Annual Recurring Revenue (ARR): Meaning, Formula & Calculation

In SaaS, 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.

Annual Recurring Revenue Meaning

Annual Recurring Revenue (ARR) is a key financial metric used by subscription-based businesses, particularly SaaS companies, to measure predictable revenue generated annually. ARR represents the total value of recurring subscription revenue, excluding one-time fees or variable charges.

ARR in SaaS

ARR is a fundamental metric for SaaS companies because it reflects business scalability and financial predictability. SaaS firms rely on ARR to:

• Track customer retention and churn rates.

• Forecast revenue growth.

• Determine valuation during fundraising or acquisition discussions.

What Is Annual Recurring Revenue?

ARR quantifies the stability and growth potential of a business by focusing on long-term customer contracts. Investors, CFOs, and business leaders use ARR to assess financial health, project revenue trends, and evaluate company valuation.

Annual Recurring Revenue

Annual Recurring Revenue (ARR) refers to the predictable and consistent income that a company expects to receive annually from its customers for providing ongoing services or products. In the context of SaaS, ARR is a critical financial metric that helps businesses understand their revenue stability and growth potential. It encompasses all recurring revenue components, such as subscription fees, renewals, and any additional charges that occur on a regular basis. By focusing on ARR, companies can better forecast their financial future, make informed strategic decisions, and demonstrate their value to investors. Understanding ARR is essential for SaaS companies aiming to achieve long-term success and sustainability in a competitive market.

Activated ARR

Activated ARR, or Activated Annual Recurring Revenue, is a crucial metric for SaaS companies seeking to understand their current revenue landscape. It specifically accounts for the revenue generated from contracts that are actively in effect, providing a real-time view of the income being realized. This approach ensures that only the revenue from contracts that have commenced is included, offering a more accurate reflection of the company's present financial status.

By focusing on Activated ARR, businesses can avoid overestimating their revenue potential by excluding contracts that have been signed but not yet initiated. This precision in revenue tracking allows for better financial planning and resource allocation, ensuring that strategic decisions are based on the most reliable data available. Understanding and utilizing Activated ARR can help SaaS companies maintain a clear picture of their financial health, enabling them to navigate the complexities of growth and customer retention with greater confidence.

Contracted ARR

Contracted ARR, or Contracted Annual Recurring Revenue, is a pivotal metric for SaaS companies aiming to secure a clear picture of their future revenue streams. Unlike Activated ARR, which focuses on revenue from active contracts, Contracted ARR encompasses all signed agreements, including those yet to commence. This forward-looking approach provides a comprehensive view of the revenue pipeline, capturing the total value of commitments made by customers.

By including new sales, upsells, and expansions that are contractually secured but not yet activated, Contracted ARR offers a robust indicator of a company's growth trajectory and financial stability. It allows businesses to plan strategically, ensuring that resources are allocated efficiently to support anticipated growth. Understanding Contracted ARR is essential for SaaS companies to maintain a competitive edge, as it highlights the potential for revenue expansion and underscores the importance of securing long-term customer commitments.

Activated or Contracted 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.

How Do You Calculate Annual Recurring Revenue?

To calculate ARR accurately, follow these steps:

1. Identify recurring revenue sources – Subscription fees, contract renewals.

2. Exclude one-time payments – Setup fees, consulting charges.

3. Adjust for discounts and churn – Deduct customer cancellations and applied discounts.

4. Sum the values for a 12-month period – This provides the ARR figure.

Annual Recurring Revenue Formula

To calculate Annual Recurring Revenue, you begin by identifying all sources of recurring revenue within your SaaS business.

This typically includes subscription fees, renewals, and any other predictable charges that occur on a regular basis. Once these revenue streams are identified, the formula for ARR is straightforward: multiply the Monthly Recurring Revenue (MRR) by 12.

The standard ARR formula is:

ARR = (Total Subscription Revenue Per Year) - (Discounts + Refunds)

For example, if a SaaS company has 100 customers paying $1,200 annually, the ARR is:

$1,200 * 100 = $120,000 ARR

This calculation provides a clear picture of the annualized revenue your company can expect from its recurring sources. It's important to ensure that only consistent and reliable revenue streams are included in this calculation to maintain accuracy and provide a true reflection of your company's financial health. By accurately calculating ARR, SaaS companies can better forecast their financial future and make informed strategic decisions.

ARR Revenue vs. Other Revenue Metrics

ARR is often compared to other financial indicators:

Define ARR

ARR refers exclusively to revenue that is contractually recurring on an annual basis, ensuring predictability.

ARR vs. Revenue

• ARR includes only recurring subscription revenue.

• Revenue includes all earnings, including one-time sales, services, and transactional income.

What Is ARR in Business?

In business, ARR provides insight into future revenue expectations, making it essential for companies relying on long-term customer contracts. Essentially, you could claim that the ARR is the expected revenue the next 12 months, ceteris paribus.

ARR vs. ACV (Annual Contract Value)

• ARR standardizes revenue on an annual basis.

• ACV includes total contract value spread over its duration (e.g., a 3-year contract worth $30,000 has an ACV of $10,000 but may have varying ARR contributions).

ARR vs. MRR (Monthly Recurring Revenue)

ARR and MRR are closely related but differ in how they measure recurring revenue:

• ARR represents total predictable revenue on an annual basis.

• MRR represents total predictable revenue on a monthly basis.

To convert between them:

• ARR = MRR × 12

• MRR = ARR ÷ 12

ARR is useful for long-term planning and investor reports, while MRR is often used for short-term performance tracking.

Why Is ARR Higher Than Revenue?

In some cases, ARR appears higher than reported revenue because:

• Some contracts are recognized as ARR but not yet billed.

• Deferred revenue from annual subscriptions is counted as ARR but split across fiscal years.

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.

Recurring Revenue Examples

Recurring revenue examples in the SaaS industry are diverse and can significantly impact a company's financial stability and growth trajectory. Subscription fees are the most common form, providing a steady stream of income from customers who pay monthly or annually for access to software services. Beyond subscriptions, many SaaS companies generate recurring revenue through renewals, where customers extend their service agreements, ensuring continued cash flow. Additionally, usage-based charges, such as fees for extra data storage or additional user licenses, offer another layer of predictable income. These examples highlight the multifaceted nature of recurring revenue, underscoring its importance in building a resilient and scalable business model.

Subscription Revenue

Subscription revenue is the backbone of the SaaS business model, providing a steady and predictable income stream that allows companies to plan for the future with confidence. This revenue is generated from customers who pay a recurring fee, typically on a monthly or annual basis, to access software services. The predictability of subscription revenue not only aids in financial forecasting but also enhances a company's ability to invest in product development and customer support. By focusing on building a robust subscription base, SaaS companies can ensure a stable cash flow, which is crucial for sustaining operations and driving growth. This model also fosters long-term customer relationships, as businesses strive to deliver continuous value to retain subscribers and minimize churn.

Transactional and campaign-driven revenue streams

Another key revenue stream commonly integrated into the ARR metric are 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.

Decompose 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. 

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 decomposing recurring 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.

Conclusion: Annual recurring revenue in SaaS

Annual Recurring Revenue (ARR) is a vital metric for subscription-based businesses, providing financial stability and investor confidence.

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. By understanding ARR, its calculation, and its importance in SaaS, companies can drive sustainable growth and optimize pricing strategies.

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Looking to optimize your Annual Recurring Revenue (ARR)? Bentega helps SaaS companies track ARR for compensation purposes. Learn more about ARR, SaaS revenue forecasting, and pricing strategies on our blog.