What is ARR? When I first started my business, I had no idea what ARR was. My friend told me it stood for “annual recurring revenue” and that it was a metric used by startups to measure their growth. At the time, I didn’t really understand how it could help my business. But after doing some research, I realized that tracking our company’s ARR was essential to understanding our progress and making sure we were on track to hit our goals. Although I’m not an expert on ARR, here’s what I’ve learned about this important metric.
What is ARR? Annual recurring revenue is basically all the money your company brings in every year from repeat customers. This can include things like monthly subscriptions, annual contracts, etc.
Why is ARR important? Tracking your company’s ARR gives you a clear picture of its health and growth potential. It also allows you to set realistic targets for future growth.
How do you calculate ARR? There are different ways to calculate ARR depending on your business model (subscription-based vs product-based).
What is ARR?
Recurring annual revenues are a figure used to help predict how much a business will make from annual subscriptions. This projection includes all revenue from a product or service for an entire year. Businesses that charge customers every year use this to budget for their projected growth.
As a Software-as-a-Service (SaaS) business, your AAR calculation should not only include your product’s subscription revenues but all additional services you provide. These could include installation, training, or maintenance services. Including these in your AAR projections will give you a better idea of your potential annual revenue.
Who Should Track ARR?
The ARR model is best for companies whose customers typically sign up for at least a year. The ARR method helps predict a company’s future revenues by taking into account past and current client behaviors.
Companies that charge customers every month can project their annual revenue by estimating how much a customer will pay each month. This provides a more precise estimate of a company’s annual earnings.
The ARR model isn’t necessarily the most accurate for subscription-based businesses, as customers could cancel their monthly subscriptions at any time.
If your business sells subscriptions, then you should consider using an MRR (monthly recurring revenue) model for your financials. This will provide you with a clearer picture of how well your business is doing.
What is the Formula for Calculating ARR?
Your business model and pricing structure will both impact how you calculate ARR.
There are a few key performance indicators that you should be tracking when determining your growth rate.
ARR is calculated by taking the annual recurring revenue from your annual contracts and upgrades and subtracting the lost revenue from customers who cancel their contracts.
To get you started, we’ve created this simple formula.
ARR = overall subscription cost per year + revenue from add-ons or upgrades – lost revenue from cancellations.
The subscriber’s annual fee should be affected only by the additional value they receive from add-ons or upgrades. This excludes any one-time fees.
If your pricing model is based on MRR, you can calculate 12 times that to get 12 months of ARR.
Why Is ARR Important?
There are several reasons why ARR is considered the most important measure of success for many SaaS companies.
1. It Shows What’s Working and What’s Not
By knowing how much revenue your product or service generates, you can determine if your sales and marketing efforts are working.
2. It Provides Context for Other KPIs
If 3% of customers cancel their subscriptions annually, is that good or bad?
To truly know your numbers, you need to know your ARR.
A clear picture of your ARR allows you to better understand what KPIs are signaling problems and which ones aren’t.
3. It Can Lead to High Valuations
Investors prefer subscription-based businesses because they create a reliable revenue stream.
What the financial market values most is not monthly income, but reliable annual recurring income. This is because yearly earnings are more consistent and are thus a better investment. Companies that can show consistent ARR are more appealing to investors.
What Should Not Be Included in ARR?
ARR is ongoing revenue. It should not include any one-off payments.
Here’s a great example.
Let’s say your company sells a B2B SaaS product with an annual subscription. Some of your options for up-selling include a premium version and on-site training.
All of those add-ons are a great way to increase your ARR.
Now, if you offer to rebrand your customer’s mobile app with their company logo and colors, this will allow them to integrate their branded application into their overall digital strategy.
After your sales team charges for a one-time custom setup fee, the customer will then be charged the regular annual subscription fee.
This one-time service will have an impact on your revenue for that year but will not change the annual recurring revenue.
For that reason, this won’t be included in your ARR calculation.
What is the Difference between ARR and Revenue?
All types of income generated by the company are included in what we call revenue.
This covers subscription revenue, late payments, one-time transactions, donations, tips from patrons, purchases made from special offers, and other revenue from consumers, government, and corporate aprtners.
This revenue stream, however, is unpredictable and, without an extensive history or thorough analysis of finances, might not be reliable for financial decisions.
Annual Recurring Revenue (ARR) is a metric that calculates the annualized, guaranteed revenue from subscriptions and contracts. This metric removes all revenue that is not contractually obligated from its equation.
3 Examples of ARR for Real Companies
Before we look at some ARR examples from real subscription businesses, let’s first take a look at how to calculate AAR for your subscription business.
Music streaming giant Spotify had worldwide revenues of $2.18 billion in the third quarter of 2021.
Spotify offers several different Premium plans to its customers, each with its own set of benefits. Here’s a quick overview of what each plan has to offer:
Let’s say a customer subscribes to an Individual plan of $9.99 per month and is paying for a full year.
This is how you would calculate the ARR of Spotify for this particular customer:
- Monthly Recurring Revenue (MRR) – $9.99
- Monthly Recurring Revenue Churn (MRR Churn) – $0
- ARR = ($9.99 – $0) x 12 = $119.88
Now, let’s say the customer decides to switch to a Duo plan that costs $12.99 a month after 6 months and continues to use it for the rest of the year.
In this case, the ARR would look like this:
- Revenue from Duo plan for 6 months: $12.99 – $9.99 = $3 x 6 = $18
- Monthly revenue lost from downgrades – $0
- ARR = $9.99 x 12 + $18 – $0 – $0 = $137,88
You can see how both the pricing strategy Spotify uses and customers’ choices affect the calculations for Average Revenue Per User (ARPU).
To calculate the total ARR for Spotify, we would have to factor in all the subscription plan changes, upgrades, and downgrades as well as the number of subscribers who cancel their premium accounts.
And now, let’s check out some examples of how some popular SaaS companies are generating ARR.
- Sendbird has $22 million in ARR with 420 customers who generate an average revenue of about $52,000 per year.
- Bombora has $30 million in ARR, only counting their subscription revenue. The company also sells one-off projects.
- Rosterfy has $100,000 in monthly recurring revenue which adds up to $1.2 million in ARR. They have about 100 customers that pay an average of $1,000 per month.
What is ARR? If you’re looking to grow your business, tracking your company’s ARR is essential. By understanding what it is and how it works, you can set realistic targets for future growth. And who knows? Maybe one day your company will be on this list of businesses with impressive ARR numbers.