Recurring revenue is the beating heart of your SaaS company. As a metric, known as ARR, this revenue helps you work towards increasing your subscriber base, compounding your growth, and developing a better product over time.
Read on as we take a look at ARR and discuss why it’s important for SaaS companies to track, providing a clear definition, the formula, and a review of some calculation examples.
ARR definition
Annual recurring revenue (ARR), sometimes referred to as annual run rate, is the normalized annual revenue from your existing subscriptions. It gives you an overview of how your business is performing year on year, and enables you to more accurately forecast your growth. ARR tends to go hand in hand with MRR (monthly recurring revenue) for SaaS.
How to calculate ARR
The ARR formula takes into account all of the recurring revenue within your business. To calculate ARR, simply add the dollar amount of yearly subscription revenue with the dollar amount gained from expansion revenue, and then subtract the dollar amount lost from churn.
ARR formula
ARR = (overall subscription cost per year + recurring expansion revenue) – revenue lost from churned customers
Expansion revenue (from recurring fees related to upgrades, upsells, add-ons) affects the yearly subscription price of customers, so must be included.
Despite the relative simplicity of this calculation, many SaaS startups are assessing their ARR incorrectly. This is caused by including or omitting recurring revenue items that shouldn’t be part of the equation.
Incorrect calculations mean that you’ll be getting the wrong picture about your company’s health and growth. It also means that reports for your stakeholders and potential investors will be misleading, which can lead to problems further down the track.
Many companies calculate their ARR by taking their MRR (monthly recurring revenue) figure and multiplying it by 12, as there are 12 months in a year. The problem with this method is the potential for volatile sales cycles, due to seasonality or other factors, which can impact acquisition and churn over a small amount of time. For example, if you have a high growth month, or sign your first enterprise customer over one month, it doesn’t make sense to calculate MRR based on that particular month as it’s not indicative of what that sample of time usually looks like for your business.
What you should include in ARR calculations
Any recurring subscriptions
Upgraded accounts
Downgraded accounts
Lost revenue from churned customers
What you shouldn’t include in ARR calculations
Set-up fees
Account adjustments
Discounts
One-off upgrades
Any other non-recurring charges
It’s important to be as honest and transparent as possible with your ARR math to get an accurate picture of your company’s health, which you can use to forecast and to present to interested investors when the time comes.
ARR calculation examples
If all your subscriptions are annual, your ARR will be relatively simple to calculate. However, when you’re taking monthly and multi-year subscriptions into account, plus one-off fees and discounts, things can get a little more sticky.
Example 1
If a customer signs up for your product for 4 years, at a total cost of $40,000, plus a cost for sign-up and training fees of $8,000, the calculation should be:
ARR: $40,000 / 4 years = $10,000
The $8,000 is not included in this calculation, as it’s non-recurring revenue.
Example 2
A customer signs up for your annual plan for $100,000 which is made up of the main subscription fee, plus two other subscription components. They’ve also paid your set up fee of $2,500.
ARR: $100,000
Your total subscription revenue from this customer is the sum of their annual plan. The set-up fee is a single payment, so isn’t included in the calculation.
Example 3
A customer signs up for a 15-month term at $150,000.
ARR: $150,000 x (12/15) = $120,000
Example 4
You have a customer that signs up to your monthly plan, and uses your product for 18 months before deciding they won’t renew their plan
ARR: $0
If the customer is paying monthly, but hasn’t signed up for an overall term of a year or more, this shouldn’t be counted as annual recurring revenue.
These are just a few of the examples that you might come across in your business. Calculating your ARR accurately can take time in these situations, but the payoff in getting things right is worth it over the long term.
In summary
Annual recurring revenue is one of the mother metrics in SaaS, and it’s fairly simple to measure. It can be used to forecast revenue for the coming year, and to give you better insights into your growth. It also enables you to gain a better understanding of customer churn and how that is affecting your business.
Tracking your ARR over time helps you plan strategies for future product development, plus refine your sales and marketing initiatives as you move forward.
Additional resources
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