Annual recurring revenue, also known as ARR, is one of the most commonly used success metrics in the software as a service industry. Keep reading to calculate ARR and increase it over time so that you can build a unicorn startup.
1. Annual Recurring Revenue (ARR) Definition
Let’s take a simple SaaS business example. The company has ten enterprise customers who all have annual contracts worth $100,000 each. In that case, the company’s annual recurring revenue would be $1 million. Few companies have an ARR that simple, however. You might have a mix of monthly contracts, annual contracts, and one-time sales revenue (e.g., consulting fees to help with implementation).
In those situations, a more sophisticated formula is helpful.
2. How To Calculate ARR with the ARR Formula
Calculating ARR in a subscription business is simple. You only need a few elements to put together this critical measure.
The ARR formula is: ARR = (Total Subscription Revenue Per Year + Recurring Revenue From Upgrades and Add-ons) – Revenue Lost From Cancelled or Churned Customers.
For instance, let’s say we want to do an ARR calculation example for a company that earns an average revenue of $12,000 per year per customer. Further, suppose the company has 500 customers. In that case, you would have an ARR of about $6 million. This simple calculation assumes no lost revenue. In reality, you will almost always have some amount of churn.
The last element of the formula is vital. If a customer cancels their service after one or two months, that fact needs to be included in your revenue. If you keep losing customer subscription revenue, then your business model may have problems.
3. What Isn’t Included in Annual Recurring Revenue?
Fundamentally, ARR focuses on subscription revenue. Therefore, if you earn a one-time fee from consulting or training, those amounts do not contribute to ARR. Also, a one time charge for onboarding would be excluded from your subscription-based billing. Further, ARR is a revenue measure alone. It does not look at expenses or profitability.
It is also critical to note that ARR is a lagging indicator of success. This SaaS business metric tells you how you performed in the past. Sure, it helps measure your revenue performance, and investors will probably ask you about ARR. On a day to day level, sales and marketing measures like customer acquisition cost (CAC) are more valuable to track.
A multi-year contract requires special treatment. Take a simple case where you have a fixed contract value of $100,000 per year. In that case, I suggest including one year’s worth of the multi-year contract into your ARR calculation. Long term contracts have an essential role in subscription-based pricing because they make it easier to forecast your revenues over time.
To reach your long term growth goals, I recommend minimizing the focus on one-time charges. Sure, those charges can boost average account size. Unfortunately, they make it far more challenging to build a realistic annual revenue forecast.
4. Should you use annual recurring revenue or monthly recurring revenue?
In the abstract, I recommend using monthly recurring revenue if possible. The monthly view provides a better picture of the performance of your subscription model. Further, you may manage expenses every month, so it makes sense to track monthly revenue.
In practice, your subscription model will probably include a variety of term contracts. For example, it is common in the SaaS business to offer both monthly and annual term contracts. In that case, it is helpful to look at monthly customers and annual customers differently. A monthly customer sees a charge come through every month, so there is a shorter runway to deliver value. With an annual contract, you have more time for your customer success department to help customers achieve their goals.
5. What about one-time sales revenue?
ARR excludes one-time sales revenue. That said, such revenue still counts, and it can make a critical difference in helping you pay the bills.
Your income statement will probably not be limited to recurring revenue. For example, what if you charge professional services fees to help enterprise customers with training and setup? That is valuable one-time sales revenue that helps your customer to succeed.
By the way, one-time sales revenue exists in the SaaS business outside of the enterprise world. Take ClickFunnels as an example. The company fundamentally sells marketing automation software. However, they use the one-time sales revenue to reduce their customer acquisition cost. Specifically, the company sells books like Dot Com Secrets, Expert Secrets, Traffic Secrets, digital training, and services. These services help customers to succeed and keep lost revenue to a minimum.
Offering training and professional services are also a win for your customers. They’re busy people. Do them a favor by guiding them through your product in depth.
Let’s illustrate the balance between professional services and subscription revenue with an example from Salesforce. In the company’s report for nine months ended on October 31, 2020, the company reported earning $14.5 billion in revenue from subscription and support and $935 million from professional services and other. In this case, Salesforce earned 94% of its revenue from subscriptions.
6. How do you balance ARR with other growth goals?
Driving ARR higher and higher sounds like a good goal. However, the pursuit of ARR growth above everything else can lead to an unhealthy business. Specifically, your expenses like customer acquisition cost may get out of control. To give an extreme example, you could spend $1 million to land a $100,000 per year customer. Theoretically, you might keep growing ARR, but such growth would place a tremendous strain on your cash resources. Even worse, profitability would become less and less likely over time.
7. What is a reasonable ARR growth goal?
Your ARR growth goals need to match your company’s current situation. Giant software companies like Oracle, Salesforce, and Microsoft will be happy if they can grow subscription revenue by 10% or 30%. On the other hand, a post Series B startup should probably need to set their sights higher.
For inspiration, take a look at the software companies on the Inc 5000. You’ll see companies that are reporting growth rates over 100%! That level of annual recurring revenue growth is certainly possible in a startup. Now, let’s say that you set a company goal to grow ARR by 100%.
Your sales and marketing teams might not be sure how to translate that company into a personal goal. For personal goal setting, I recommend two resources. First, reading Michael Hyatt’s book “Your Best Year Ever: A 5-Step Plan for Achieving Your Most Important Goals.” Second, consider using his paper planner: the Full Focus Planners. I’ve used these resources to keep my business growing over the past few years.
How To Get Marketing Support To Achieve Your ARR Goals
You don’t have to grow your business alone. Meeting your ARR growth goals is much easier when you can partner with a growth expert. Contact me to discuss your growth goals, and let’s see what we can achieve together.
