What is Annual Recurring Revenue (ARR)?
Annual Recurring Revenue (ARR) is a key metric used by Software as a Service (SaaS) companies to measure the predictable and recurring revenue generated from customers over 12 months. ARR is the sum of all subscription revenue that a SaaS company expects to receive from its customers each year.
ARR is a useful metric for SaaS companies because it provides insight into the health and predictability of their revenue streams, and can be used to project future growth and forecast revenue.
It is also a key performance indicator (KPI) used by investors to evaluate the financial performance of a SaaS company.
A high ARR indicates that the business is generating a significant amount of revenue and has a strong customer base, while a low ARR may indicate that the business is struggling to acquire and retain customers.
In addition to being a KPI, ARR is also used to calculate other important metrics such as customer lifetime value (LTV) and customer acquisition cost (CAC). LTV represents the total revenue a customer is expected to generate over their lifetime, while CAC represents the cost of acquiring a new customer.
Here are the 5 ways in which ARR is impacted:
- New Sales: When you make a new sale, the revenue generated from that sale will increase your ARR. For example, if you sell a new subscription for $1,000 per year, your ARR will increase by $1,000.
- Renewals: When a customer renews their subscription, the revenue generated from that renewal will also increase your ARR. For example, if a customer renews their subscription for $1,000 per year, your ARR will increase by $1,000.
- Cross-sell: When you sell additional products or services to an existing customer, the revenue generated from those sales will increase your ARR. For example, if you sell a new product to an existing customer for $500 per year, your ARR will increase by $500.
- Upgrades/Downgrades: When a customer upgrades their subscription, the revenue generated from that upgrade will increase your ARR. Conversely, when a customer downgrades their subscription, the revenue generated from that downgrade will decrease your ARR. For example, if a customer upgrades their subscription from $500 per year to $1,000 per year, your ARR will increase by $500. If a customer downgrades their subscription from $1,000 per year to $500 per year, your ARR will decrease by $500.
How is Annual Recurring Revenue (ARR) different from Annual Contract Value (ACV)?
While Annual Recurring Revenue (ARR) and Annual Contract Value (ACV) are both important metrics used to measure the revenue generated by SaaS companies, they represent slightly different calculations.
ARR represents the predictable and recurring revenue that a SaaS company expects to generate over 12 months from its customers. It is calculated based on the sum of all subscription revenue that a SaaS company expects to receive annually from its customers.
In contrast, ACV represents the total value of contracts signed with customers over 12 months. It takes into account any one-time fees, such as setup fees or professional services fees, that may be included in the contract in addition to recurring subscription revenue.
To illustrate the difference between ARR and ACV, let's consider an example. Suppose a SaaS company signs a 12-month contract with a new customer for a monthly subscription fee of $100. In addition, the contract includes a one-time setup fee of $1,000.
Using this scenario, the ARR for this customer would be $1,200 ($100/month x 12 months), while the ACV would be $2,200 ($1,000 setup fee + $100/month x 12 months).
So, in summary, ARR focuses solely on the recurring revenue generated by a SaaS company's customers, while ACV takes into account any one-time fees included in contracts signed with customers.
How is ARR calculated from contract value?
To calculate Annual Recurring Revenue (ARR) using contract value:
- Determine the contract length: This is the length of time that the customer has committed to using your product or service. For example, if the customer signs a one-year contract, the contract length is one year.
- Calculate the contract value: This is the contract's total value over the contract length. For example, if the customer signs a one-year contract for $10,000, the contract value is $10,000.
- Divide the contract value by the contract length: This will give you the Annual Recurring Revenue (ARR). For example, if the contract value is $10,000 and the contract length is one year, the ARR would be $10,000 divided by one year or $10,000 per year.
Note that this method assumes that the customer will renew their contract at the end of the contract length. If the customer signs a multi-year contract, you will need to divide the contract value by the total number of years to get the ARR.
How is Annual Recurring Revenue (ARR) related to Monthly Recurring Revenue (MRR)?
Annual Recurring Revenue (ARR) and Monthly Recurring Revenue (MRR) are closely related metrics that are often used by SaaS companies to measure their revenue streams.
ARR represents the predictable and recurring revenue that a SaaS company expects to generate over 12 months from its customers. ARR is calculated by multiplying the average monthly recurring revenue (MRR) per customer by the total number of customers in a given period, and then multiplying that by 12 (the number of months in a year). ARR can also be calculated from the contract value
MRR, on the other hand, represents the predictable and recurring revenue that a SaaS company generates from its customers every month. It is calculated by taking the total revenue generated from subscription fees in a month and dividing it by the number of customers.
MRR is a valuable metric because it provides insight into the health and predictability of a SaaS company's revenue stream on a month-to-month basis. By tracking changes in MRR over time, SaaS companies can identify trends and make adjustments to their pricing or marketing strategies as needed.
ARR is a more holistic view of a SaaS company's revenue stream, as it takes into account the total revenue generated from customers over 12 months. While MRR provides a more granular view of monthly revenue, ARR provides a broader perspective on the overall financial health of a SaaS business.
How does Annual Recurring Revenue (ARR) contribute to Customer Lifetime Value (LTV)?
Annual Recurring Revenue (ARR) and Customer Lifetime Value (LTV) are two key metrics used by SaaS companies to measure the financial performance of their businesses, and they are related to each other.
ARR represents the predictable and recurring revenue that a SaaS company expects to generate over 12 months from its customers. In contrast, LTV is a metric that calculates the total revenue a SaaS company expects to receive from a customer over the entire duration of its relationship with the company.
To calculate LTV, you need to know several other metrics, such as customer acquisition cost (CAC), customer churn rate, and average revenue per account (ARPA). Once you have these metrics, you can calculate LTV by multiplying ARPA by the gross margin and then dividing that by the customer churn rate. The result is the expected revenue a company will earn from a customer over their entire relationship with the company.
So, how are ARR and LTV related? ARR is one of the key components used to calculate LTV. Specifically, the ARPA metric used in the LTV calculation is equal to ARR divided by the total number of customers. In other words, ARR is a measure of the predictable, recurring revenue generated by each customer, and this information can be used to estimate the average revenue a customer will generate over their lifetime with the company.
In summary, while ARR provides a snapshot of a SaaS company's annual recurring revenue, LTV takes a longer-term view of the revenue generated by each customer over their lifetime with the company, and ARR is a key component used in the LTV calculation.
Example: Calculation of MRR, ARR, ARPA, TCV, ACV, and LTV
Let's walk through an example to illustrate how Monthly Recurring Revenue (MRR), Annual Recurring Revenue (ARR), Annual Contract Value (ACV), and Customer Lifetime Value (LTV) are calculated.
Suppose a SaaS company offers its product for a
- Monthly subscription fee of $100; and a
- One-time setup fee of $500 for new customers.
MRR: To calculate MRR, we simply multiply the number of customers by the average monthly subscription fee. In this case, the MRR would be $100,000 ($100/month x 1,000 customers).
ARR: To calculate ARR, we multiply the MRR by 12 (the number of months in a year). The ARR for this SaaS company would be $1,200,000 ($100,000/month x 12 months).
ARPA (Average Revenue per Account) per month = MRR / Number of Customers = $100,000 / 1,000 = $1000
Customer Lifetime (in years) = 1 / Churn Rate = 1 / 0.1 = 10 years
LTV = ARPA x Customer Lifetime = $100 x 10 = $1,000
If the company signs a two years contract then:
TCV: Total Contract Value = Monthly Subscription * 24 + One Time Setup = $100 * 24 + $500 = $2,900
ACV: To calculate ACV, we need to take into account any one-time fees included in contracts signed with customers. Therefore, the ACV would be $2,900/2 years.
ACV = TCV / Contract Term Length in Years.
LTV: To calculate LTV, we need to know several other metrics, such as customer acquisition cost (CAC), and customer churn rate. Let's assume the CAC is $1,000, the churn rate is 10% per year. Using these metrics, we can calculate LTV as follows:
LTV = ARPA / Churn Rate = $1000 / 0.1 = $10,000
So, in summary:
- MRR = $100,000
- ARR = $1,200,000
- ARPA = $1,000
- TCV = $2,900
- ACV = $1,450
- LTV = $10,000
These metrics provide valuable insights into the financial performance of the SaaS company and can be used to make informed decisions about pricing, marketing, and customer acquisition strategies.