What Is Annual Recurring Revenue (ARR)?
Annual recurring revenue (ARR) refers to all ongoing revenue for a product or business, projected over one year. Companies that offer yearly subscriptions use this metric to determine how much revenue they can expect each year.
For a SaaS company, ARR should include both the product’s subscription fees plus additional professionals services the company offers. Common examples of these services include product installation, training, and maintenance contracts.
Who Should Use the Annual Recurring Revenue Model?
The ARR model of determining ongoing revenue is best suited to companies that sign most customers to a term of at least one full year.
Businesses that offer monthly subscriptions can also estimate annual recurring revenue by projecting each customer’s monthly charges out to one year. But because customers can end their subscriptions at the end of any month, these businesses will find the ARR model less accurate. Companies offering monthly subscriptions should instead use a monthly recurring revenue (MRR) model.
How Do You Calculate Annual Recurring Revenue?
To calculate your annual recurring revenue, you will first need to calculate three figures:
1. The total dollar amount of annual subscriptions.
2. The total dollar amount of additional ongoing revenue (training, installation, support, etc.).
3. Total dollar amount lost through subscription cancellations (customer churn).
The formula looks like this:
Annual subscriptions + additional ongoing revenue – cancellations (3) = ARR.
If you sell your product via a monthly subscription model, you can use a similar formula to the one above, then multiply the monthly number by 12.
Why Is Annual Recurring Revenue Important?
Many SaaS businesses consider ARR the most important single metric in measuring their company’s success. There are several reasons for this.
1. It highlights what’s working (and what isn’t)
A company that knows the annual recurring revenue of a product can more easily determine whether their sales and marketing campaigns for that product, as well as the overall customer acquisition cost, are profitable.
2. It gives valuable context to the other figures
Let’s say your product has a churn rate of 3% each year—meaning 3% of your customers end their subscription every year. Is that number acceptable, or something to worry about? Without the bigger picture—your product’s overall annual recurring revenue, with churn factored in—you won’t know. By having a clear picture of your ARR, you can better understand what other metrics might be signaling trouble, and which ones shouldn’t keep you up at night.
3. It can lead to extremely high valuations
Wall Street has always favored subscription business models because they create more predictable revenue than businesses that make one-time sales of products or services. What the financial markets favor even more than predictable monthly revenue is predictable annual revenue—because the dollar amounts are higher and the income is more stable. For this reason, a business that can provide an impressive and reliable ARR is more attractive to the capital markets.
What Isn’t Included in Annual Recurring Revenue?
It’s essential to keep in mind that ARR refers to ongoing revenue. A business measuring its ARR should exclude any one-time charges or fees related to its products or services. Here is an example.
Say your company sells a B2B SaaS app on an annual subscription basis. Some of your upsell options include an enterprise version of the software and regular onsite training with your staff. All of those add-ons are examples of expansion revenue—and you will want to count them among your ARR.
Now, let’s say you also offer a one-time charge to brand your new customer’s app with their company’s color scheme, logo, and website look and feel. This will enable your customer to embed your app into their digital corporate ecosystem and create a seamless experience. After your team has charged for this one-time customization service, your customer will then be paying the standard annual subscription rate.
This one-time upsell will affect your revenue in the year your team does the work for your new customer. But it will not affect the annual recurring revenue you generate from that customer. For that reason, this won’t factor into your ARR calculation.