CARR vs. ARR
A System Integrator's Perspective
Overview
This guide compares two options and recommends a best practice for implementing annualized recurring revenue reporting for subscription-based businesses. The comparison is between Annual Recurring Revenue (ARR) and Contracted Annual Recurring Revenue (CARR), for non-GAAP/IFRS recurring revenue.
The guide presents two primary methods for ARR calculation: 'ARR Beginning at Contract Start,' which takes into account subscription revenue from the contract's initiation regardless of customer activation time, and 'ARR Beginning at Go-Live,' which factors in Time to Live (TTL) in the calculation.
Furthermore, the guide delves into the use of CARR by Revenue Professionals to mitigate ARR fluctuations and expedite revenue recognition. It explores two standard CARR timing methods, 'CARR Beginning at Contract Start' and 'CARR Beginning at Contract Signature.'
Ultimately, the guide recommends using the 'ARR Beginning at Contract Start' method for more reliable revenue treatment and smoother implementation.
There are two leading triggers used for ARR, which are summarized below.
ARR Beginning at Contract Start
This definition of ARR includes the annual run rate of subscription revenue for active contracts with contract start dates on or before the same period, without considering the time required to get the customer live, also known as Time to Live (TTL).
This method also has the significant benefit of being the most straightforward to implement within Salesforce and NetSuite.
ARR Beginning at Go-Live
This definition of ARR includes the annual run rate of subscription revenue for active contracts with Go-Live dates on or before the same period, taking TTL into account.
Consider this example: A new customer has signed a twelve-month contract worth $120,000. Assume a three-month TTL. Using the 'ARR Beginning at Contract Start' method, revenue for the twelve months of the contract will be $10,000 per month.
On the other hand, using the 'ARR Beginning at Go-Live' method, revenue will be zero for the first three months. From the fourth month, the revenue will be $40,000 due to catch-up ARR, and then $10,000 from the fifth month onwards. Here's an illustration to help visualize this:
Entrepreneurial revenue leaders, recognizing the characteristics of ARR and eager to meet revenue targets, have begun levering a derivative recurring revenue metric called Contracted Annual Recurring Revenue (CARR) to achieve the following two benefits:
CARR Benefits
1) Ability to Accelerate Revenue: CARR allows companies to recognize revenue sooner, accelerating revenue recognition to meet targets faster than ARR. Consider a scenario where a deal is closed and counted as ARR on the last day of the quarter, while the performance period does not begin until the next quarter.
2) Reduction of ARR Volatility: CARR allows firms to avoid revenue spikes resulting from catch-up ARR.
There are two common methods for timing CARR, which are described below.
CARR Beginning at Contract Start
This definition of CARR is the same as the ARR at Contract Start method already discussed above and, therefore, is unnecessary. Suppose a company is considering adopting this method to avoid the spikiness associated with revenue accrual. In that case, the correct solution is to update the ARR method to recognize revenue at contract start instead of Go-Live. It is essential to understand that SAAS Recurring Revenue is a non-GAAP/IFRS metric and does not need to comply with ASC 606, therefore, it is commonplace for privately held companies to use the ‘ARR Beginning at Contract Start’ method.
CARR Beginning at Contract Signature
This definition of CARR includes the annual run rate of subscription revenue for active contracts with contract signature dates on or before the same period, without considering the contract start date or the TTL.
Lightbridge recommends against using the contract signature date as a revenue trigger for the following reasons:
Using the 'CARR at Contract Signature' method is certainly tempting as it allows claiming next quarter's or year's revenue in the current period; however, the costs likely outweigh the benefits. This approach carries substantial technical and business implications and could be classified as a short-sighted play to achieve short-term objectives while offering questionable long-term benefits at the expense of lasting technical debt and business risk.
Here are some specific issues to consider:
Firstly, relying on CARR can result in revenue gaps or exaggerated revenue recognition period length. This is because CARR can start before the contract's start date, and when it comes to renewal, a revenue gap could arise unless additional months of revenue are added beyond the contract's length.
Consider this example: A new customer has signed a twelve-month contract worth $120,000 that is signed two months before the Contract start date. Also, assume a three-month time-to-live (TTL).
Using the 'ARR Beginning at Contract Start' method, revenue will run for the length of the contract at $10,000 per month.
On the other hand, using the 'CARR Beginning at Contract Signature' method, revenue will begin before the contract starts but will have to continue for the duration of the contract at $10,000 per month to avoid a revenue gap. Refer to the CARR Timing Methods illustration to help visualize this:
Refer to the following image illustrating the differences between the different approaches for the same example where a new customer has signed a twelve-month contract worth $120,000 that is signed two months before the Contract start date with a three-month TTL. Notice that the ‘ARR at Contract Start Method’ best represents the actual timing of the revenue while avoiding the spikiness inherent in GAAP/IFRS revenue accounting or ‘ARR at Go-Live.’
Additionally, implementing the CARR model based on the signature date can significantly complicate the system. Both Salesforce and NetSuite lack native support for this approach, necessitating customization to accommodate non-standard calculations and different treatment of new, upsell and renewal opportunities. For instance, it's essential to avoid recognizing renewal Annual Recurring Revenue (ARR) upon signature since it could lead to revenue overlap with the subsequent contract period. Therefore, a well-defined logic is needed to handle ARR for renewals differently. Moreover, it is unwise to recognize churn and upsells in periods different from when they actually occur.
Another risk associated with substituting CARR for ARR is the potential erosion of investor confidence and reliance on a recurring revenue metric unsuitable for budgeting. Decoupling reported CARR timing from real-world contract timing introduces the risk of substantial disparities between reports and actual revenue as will become readily apparent in financial reporting, which can undermine lenders' and investors' confidence in the recurring revenue forecast. Additionally, CARR does not serve as a suitable metric for budgeting due to the same inherent issue.
ARR Is the Reliable Choice
In light of the complexities and risks introduced by CARR, we recommend that SaaS companies seeking an annualized recurring revenue method adopt the 'ARR Beginning at Contract Start' approach. This method aligns revenue to contract dates to provide a smooth metric that generates realistic figures supporting year-over-year growth and a more straightforward implementation process.