The software industry has evolved into various business models and each business model tracks performance based on its own set of metrics.
Conventional software businesses used P&L financial metrics including recognized revenues, operating expenses, gross profit, and net profit. Therein, they used recognized revenues and booked software licenses as the key metrics to determine current and future sales performance.
Relative to the modern-day subscription-based businesses, traditional businesses have key performance indicators (KPIs) to track.
Software as a Service (SaaS) business typically tracks various financial and non-financial operating metrics. And one of the significant performance metrics of a SaaS-based business is recurring revenue.
The recurring revenue metric comprises two metrics: Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR).
In this, we will try to understand what is Annual Recurring Revenue in SaaS accounting and how to calculate ARR?
Annual Recurring Revenue (ARR) Meaning
Annual Recurring Revenue (ARR) is a key performance revenue-based metric that measures the amount of recurring revenue to be collected by a SaaS business over a period of one year. In other words, it measures the annual run rate of recurring revenue from the current install base.
Recurring revenue in a SaaS business refers to the revenue generated in the form of the subscription fee for accessing the software as well as cloud-based services. Such services may include upgrades, maintenance, and support offered by the SaaS provider.
SaaS providers take much of the responsibility for the security, availability, and performance of specialized software. For offering software as well as full-service access, the SaaS providers charge a monthly or annual subscription fee.
Thus, it is important for a subscription-based business to evaluate and track ARR as it represents the value of contracts entered into by the business.
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In fact, B2B subscription-based businesses characterized by lower transaction volumes
and higher transaction values must ARR. This means that ARR is an effective performance metric to track in situations where contracts have multi-year agreements or a minimum of a one-year contract.
Note that the revenue for delivering SaaS products or services accrues and is recognized over time. Hence, revenue-based metrics in SaaS businesses are calculated using revenue proxies such as license bookings, recurring revenues deferred revenue, calculated billings, and backlog.
Annual Recurring Revenue (ARR) represents the value of the contracted recurring revenue components of your SaaS business’ term subscriptions normalized to the annual period. Accordingly, ARR comprises the following categories of recurring revenue components:
Annual Recurring Revenue Components
- New ARR
New ARR refers to the new sales of your subscription-based products or services to new customers. It covers the recurring revenues generated as a result of onboarding new customers in a given 12-month period.
- Expansion ARR
Expansion ARR refers to the recurring revenues generated as a result of additional sales to the existing customers. Such sales can be in the form of subscription upgrades, complements or premium add-ons, increase in user counts, price increases etc.
- Contraction ARR
Contraction ARR represents the decrease in annual recurring revenues of a SaaS business. The decline in ARR happens when the existing customers renounce or reduce the scope of their current subscription or service.
- Canceled ARR
Canceled ARR refers to the annual recurring revenues lost as a result of the existing customers giving up on their product or service subscription altogether. It may include non-renewals, cancelation of customer subscriptions, etc.
Components to be Excluded in ARR Calculation
ARR is a forward-looking metric. It gives a snapshot of how much revenue a SaaS business can expect. Accordingly, the following components would not form a part of ARR as these are of non-recurring nature. These components include:
- One-time fees
- Set-up fees
- Non-recurring add-ons
Thus, the Net ARR of a SaaS business represents the new ARR, Churned ARR, and expansion ARR, and Canceled ARR.
Now, the way you will calculate ARR will depend upon a number of factors. These include pricing strategy and business model complexity.
Besides these, there are a host of other factors that help in determining the overall growth and momentum at which a SaaS business can scale.
The following section represents a basic equation that helps in evaluating the health of the recurring revenues of a subscription-based business model.
Annual Recurring Revenue Formula
The following is the Annual Recurring Revenue formula:
ARR Formula for Yearly Billing
ARR = Value of Subscription Contract/Number of Contract Years
Let’s consider an example in order to understand the ARR formula.
Say for instance ‘Zootin’ is a web streaming app and has a customer who signs for a 2-year subscription for $30,000. Accordingly, the yearly ARR would be:
ARR = $30,000/2 = $15,000
ARR Formula for Monthly Billing
ARR = MRR x 12 Months
Let’s consider the same example in order to understand the ARR formula. ‘Zootin’ is a web streaming app and has a customer who signs for a yearly subscription for $200 per month. Accordingly, the yearly ARR would be:
ARR = $200 x 12 = $2,400
ARR Formula for Fluctuating Revenues
ARR = Value of Yearly Subscriptions + Recurring Revenue from Add-Ons and Upgrades – Revenue Lost in Subscription Cancelations
Let’s consider the same example in order to understand this ARR formula. Suppose ‘Zootin’ has $100,000 as MRR at the start of the month. In other words, it has an ARR of $1,200,000. The following are the changes that took place during the month:zx
- MRR lost due to subscription cancellations: $10,000
- MRR lost due to subscription downgrades: $5,000
- Expansion in MRR: $15,000
- MRR gained from new signups: $20,000
Here’s how you will calculate the MRR for the said month:
Net New MRR for the month = Beginning MRR + MRR Expansion + New MRR – MRR Contraction – MRR Cancellation
Net New MRR for the month = $10,000 + $15,000 + $20,000 – $5,000 – $10,000 = $30,000
ARR = $30,000 X 12 = $360,000
There are a host of factors that drive each of these growth components. Thus, the changes in each of these components help a SaaS business in understanding its revenue model and growth prospects.
Accordingly, the Expansion ARR of a SaaS business will drive a large proportion of business growth, if such a business is focused on a “land and expand” growth model. While New ARR generated as a result of onboarding new customers may drive growth of other SaaS businesses.
Likewise, SaaS companies having lower Churned ARR as a percentage of their beginning ARR are better at retaining their customers and have longer customer lifetimes.
Difference Between ARR and Revenue
ARR is a performance metric that SaaS and subscription companies typically use. It is not an accounting metric recognized by GAAP. Thus, it is separate from the revenue number that a business typically finds on its income statement.
ARR measures the recurring revenues of a SaaS business at a single point in time or on a specific date. Whereas, revenues of a business measure the sales generated by a business over a period of time. The period can be a month, a quarter, or a year.
Further, a SaaS company considers new ARR at the time the contract is signed between the subscriber and the SaaS company. However, revenue in the income statement is not recognized unless the service is implemented.
MRR to ARR
As mentioned earlier, ARR is the sum of all subscription revenue that a SaaS business earns over a period of one year. Typically, ARR is the sum of new subscriptions and upgrades, less downgrades, and canceled subscriptions.
While MRR s the sum of all subscription revenue that a SaaS business earns every month. Typically, MRR is the sum of all new business subscriptions and upgrades less, downgrades, and canceled subscriptions over a period of one month.
The following are the different ways in which one can convert MRR to ARR.
- ARR = MRR x 12 Months
- Net New MRR for the month = Beginning MRR + MRR Expansion + New MRR – MRR Contraction – MRR Cancellation
- Monthly Recurring Revenue = ARPU x Total Number of Monthly Users
Now, the simple way to calculate MRR is to calculate your Average Revenue per User (ARPU) on a monthly basis and then multiply it by the total number of users in a given month.
Let’s understand this with the help of the example mentioned above. Say, for instance, ‘Zootin’, a web streaming app, has 1000 customers and its ARPU per month is $200. Thus, the total MRR of ‘Zootin’ is $200,000.
Forecasting Annual Recurring Revenue
Typically, SaaS businesses use two methods for forecasting ARR. These include Bottoms-Up or Revenue Driver ARR Modelling and Top-Down or Trendline ARR Modelling.
1. Bottoms-Up or Revenue Driver ARR Modelling
The bottom-up ARR Modelling approach involves breaking down the key components of a SaaS company’s growth into ARR metric revenue drivers. The business determines the changes occurring in each of the ARR components metrics over time.
This approach is typically used by early-stage companies. It’s because such businesses do not have sufficient historical ARR data on the basis of which trend lines can be forecasted.
2. Top-Down or Trendline ARR Modelling
The Top-Down or Trendline ARR Modelling involves evaluating the historical trendlines for ARR growth and calculating future growth based on those trendlines. As compared to the Bottoms-Up approach, this is a less detailed method to forecast ARR.
Typically, the later-stage SaaS businesses have enough history and revenue growth to date using this approach.
For using ARR as a performance metric, a business needs to have a minimum of one-year contracts. In other words, multi-year contracts use ARR. One advantage of using ARR as a performance metric is that aligns well with the GAAP revenue.