Best Practices Guide: Navigating the World of SAAS Annual Recurring Revenue (ARR)
Annual Recurring Revenue (ARR) is a pivotal metric for SAAS companies and investors, offering insights into a business's health and strategies. However, its lack of standardization creates challenges. This guide navigates the complexities of ARR, offering best practices for its measurement while shedding light on its significance in SAAS valuations and the emergence of Committed Annual Recurring Revenue (CARR).
Defining ARR
Annual Recurring Revenue (ARR) is crucial for company management and investors. Simply put, ARR measures the expected yearly revenue from any given point in time, normalized on an annual basis. It represents the revenue a company anticipates receiving from its customers for subscription products or services. ARR is widely accepted as a way to evaluate the business's overall health and assess its long-term strategies. From an investor's perspective, the predictability and stability of ARR provide the ability to compare a company's performance against its peers over time. Standardization of ARR is crucial for a Software-as-a-Service (SAAS) company, but unfortunately, it's not yet standardized in the industry. Despite efforts by organizations like the SAAS Metric Standards Board, there is no universally accepted definition of ARR (https://www.saasmetricsboard.com/about-us).
Since there is no universally accepted standard for ARR, it is important to explain the number's assumptions confidently. The SAAS Metrics Standards Board defines ARR as the sum of subscription recurring revenue on an annualized basis, based on revenue recognition policy. It should exclude any one-time fees or professional services, even if they are recurring. If you want more information on this standard, please refer to https://www.saasmetricsboard.com/annual-recurring-revenue.
However, most companies and definitions of ARR include all recurring products and services in ARR, including professional services and support provided on a subscription basis. The Corporate Finance Institute provides instructions for calculating ARR that consider all sources of recurring revenue and do not include any variable or one-time fees. For more information on calculating ARR, please see https://corporatefinanceinstitute.com/resources/valuation/annual-recurring-revenue-arr/.
Lightbridge’s recommended best practice for early-stage SAAS Companies is to optimize fundability, include all predictable recurring revenue in its ARR calculation, and be prepared to provide SAAS-specific ARR. For example, a firm that can achieve a substantial recurring revenue stream by offering ongoing support should not exclude this revenue from its Total ARR calculation.
ARR Reporting Best Practices
It is important to be able to slice and dice ARR to understand its composition. We recommend tagging ARR with multiple profit center dimensions (or segments in NetSuite lingo) to enable comprehensive investor reporting, financial planning, and analysis (FP&A). We recommend tagging ARR with the following three dimensions:
Key Revenue by Profit Center Metrics
ARR by Product Category EXAMPLES Software Recurring Professional Services
ARR by Product Line EXAMPLES Product Line A Product Line B
ARR by Customer Category EXAMPLES Customer Category 1 Customer Category 2
A common mistake that SAAS companies encounter is the combination of multiple of the above dimensions into a single dimension. An example is where a company defines customer categories within the product line dimension. While this structure can work with a client’s current portfolio of products, the structure can begin to break down over the lifecycle of the product catalog due to strategic realignments, acquisitions, or the introduction of new products targeted at multiple customer categories.
In addition, it is critical to understand the inflows and outflows of ARR; therefore, ARR should be broken down into the following categories.
Revenue Inflows and Outflows
ARR added from new customers
ARR added from renewals from current customers
ARR added from upgrades from current customers
ARR lost from downgrades from current customers
ARR lost from churned customers
ARR KPIs
Tracking ARR growth and churn rates is crucial to planning for capital and optimizing exit strategy. Two key KPIs are recommended for clients to monitor:
Key Revenue KPIs
Annual Recurring Revenue (ARR) Growth Rate
Net Revenue Retention
The ARR metric is crucial for SaaS companies because it provides investors with a reliable benchmark to assess the value of a startup and the market. Although multiples are less commonly used in the early investment stages, growth stage and buyout investors use various competitive multiples to determine an acceptable valuation. Recently, SaaS Capital published an update on how to value private SaaS companies based on ten years of data analysis. The methodology uses three primary variables to determine valuations:
Current Public Market Valuations
Annual Recurring Revenue (ARR) Growth Rate
Net Revenue Retention.
Although several factors are considered when valuing companies, these three variables are the most important. SaaS Capital's research and downloadable Excel model can be found on their website at https://www.saas-capital.com/research/whats-your-saas-company-worth/.
Calculating the Annual Recurring Revenue (ARR) Growth Rate accurately based on actual trailing data is crucial. Forecasts and projections should be avoided. ARR growth rate strongly correlates with valuation multiples, but it's better to use it in combination with other factors for a more accurate estimate.
The Net Revenue Retention Rate (NRR) measures customer retention, revenue quality, customer satisfaction, and pricing power. It correlates with valuation and provides more information about a company's revenue quality than its growth rate alone. To learn more about these metrics and their importance, you can read about them in detail on SaaS Capital's website at https://www.saas-capital.com/blog-posts/private-saas-company-valuations-multiples/.
Calculating ARR
Once you have determined what to include in the Annual Recurring Revenue (ARR) and which dimensions it will be sliced into, the next step is to decide how to calculate Net ARR. Net ARR is calculated at a specific point in time by taking the beginning ARR, adding the ARR from add-ons and upgrades, and then subtracting the ARR from cancellations and downgrades during that year. To obtain Net ARR, you must initially calculate the underlying ARR. There are two commonly accepted methods of calculating Net ARR, and you should choose the one that aligns with your strategy.
ARR Calculation Methods
1. Calculate ARR Using Deal Averages
2. Calculate ARR Using MRR
Calculate ARR Using Deal Averages
Under this method, ARR is calculated by taking recurring revenue by dividing the total recurring revenue by the term in months and then multiplying the product by twelve.
Formula:
ARR = Revenue / Term * 12
Calculating ARR Using MRR:
Under this method, ARR is calculated by multiplying MRR for the most recent month (the run rate) and multiplying by twelve.
Formula:
ARR = MRR for the latest month * 12
Select the method that best aligns with your goals. Lightbridge recommends a long-term value focus calculating ARR using MRR to produce a more favorable ARR growth rate in the case where multi-year deals ramping deals are used (we recommend leveraging Salesforce CPQ Multi-Dimensional Quoting for this use case). For example, say your sales team sells a multi-year ramping annual contract deal with the following contract legs:
Example Multi-Year Ramping Deal:
· Year 1: 20 seats for $12,000
· Year 2: 40 seats for $24,000
· Year 3: 60 seats for $36,000
ARR using deal averages = (12,000 + 24,000 + 36,000) / 36 * 12 =
o Year 1 ARR= (12,000 + 24,000 + 36,000) / 36 * 12 = $24,000
o Year 2 ARR= (12,000 + 24,000 + 36,000) / 36 * 12 = $24,000
o Year 3 ARR= (12,000 + 24,000 + 36,000) / 36 * 12 = $24,000
ARR using MRR =
o Year 1 ARR = (12,000 / 12 * 12) = $12,000
o Year 1 ARR = (24,000 / 12 * 12) = $24,000
o Year 1 ARR = (36,000 / 12 * 12) = $36,000
As exhibited by the above example, ARR using deal averages will favor current ARR at the expense of ARR Growth Rate and may ultimately lead to a lower enterprise value if such deals are prevalent.
The Rise of CARR
Committed Annual Recurring Revenue (CARR) has become increasingly popular for fast-growing businesses as it measures revenue booked and committed to recurring but has not started to be recognized yet. It is an extension of the Annual Recurring Revenue (ARR) concept, recognized as vital for fast-growing subscription businesses. ARR gives a recurring business credit for where they are on an ongoing recurring basis rather than where they've been.
According to subscript (https://www.subscript.com/the-dive/what-is-carr-and-why-are-50-of-companies-using-it-as-a-primary-metric), nearly 50% of businesses focus on CARR as their primary metric as it helps them better reflect how the business is growing. Subscription businesses are annuity-based, and the quality of an annuity-based business is determined by just a few factors, such as how much it costs to acquire the customer, how much each customer pays, and how long the customer stays in place. The ultimate summary measurement is the recurring revenue number.
Committed Recurring Revenue removes the "live" part of that statement. Instead of only counting contracts where the service is live, and revenue is accruing, it counts contracts that have been booked (or signed) but haven't started yet. Committed ARR can also be a leading indicator for account health issues. Committed ARR makes the most sense when a business grows rapidly or revenue frequently gets booked a month or two before they start using the service.
Having good systems and processes to handle the complexities of Committed Revenue reporting is important. There are a few complexities to watch out for, such as upsell, down-sell, and churn metrics that are harder to account for. Investors and acquirers may still want to see "classical" ARR numbers and roll forward to keep things more standardized. Overall, CARR is a crucial metric that helps businesses reflect on their growth and plan for the future.
ARR Best Practices Recap Cheat Sheet
1. Definition and Importance:
ARR: Expected yearly revenue from subscriptions, crucial for business evaluation and investor assessment.
Importance: Measures business health and strategies; facilitates comparisons with peers and historical performance.
2. Standardization Challenges:
SAAS Metric Standards Board: Efforts for standardization, but no industry-wide agreement.
Recommendation: Clearly explain assumptions behind ARR numbers.
3. Measuring ARR:
Inclusions: Include all predictable recurring revenue for a comprehensive ARR calculation.
Dimensions: Tag ARR with Product Category, Product Line, and Customer Category for accurate analysis.
Breakdown: Understand ARR inflows (new customers, upgrades) and outflows (downgrades, churn) for strategic planning.
4. ARR and Valuation:
Key Metrics: ARR growth rate and Net Revenue Retention are essential for SAAS valuation.
SaaS Capital's Research: Focuses on current public market valuations, ARR growth rate, and Net Revenue Retention.
Calculation: Use actual trailing data for accurate ARR growth rate estimation.
5. ARR Calculation Methods:
Deal Averages: Dividing total recurring revenue by term in months, then multiplying by twelve.
MRR Method: Multiply the Monthly Recurring Revenue (MRR) for the latest month by twelve for ARR calculation.
6. Committed ARR (CARR):
Definition: Revenue booked and committed to recurring, not yet recognized.
Significance: Reflects business growth; important for rapidly growing businesses.
Complexities: Upsell, down-sell, and churn metrics require careful handling.