What is ARR?
Annual Recurring Revenue (ARR) estimates the predictable revenue generated per year by a SaaS company from customers on either a subscription plan or a multi-year contract.
How to Calculate ARR?
ARR stands for “Annual Recurring Revenue” and represents a company’s subscription-based revenue expressed on an annualized basis.
While not a GAAP metric, the annual recurring revenue (ARR) metric captures a SaaS company’s historical (and future) financial performance more accurately than the revenue recognized under accrual accounting standards.
The annual recurring revenue (ARR) reflects only the recurring revenue component of a company’s total revenue, which is indicative of the long-term viability of a SaaS company’s business model.
Typically, ARR is the primary metric used to measure the health of SaaS and other subscription-based companies with business models oriented around recurring revenue and multi-year contracts, particularly for forecasting year-over-year (YoY) growth.
Since ARR represents the revenue expected to repeat into the future, the metric is most useful for tracking trends and predicting growth, as well as for identifying the strengths (or weaknesses) of the company.
The annual recurring revenue (ARR) metric is a company’s total recurring revenue as expressed on an annualized basis.
Conceptually, the ARR metric can be thought of as the annualized MRR of subscription-based businesses.
Taken into account within ARR is the revenue from subscriptions and expansion revenue (e.g. upgrades), as well as the deductions related to canceled subscriptions and account downgrades.
In order to properly calculate the metric, one-time fees such as set-up fees, professional service (or consulting) fees, and installation costs must be excluded, since they are one-time/non-recurring.
For example, let’s say a customer negotiated and agreed to a four-year contract for a subscription service for a total of $50,000 over the contract term.
To calculate the ARR, we would divide the contract value ($50,000) by the number of years (4), which comes out to an ARR of $12,500 per year.
- Annual Recurring Revenue (ARR) = $50,000 ÷ 4 Years = $12,500
What is the Difference Between ARR vs. MRR?
The monthly recurring revenue (MRR) and annual recurring revenue (ARR) are two of the most common metrics to measure recurring revenue in the SaaS industry.
The differences between ARR vs. MRR, including the relationship between the two, is as follows.
- Monthly Recurring Revenue (MRR): MRR is a company’s normalized revenue, expressed on a per-month basis. Like the annual recurring revenue (ARR) metric, MRR only captures the revenue from active accounts on subscription-based payment plans. When evaluating companies with short-term contracts that last less than one year, MRR is the appropriate metric to focus on.
- Annual Recurring Revenue (ARR): Both KPIs, MRR and ARR, are intended to measure the predictable and recurring revenue of a SaaS company, but ARR is more “forward-looking” as it is commonly used to estimate revenue for future years. Moreover, ARR is derived from the most recent MRR, which also represents the main drawback to ARR because this assumes that the most recent month is the most accurate indicator of future performance.
We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. SaaS Annual Recurring Revenue Operating Drivers
Suppose we’re projecting the annual recurring revenue (ARR) of a SaaS company that ended December 2021 with $4 million in ARR.
The ending ARR will be equal to the beginning ARR plus the net new ARR, which is composed of three factors:
- New ARR: The new ARR added from new customers acquired in the month
- Churned ARR: The lost ARR from customers that churned in the month (e.g. cancellations, non-renewal, downgrade)
- Expansion ARR: The additional ARR from the existing customer base (e.g. upselling, cross-selling)
For January 2022, we will assume that $200,000 worth of new ARR was brought in, followed by $250,000 in February.
- New ARR, January = $200,000
- New ARR, February = $250,000
In both months, the churn rate and expansion ARR will be estimated as 6% and 2% respectively.
- Churned ARR (% Churn) = 6%
- Expansion ARR (% Upsell) = 2%
The new ARR will be hard coded for January and February, and then the beginning ARR will be multiplied by the respective churn rate and upsell assumptions.
- Churned ARR = –$240,000
- Expansion ARR = +$80,000
- Churned ARR = –$242,000
- Expansion ARR = +$81,000
2. ARR Calculation Example
Since we now have all the necessary inputs for our annual recurring revenue (ARR) roll-forward schedule, we can calculate the new net ARR for both months.
- Net New ARR, January = $200,000 – $240,000 + $80,000 = $40,000
- Net New ARR, February = $250,000 – $242,000 + $81,000 = $88,000
The ending ARR for January comes out to $4,040,000, which becomes the beginning ARR for February.
If we add $88,000 to the beginning ARR, we calculate the ending ARR in February of $4,128,000.
- Ending ARR, January = $4,000,000 + $40,000 = $4,040,000
- Ending ARR, February = $4,040,000 + $88,000 = $4,128,000