Annual Recurring revenue: What is ARR and how to calculate it

In the dynamic world of Software as a Service (SaaS) businesses, metrics are crucial for gauging success and growth. Annual Recurring Revenue (ARR) is one such metric that plays a pivotal role in assessing SaaS companies’ financial health and sustainability. ARR could contain several revenue streams, and often, there can be some confusion on which streams to include. In this article, we will explore these different aspects of ARR, highlighting their significance in the SaaS industry.

Decomposing recurring revenue

Recurring revenue is a broader term that encompasses both subscription and transactional revenue. It represents the portion of a SaaS company’s revenue that we expect to continue in the future, excluding one-time or non-repeating payments. By focusing on recurring revenue, SaaS businesses can gauge their stability and ability to sustain growth over time.

As the SaaS business model has proved itself to be robust in challenging economic environments, an increasing number of businesses have considered implementing a subscription-like business model for multiple products and services, such as professional services, hardware, etc. The challenge, however, with treating recurring revenue as your go-to ARR metric is that the different revenue streams are very different in nature.

Split your recurring revenue streams

We won’t argue that this is a step in the wrong direction (by all means, we love the subscription model!). However, we believe best practice is to distinguish between the different types of recurring revenue in your business. This provides better visibility into your business mechanics which will prove itself to be very valuable when scaling your business.

Subscription revenue is the bedrock of ARR for most SaaS businesses. This refers to the income generated from recurring monthly or annual subscriptions customers pay to access the software service.

This predictable revenue stream provides a stable foundation for a SaaS company’s finances. To calculate subscription ARR, multiply the monthly recurring revenue from license subscriptions by the factor of 12.

How to treat transactional and campaign based revenue streams

Another revenue stream we often see included in the ARR metric is transactions. Over time, in the hunt for yield, SaaS companies have decomposed their delivery model, looking for ways to monetize different aspects of their platform. As some of this functionality is usage-based or consumption-based, revenue is typically generated when customers pay for specific actions or additional services within the SaaS platform. These actions could include data storage, API calls, or other usage-related charges such as signatures, log-ins, published ads, etc.

As this revenue stream often scales with the number of users/customers, it makes sense in many ways to include it as part of the ARR. In fact, when the market is in your favor, it acts like a subscription model on steroids. Depending on the product’s nature, however, things can look quite different when the markets change.

In economic slowdowns, a large part of the demand will fall short due to natural changes in behavior and needs. In such a situation, it is hard to argue that a transactional business model comes with the same robustness as a subscription model does, as transactional revenue can be variable and less predictable compared to subscription revenue. Therefore, we prefer transactional revenue streams to be treated on their own as re-occurring revenue in parallel to the ARR unless the transactions are consistently growing, then we could argue to include transactions as part of the ARR. In any case, it would make sense to highlight whether the revenue streams stems from transactions or subscriptions.

Nuances of transactional and recurring revenues

As for transactions, many companies have revenue stemming from in-house consultancy and services. To make this revenue stream more predictable, we have seen several examples of customers signing up for annual consultancy or service agreements. Although this is a good way of keeping your consultants off the bench and monetizing on your know-how, you lose flexibility. Therefore, you could set yourself up to allocate an increasing amount of capital to a non-core part of your business to handle demand.

Finally, although distinguishing between truly recurring revenues and transactions may seem reasonable, there are revenue streams that fall in between the two definitions. These are typically revenues with a campaign-like pattern where they are not naturally recurring, but you still expect that they will re-occur regularly. Examples of such revenues could be campaigns within Martech where seasonality and budgets could be leading to shorter periods of revenues, and where you expect new campaigns will generate similar revenues in the future. We argue that these revenue streams should be treated as re-occurring revenues separated from recurring revenues.

Why should these revenue streams be split?

The main reason revenue streams should be separated is that they are quite different by nature. Various products and services have differing costs of goods sold (SaaS COGS, including Support, services, transaction costs, Customer Success, Hardware, and Dev Ops), meaning SaaS gross margins (GM) differ across the revenue streams. Knowing your GM is crucial when assessing the scalability of your business, which has a huge impact on your valuation.

For cloud-based software products, the GM is generally high, typically in the 70-80% range. A high GM indicates a high potential for scalability, which makes sense as you can sell the same digital product repeatedly at a limited marginal cost. If your software component yields sub 70% GM, you should investigate how efficient your delivery model is as it indicates your offering is too operations-heavy. When we look at transactions, services, and hardware, margins typically vary anywhere from 5% and upwards and are usually impacted by seasonality and cyclical headwinds.

Activated or Contracted ARR?

Activated ARR refers to the revenue that comes from active contracts. Let´s say you have just sold a subscription to a new customer, but the contract has a start date one month from now. Then, you should not include the contract value in today’s ARR but rather in a month when the contract has been activated and generates a revenue stream. In the same way, a customer who communicates they will churn at the end of their current contract is often removed from the reported ARR at the time of notification. When using this approach, however, we need to remember that there are contractual agreements in place, such as our potential to win back a churned customer by entering a negotiation during the time window the notice period grants us. Therefore, we prefer to include churned customers in as part of the reported Annual Recurring Revenue until the customer actually leaves.

Although activated ARR gives us a real-time view of the contractual arrangements, we are much fonder of using Contracted Annual Revenue (CARR) as a guiding star for the future. CARR is a subset of ARR representing the guaranteed, contracted income from annual subscriptions. This includes any contracts signed (new sell, upsell, net expansion, and price increases), but not yet activated, and even communicated churned contracts until they are out of the books. CARR is especially significant for SaaS companies as it reflects the revenue they can count on from long-term commitments.

CARR provides a sense of security and stability, as it represents locked-in revenue for the coming year. This allows SaaS businesses to make informed decisions about resource allocation and growth strategies and is the metric we refer to when discussing ARR.

Conclusion: Annual recurring revenue in SaaS

Annual Recurring Revenue is a fundamental metric for assessing SaaS businesses’ financial performance and sustainability. It comprises various revenue streams, and each of these components plays a unique role in shaping a SaaS company’s financial picture. To make this picture clearer, we suggest you decompose the revenue streams, as this will enable you to track performance and get a sense of the scalability of your business.

By understanding and optimizing these different aspects of ARR, SaaS businesses can not only measure their current performance but also make informed decisions about pricing strategies, customer acquisition, and product development. A strong grasp of ARR is essential for success and long-term growth in a competitive and ever-evolving industry.

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