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 both SaaS startups and more mature tech businesses.
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 = (total subscription revenue 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 it must be included.
Despite the relative simplicity of this calculation, many SaaS startups still get ARR wrong. That's because they include or omit revenue that shouldn’t be part of the equation.
ARR best practices for SaaS businesses
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
Another common mistake companies make when calculating ARR is taking their MRR figure and multiplying it by 12, as there are 12 months in a year. Seems logical.
The problem with this method lies in the volatility of SaaS sales cycles, due to seasonality or other factors, which can impact acquisition and churn over a short period of time. For example, if you have an unusually good month or close your first enterprise deal, those outliers can inflate your ARR–it won't be indicative of what your yearly business typically looks like.
Why it's important for SaaS startups to get ARR right
Incorrect calculations mean you’ll get the wrong picture about your company’s health and growth. It also means reports for your stakeholders and potential investors will be misleading, which can lead to even bigger problems down the road.
It’s important to be as honest and transparent as possible with your ARR methodology so you can get an accurate read on your company’s health, and when the time comes, so you can present achievable forecasts to interested investors.
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 tricky.
Let's go through a few examples so you can see how the ARR calculations differ: