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Annual Recurring Revenue (ARR)

ARR is pivotal a metric for SaaS companies, especially ones with longer-term contracts, used to measure the annual revenue generated by subscription services.

What is annual recurring revenue (ARR)?

Annual Recurring Revenue (ARR) is pivotal a metric for SaaS companies, especially ones with longer-term contracts, used to measure the annual revenue generated by subscription-based services. It is commonly derived by multiplying a company’s monthly recurring revenue (MRR) by twelve, but exceptions exist. ARR helps SaaS businesses understand the current state of their business, forecast the future growth, and can be used to compare performance across different time periods.

How do you calculate ARR?

There are several ways to calculate ARR.  To calculate ARR from the terms of a contract, one must know the total value of the recurring revenue of a contract and the term of a contract. For example, the ARR for a customer contract that included $100,000 of non-recurring revenue, and $1,800,000 of recurring revenue over 18 months would be calculated as follows:

$1,800,000 of recurring revenue / 18 months x 12 months = $1,000,000 of ARR.

Often, companies simply annualize MRR to calculate ARR.  In that case, ARR would be 12 x MRR. This means that for every dollar of monthly recurring revenue (MRR), the annual recurring revenue (ARR) is twelve times that number.

ARR Formula

Why is annual recurring revenue essential to measure? 

ARR is an important metric to track as it provides a normalized view of the current revenue run rate of a business or customer.  It can be a useful metric to use to calculate the current revenue profile or to forecast future revenue growth of a subscription-based business.  A rising ARR indicates more customers are signing up for a service or current customers are generating more revenue over time. A decrease in ARR could mean that fewer new customers are signing up or existing customers may be canceling their subscriptions. 

In addition to monitoring their customer growth, investors often use ARR to compare and value SaaS companies relative to competitive companies and industry standards. This is done by calculating average valuation to revenue multiples of comparable companies (both public and private) and applying that multiple to another company’s ARR to devise a valuation for the target company.  For instance, if SaaS companies in the cybersecurity industry are valued, on average, at the equivalent of 10x ARR, then an investor might expect a company with $1,000,000 to have a valuation of $10,000,000.  

There are also other common ARR benchmarks that companies use. For example, many investors might only consider investing in a Series A fundraising round if a company has more than $1 million in ARR.  By utilizing ARR benchmarks, companies can set realistic expectations with stakeholders around valuations, performance, and stage, allowing stakeholders and investors alike to plan accordingly.

Should I use ARR or MRR? 

There still is no definitive answer to this question, but ARR is often used for companies that deal in longer-term contracts (greater than 1 month) with a definitive term so that they must be renewed, renegotiated, or canceled by a specific date.  This is often associated with companies that sell enterprise software or other higher-value business-to-business “B2B” contracts.

Alternatively, companies that sell monthly “evergreen” subscriptions that renew automatically until they are canceled, are often measured using MRR. Companies in this group often sell to consumers or to businesses at lower dollar amounts, and these arrangements are often paid via credit card.

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