Decoding ARR for SaaS Companies: A Comprehensive Guide

In the Software as a Service (SaaS) industry, metrics are essential for measuring progress and expansion. Annual Recurring Revenue (ARR) stands out as a key metric in evaluating the financial well-being and longevity of SaaS companies. With ARR encompassing multiple revenue streams, there can often be confusion about which streams to include. In this post, we are decoding the nuances of ARR, providing a guide shedding light on its importance in the SaaS industry.

Breaking down recurring revenue

Recurring revenue is a comprehensive term covering both subscription and transactional income, representing the consistent flow of revenue for a SaaS company. By focusing on recurring revenue, SaaS businesses can assess their stability and potential for sustained growth.

In light of the resilience of the SaaS business model in challenging economic climates, more companies are exploring subscription-based models for various products and services like professional services and hardware. However, it's essential to acknowledge that different revenue streams have distinct characteristics, making it crucial to differentiate between them when using ARR as a metric.

Distinguish your recurring revenue streams

While we appreciate the subscription model and its benefits, it's essential to differentiate between the various recurring revenue streams in your business. This distinction offers valuable insights into your business operations, especially as you scale. Subscription revenue serves as the cornerstone of ARR for most SaaS companies, representing the consistent income from monthly or annual subscriptions that customers pay for software access. This reliable revenue stream forms a solid financial base for SaaS companies, calculated by multiplying the monthly recurring revenue from license subscriptions by 12.

Managing transactional and campaign-driven revenue streams

Another key revenue stream commonly integrated into the ARR metric is transactions. As SaaS companies continuously evolve their delivery models to optimize revenue generation, they explore ways to monetize different functionalities within their platforms. This often involves charging customers for specific actions or additional services, such as data storage, API calls, or other usage-related fees like signatures, log-ins, and published ads.

Given that transactional revenue tends to scale alongside the number of users or customers, it can be beneficial to include it in the ARR calculation. During favorable market conditions, transactional revenue can even outperform a traditional subscription model, acting as a robust source of income. However, the dynamics shift when markets change, impacting the predictability and stability of transactional revenue compared to subscription revenue.

In times of economic downturns, shifts in consumer behavior and needs can lead to fluctuations in demand, potentially affecting the reliability of transactional revenue streams. As a result, it is recommended treating transactional revenue separately as recurring income alongside ARR, unless there is consistent growth in transactions, in which case they could be considered part of the ARR. It is essential to distinguish between revenue stemming from transactions and subscriptions to provide clarity and insight into the financial health of the business.

Differentiating transactional and recurring revenues

Regarding transactions, numerous companies generate revenue from in-house consultancy and services. To enhance the predictability of this revenue stream, it's common to see customers opting for annual consultancy or service agreements. While this approach keeps consultants engaged and leverages your expertise, it may limit flexibility. Consequently, you might find yourself needing to allocate more resources to a non-core aspect of your business to meet demand.

Furthermore, while distinguishing between truly recurring revenues and transactions seems straightforward, there are revenue streams that fall in between these categories. These are revenues with a campaign-like pattern, where they don't naturally recur but are expected to reappear regularly. For instance, campaigns within Martech exhibit seasonality and budget constraints, leading to sporadic revenue periods. Despite their non-traditional recurrence, we believe these revenue streams should be classified as recurring revenues separate from the typical subscription income.

What is the significance of separating these revenue streams?

The importance of separating revenue streams lies in their inherent differences. Each product and service incurs varying costs of goods sold (COGS), including support, services, transaction costs, customer success, hardware, and Dev Ops. This diversity impacts SaaS gross margins (GM) across different revenue streams, making it crucial to understand your GM when evaluating scalability and its impact on your company's financial health and valuation.

Cloud-based software products typically boast high GM, ranging from 70-85%. This high GM signifies significant scalability potential, as selling the same digital product repeatedly incurs minimal marginal costs. Conversely, a sub-70% GM for your software component indicates an overly operations-heavy offering, necessitating a closer look at your delivery model. When considering transactions, services, and hardware, margins usually range from 5% upwards and are susceptible to seasonal and cyclical influences.

Activated or Committed ARR?

When it comes to Activated ARR, we're talking about revenue generated from contracts that are currently active. Imagine you've just closed a deal with a new customer, but the contract doesn't kick in until a month from now. In this scenario, it's best not to include the contract value in today's ARR. Instead, wait until the contract is activated and starts bringing in revenue. Similarly, if a customer informs you they will churn at the end of their current contract, it's common practice to remove them from the reported ARR at that time. However, it's crucial to keep in mind any existing contractual agreements, such as the possibility of re-engaging a churned customer through negotiations within the notice period, where the customer might as well renew their contract. That's why we at Bentega prefer to keep churned customers included in the reported Annual Recurring Revenue until they actually leave.

While Activated ARR gives us a real-time snapshot of current contracts, we find Contracted Annual Revenue (CARR) to be a more forward-looking indicator as this is committed ARR. CARR is a subset of ARR that represents the guaranteed, contracted income from annual subscriptions. This includes any signed contracts (new sales, upsells, net expansions, and price increases) that have not yet been activated, as well as communicated churned contracts until they are officially off the books. For SaaS companies, CARR holds particular significance as it showcases revenue that can be relied upon from long-term commitments.

By providing a sense of security and stability, CARR enables SaaS businesses to make strategic decisions regarding resource allocation and growth plans. It serves as a key metric for forecasting future revenue and ARR Growth, and is a valuable tool in discussions surrounding ARR.

Conclusion: Annual recurring revenue in SaaS

Annual Recurring Revenue (ARR) serves as a foundational metric in evaluating the financial health and longevity of SaaS companies. Comprised of multiple revenue streams, each component plays a crucial role in molding the financial landscape of a SaaS company. To gain a clearer understanding, we recommend dissecting these revenue streams to track performance and gauge the scalability of your business.

By delving into and optimizing the various facets of ARR, SaaS businesses can not only assess their current performance but also make strategic decisions regarding pricing strategies, customer acquisition, and product development. A comprehensive understanding of ARR is vital for achieving success and sustainable growth in a competitive and ever-evolving industry.

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