Easy Guide: What’s Annual Recurring Revenue in SaaS?
The software industry has evolved into various business models, and each business model tracks performance based on its metrics.
Conventional software businesses use P&L financial metrics, including recognized revenues, operating expenses, gross profit, and net profit. They used recognized revenues and booked software licenses as key metrics to determine current and future sales performance.
Traditional businesses have key performance indicators (KPIs) to track relative to modern-day subscription-based businesses.
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 Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR).
In this, we will try to understand 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 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 through the subscription fee for accessing the software and cloud-based services. Such services may include upgrades, maintenance, and support offered by the SaaS provider.
SaaS providers are responsible for specialized software security, availability, and performance. The SaaS providers charge a monthly or annual subscription fee for the software and full-service access.
Thus, a subscription-based business needs to evaluate and track ARR as it represents the value of contracts entered into by the business.
B2B subscription-based businesses with lower transaction volumes
and higher transaction values must ARR. This means that ARR is an effective performance metric to track when 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 from onboarding new customers in 12 months.
- Expansion ARR
Expansion ARR refers to the recurring revenues generated from additional sales to 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.
- Cancelled ARR
Cancelled ARR refers to the annual recurring revenues lost due to the existing customers giving up on their product or service subscription. It may include non-renewals, cancellation 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 non-recurring. 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, expansion ARR, and Canceled ARR.
Now, how you will calculate ARR will depend upon several factors. These include pricing strategy and business model complexity.
Besides these, a host of other factors help determine 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 to understand the ARR formula.
For instance, ‘Zootin’ is a web streaming app with a customer who signs up 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 to understand the ARR formula. ‘Zootin’ is a web streaming app with a customer who signs 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 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 component help a SaaS business understand 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 the growth of other SaaS businesses.
Likewise, SaaS companies with lower Churned ARR as a percentage of their beginning ARR are better at retaining their customers and have longer 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 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. At the same time, the revenues of a business measure the sales generated by a business over time. The period can be a month, a quarter, or a year.
Further, a SaaS company considers a new ARR when the contract between the subscriber and the SaaS company is signed. 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 a SaaS business’s subscription revenue over a year. Typically, ARR is the sum of new subscriptions and upgrades, fewer downgrades, and cancelled subscriptions.
While MRR s the sum of all monthly subscription revenue that a SaaS business earns, typically, MRR is the sum of all new business subscriptions and upgrades, downgrades, and cancelled subscriptions over one month.
The following are the different ways 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
The simple way to calculate MRR is to calculate your Average Revenue per User (ARPU) every month 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. For instance, ‘Zootin’, a web streaming app, has 1000 customers, and its monthly ARPU 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 ARR component metric over time.
Early-stage companies typically use this approach. SIt’such businesses do not have sufficient historical ARR data based on 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. 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 must 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 it aligns well with GAAP revenue.