Welcome to Part-2 of our ACV vs. ARR discussion. In Part-1, we took a closer look at what ACV is, how to calculate it and how decision makers can leverage it to capture valuable business insights. If you haven’t read Part-1 yet, we recommend that you take a look at it here.
In this Part-2 article, we’ll take a look at what exactly ARR is, how to calculate it and how to leverage it in measuring the success of your startup.
What is Annual Recurring Revenue?
Annual Recurring Revenue (ARR) is an important metric for SaaS companies that describes the total annual revenue a startup generates from recurring sales. Only contracts that have a minimum duration of 12 months qualify to be included in the ARR calculation.
ARR is one of the primary metrics used to measure year-over-year growth of SaaS companies that use recurring revenue models.
How do you calculate ARR?
In a simple scenario, ARR can be calculated by finding your startup’s monthly recurring revenue and then multiplying that by 12.
ARR calculation has to be adjusted for upgrades/ downgrades and churn. Therefore, you’ll need to include MRR from all of the following:
MRR from existing customers
+ MRR from new customers
+ MRR from upsells - MRR lost due to downgrades
- MRR lost due to churn
As the final step, you take the number from the above calculation and multiply it by 12.
Let’s try and understand this further with the help of an example. Let’s say that a SaaS startup has following customers and contract changes in a given month:
Customer A has subscribed to Basic Plan for £20/ month (i.e. Customer A’s MRR is £20)
Customer B is a new customer in the current month for Basic Plan (£20/month)
Customer C who was already a Basic Plan customer (£20/month) upgrades to Premium plan for £30/ month
Customer D who was a Basic Plan customer (£20/month) cancelled subscription
From above, company’s total MRR in that month will be:
£60 from customer A, C, D
+ £20 from new Customer B
+ £10 from Customer C from the upgrade this month
- £20 from Customer D for cancelled subscription
= £70. Therefore, the ARR of the company as of that month = £70*12 = £840.
How to use your ARR number?
A good understanding of your ARR number lets you plan and strategise for the future. Whether it be assessing product market fit, investor communication or leveraging financial insights, ARR is a fairly simple metric that packs a punch in terms of delivering actionable insights. Let’s take a closer look:
Growth momentum/ Product-Market Fit
ARR is one of the most effective metrics to measure momentum, which in turn signals product-market fit. ARR shows whether your business is gaining traction or waning over time. It gives insights into the demand for your product.
Critical financial metric
ARR, along with MRR is a fundamental element of financial forecasting for subscription based companies. It gives you a clear and accurate status on the health of your SaaS company. These numbers help you understand both short and long term cash flows. Understanding the timing of your cash flows will let you plan and drive your growth strategy.
Attracting investors
Giving potential investors a clear indication of the expected stream of recurring revenue can be a game changer for those startups looking to raise funds. Investors prefer the predictable sales models and revenue forecasts in SaaS companies and ARR is a key metric to measure that.
In essence, ARR is what keeps the wheels of your SaaS business turning. It’s the best indicator of revenue momentum and traction. The more recurring revenue your business generates, the longer you can focus on growth efforts.
Read More | What is ACV and is it the same as or similar to ARR? | Part one
In the final part of this series, we cover how ACV compares to ARR and when to use which of these metrics. Follow us on LinkedIn and get notified instantly about the next post.
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