be influenced by several factors, including your current pricing structure and the intricacy of your business plan.
  • It is important to understand that the process of calculating ARR has room for only revenue that is recurring, not one-time or variable transactions.
  • ARR can also be calculated by multiplying the MRR (Monthly Recurring Revenue) by 12.
  • Founders can use the information embodied in ARR to monitor their startup’s overall status and see how exactly any measures they implement could improve or diminish the overall growth momentum.
  • Monthly recurring revenue, or MRR, is a metric that is equal to the amount of revenue that a startup anticipates receiving from its customers monthly. In other words, MRR normalizes the startup’s revenue to a one-month duration.

What is annual recurring revenue? 

Annual recurring revenue or ARR is a metric equal to the revenue amount that a startup anticipates receiving from its customers, normalized to a one-year term. ARR, expressed in $, answers the question: How much recurring revenue can we accurately predict we’ll generate from our customers annually? This metric is essentially employed at startups that are based on a subscription model.

While term revenue might have components that are paid fortnightly, monthly, bi-annually, or annually, the differing terms are normalized to an annual basis, resulting in the motley components being converted to an annual sum expressed as a $ figure. Annual recurring revenue does not incorporate one-off payments and differs from accounting revenue. 

Founders need to know what ARR is. Why? Because most investors today expect you to have a good understanding of it and that you stay on top of your ARR. In fact, ARR is used to value startups, further underscoring why founders must know what the metric means. 

In addition to that, ARR has other benefits for founders. ARR lets founders assess the general health of their venture. It also lets them critically evaluate any long-term strategies they’ve planned for the business end of the startup. 

Investors understand that as a business metric, ARR is inherently stable and predictable. They capitalize on this fact by utilizing ARR to juxtapose the startup’s performance against that of the competing players in the market. They also utilize ARR to draw a comparison between the startup’s current performance and its performance in the past; in this way, they also analyze trends in performance across time.

For example, the $1M ARR mark has traditionally been viewed in the startup ecosystem as the key milestone that indicates that the team has understood the “right way” (or, perhaps, the best way given their specific circumstances) of doing business and is now ready to scale by receiving the next round of investment that will boost sales and marketing efforts. From that point onward (the point of $1M ARR), scaling up to ARR $10M and above is generally considered the next priority. 

Source

How to calculate ARR? 

It is important to understand that the process of calculating ARR has room for only revenue that is recurring, not one-time or variable transactions.

The method you use to determine ARR will be influenced by several factors, including your current pricing structure and the intricacy of your business plan. Given that ARR is a fundamental instrument to contextualize your entire growth and the pace at which you could expand, there are a couple of factors that enter the picture. 

If we take up a simplistic situation first, then ARR can be deduced from multi-year contracts. For example, assume that your startup has 1 customer with a 5-year subscription package priced at $10,000. Now, divide the total price of the subscription package by its entire duration. That is:

$10,000 / 5 

This will give you the startup’s ARR. Therefore: 

ARR = $2000 

Assuming you have more customers than that (and you probably do), all you have to do is calculate the ARR for each customer (through the way shown above) and then obtain the startup’s total ARR by adding up the annual dollar figures that you obtained for each customer.

In practice, though, startups separate the total ARR into sets of singular ARR’s.

Thus, the overall ARR of the startup gets broken down into various components, such as:

  • ARR generated from new consumers
  • ARR generated from existing consumers who renew their subscriptions
  • ARR generated from existing consumers who upgrade/are upsold
  • ARR deducted from existing consumers who downgrade their subscriptions
  • ARR deducted from consumers who cancel their subscriptions

Separating the overall ARR of the startup into segments (such as the aforementioned segments) allows founders to understand which categories of consumers (or which user segments) pitch in the maximum amount to the total ARR.

There is also a handy formula for calculating your ARR:

Source

Though it’s been mentioned earlier, it bears repeating: one-time payments from consumers must not be incorporated in any ARR calculation. First-time founders in the startup’s early stage can sometimes forget that the “R” in the middle of ARR stands for “recurring,” which is the underlying logic of not including one-time transactions (which are, by definition, not recurring) in the ARR calculation. 

With that said, it pays to note that expansion revenue (for, e.g., revenue generated from existing customers who upgrade or pay for add-ons) ends up adding to the consumer’s annual subscription pricing. 

There is another way of calculating ARR, especially for those startups whose pricing models lean more toward MRR (Monthly Recurring Revenue) than toward ARR. Such startup founders can multiply the MRR by 12 to figure out their ARR. 

What is ARR used for?

ARR is a critical requirement for any subscription-based startup. You'll be able to use the information embodied in this metric not just to monitor your startup’s overall status but also to see how exactly any measures you implement could improve or diminish the overall growth momentum. The ability to grow based on recurring revenue is a compounding sign.

Tracking these changes in growth also aids you in determining the best course of action for your startup. The more recurring income you earn, the better products/services you can develop and the better (the quality of) your team can become. It will be difficult for your startup to understand its continuous financial performance without using ARR as a benchmark.

Benefits of ARR 

As a metric, ARR is of crucial importance to startups with a subscription model. Here’s why:

#1. It measures growth 

ARR is a useful instrument for quantifying the growth of a startup due to how inherently stable and predictable the metric is. First and foremost, this quantification of growth aids in comparing the startup with its competitors (based on their respective performances). 

But it doesn’t end there. When analyzing the trend in ARR across time, founders can evaluate any growth that the startup is experiencing due to the implementation of internal strategies, decisions, and hypotheses. 

#2: Reveals the feasibility of the subscription model

As mentioned earlier, ARR calculations incorporate only recurring revenue, i.e., the revenue generated from customers who subscribe. This is in stark contrast to the total revenue, which includes every single inflow of cash into the startup’s war chest (even onboarding, one-time, and/or variable fees). 

As a result, since ARR focuses on subscription-related revenue, it becomes a great tool to validate the entire (subscription-based) business model of the startup and reveals whether that model is working or not. 

#3: Baseline for revenue projections

ARR is widely used to calculate the projections of the (future) revenues of the startup. Considered to be a baseline, ARR is included in complicated computations for forecasting the startup’s revenues.

Limitations of ARR 

#1: Complicates revenue tracking

Startups based on a subscription model (and earn recurring revenue) could easily have numerous consumers (in the range of dozens or even hundreds) simultaneously positioned at different points in their billing cycles. 

As a result, if you wish to track the health of your startup at any given moment in time, you will be required to stay on top of metrics like contract durations, churn, upgrades, downgrades, add-ons, cancellations, renewals, etc. This adds an unprecedented layer of complexity while tracking revenue that is not present in business models based on non-recurring revenue. 

#2: Logistical complexity associated with price updates

As a flexible subscription-based startup, you might decide to update your prices from time to time to keep up with the latest trends in the market and technology. Sounds simple enough, doesn’t it? 

Think again.

Recurring revenue detracts from the flexibility of going about and updating your prices in comparison to doing the same with a single-purchase model. It hurts the integrity of a smooth customer experience when you change the prices of a membership or a retainer for services.

This is also because this does not change something minor like the cost of a one-time purchase - instead, it changes the amount charged every month going forward.

#3: Facilitates a restrictive viewpoint

ARR does not always reliably depict how profitable and financially healthy a startup is. In fact, it might enable - and encourage - the opposite. For example, ARR does not incorporate the CAC (customer acquisition cost) and other miscellaneous costs that are inevitable in the journey of a startup. This situation becomes even more serious considering how high CAC ends up going for SaaS startups.

An impressive ARR makes founders believe that things are going well. Perhaps this conviction is justified. But oftentimes, it lulls them into complacency and distracts them from solving actual problems that are weakening their processes and overall financial health; for instance, a startup with a satisfactory ARR, on the one hand, might, on the other, have consumers who’re not bringing in sufficient value to result in a net profit margin.

#4: Doesn’t apply to all startups

ARR can not apply to startups of all kinds of business models as its very foundation is recurring revenue. And recurring revenue is a hallmark of only those startups who offer subscription-based products and/or services to their customers (for, e.g., most SaaS startups with subscription pricing). 

Thus, startups that do not offer regular subscriptions to their products/services generally can’t use ARR to measure the predictable inflow of (recurring) revenue over a year.

MRR (monthly recurring revenue) 

Monthly recurring revenue, or MRR, is a metric that is equal to the amount of revenue that a startup anticipates receiving from its customers monthly. In other words, MRR normalizes the startup’s revenue to a one-month duration, just as ARR is a measure of the startup’s revenue normalized on an annual basis. Such normalization is especially important for startups that offer a range of different pricing plans to their customers.

Thus, while each is a measure of the startup’s revenue and each is of crucial importance to SaaS startups that are based on a subscription model, the only parameter where ARR differs from MRR is the duration over which they are normalized (i.e., annually for ARR as opposed to monthly for MRR). As a result, MRR offers insights into the short-term growth of the startup, while ARR is used to understand how the startup might evolve over the long term.

There are a few reasons why MRR is important:

  • Investors like to track the MRR of startups, even though this metric is not recognized by Generally Accepted Accounting Principles, the apex accounting standard in the US. Then why do they track it? Simply because evaluating the startup’s MRR trend across months enables investors to analyze its growth. Then it’s a little wonder that most SaaS startups include their MRR in their quarterly and yearly reporting.
  • Startups stay on top of their MRR to accurately forecast their revenue (and other indicators of financial performance). MRR is suitable for such financial forecasting because of how stable and predictable the metric is. Founders who observe consistent MRR’s during several periods can forecast their venture’s revenue without a hitch. 
  • MRR is a reliable financial instrument to analyze trends in a startup’s growth. This is because it helps smoothen and normalize revenue to enable founders to evaluate trends in growth.

Here’s how you can calculate MRR:

Source

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