ARR – Annual Recurring Revenue
Your monthly or annual recurring revenue (MRR and ARR for short) is one of the primary reasons we’re all in SaaS. Recurring revenue means our growth can compound and through this momentum we can ensure we’re always improving and building something beautiful.
Yet, we’ve found that even though this momentum metric is seemingly simple to calculate, a lot of SaaS companies are calculating their ARR incorrectly. In fact, we recently found in a poll of 50 SaaS companies that 2 out of 5 were including or discluding something they shouldn’t be in their annual recurring revenue calculations.
Not calculating your MRR/ARR correctly can cause you to lie to your investors/team/advisors or worse: misjudge the true health and trajectory of your business. So let’s take a look deeper into why MRR/ARR is important, how to calculate it, and most importantly how to optimize it so that you are getting the truest picture of the health of your SaaS company.
What is annual recurring revenue (ARR)?
Annual recurring revenue (ARR) is the yearly value of revenue generated from subscriptions, contracts, and other recurring billing cycles. ARR is one of the primary metrics used for measuring the year-over-year growth of SaaS and subscription companies who use a recurring revenue model.
How to Calculate ARR
To calculate ARR (or MRR) you need to account for all recurring revenues within your subscription business.
ARR calculation & formula:
Here we simply take MRR at the beginning of the month + MRR gained from new customers for the month + MRR change gained from upgrading customers for the month – MRR change lost from downgrading customers for the month – MRR churn from the month.
The Calculation Breakdown
MRR at the beginning of the month
MRR gained from new customers for the month
MRR change gained from upgrading customers for the month
MRR change lost from downgrading customers from the month
MRR Churn from the Month
ARR (=) MRR X12
Why You Should Care about annual recurring revenue
Tracking both MRR and ARR allows you to plan for the short and long term. Yet, typically businesses with more than $10M ARR think about their recurring revenue (and most of their metrics) in an annual, ARR fashion. Those smaller than $10M ARR, typically focus on MRR. While seemingly interchangeable, the two can be used for very different foci within your business.
“Not tracking MRR/ARR is like winning the lottery and then setting the ticket on fire – #SaaSfoul”
Why Understanding Your ARR is So Important
Understanding annual recurring revenue is one of the driving factors that separates the unsuccessful from the successful elite in SaaS. The main areas of importance involve your compass metric, product/sales, and finance:
Post Product-Market Fit Compass Metric
After finding initial product-market fit through user testing and activity, MRR/ARR typically takes over as the main compass metric to track growth within a SaaS organization. This is because (quite frankly) MRR is the purest measure of your revenue in a SaaS business, indicating how your momentum is building or waning over time.
Product and Sales team
Every month your product team should be incentivised by MRR to develop features and experiences to defend MRR against MRR Churn. Most product teams also have incentives to push for net new MRR, as well. Yet, your sales and marketing teams typically will primarily be focused on net new.
Critical financial metric
MRR is a crucial financial metric to your financial projections and gives you the most accurate status check up of your SaaS company and helps you understand both short-term and long-term cash flows. It explicitly accounts for the “recurring” components in your subscription model and for those same components on a yearly scale using ARR. Together, these SaaS metrics give your finance team a crystal ball into your SaaS future.
What to include in ARR (and MRR)
MRR/ARR is the sum of all subscription revenues that came into your business within a given period. ProfitWell Metrics helps visualize this on a high level, breaking down MRR attribution by the important segments.
Here are the items that you should include in your MRR/ARR calculations:
All recurring elements
This will include any elements of your subscription model that are recurring. For example, any monthly fees or other recurring charges such as per user/seat, per visit, etc.
Capture the upgrade dollars from current customers who have expanded their use of your product, especially those who have moved up to a higher level plan or who have expanded their use of your value metric.
This includes the total dollar amount of customers that have downgraded their service. This is important because downgrades represent money lost from current customers that have not churned.
Lost MRR from churned customers
This component is tallying the MRR/ARR that you lost from customers who actually churned, not those who’ve cancelled.
What You Should Not Include in annual recurring revenue
The key to getting accurate MRR/ARR metrics is to understand that it is a tabulation of ONLY the recurring aspects of your subscription model along with subtracting downgrades and MRR Churn (monthly recurring revenue churn rate). It can be really easy to let some “non-recurring” items slip into your calculation.
Additionally, you need to understand that MRR/ARR is a “momentum metric” that should be held as pure as possible. One of the biggest ways to flub this up is to include things like recurring costs or forget to subtract discounts. You want to make sure you stay on one side of the income statement while also being completely transparent about the money you’re actually bringing in before expenses. For a larger list of all the items companies are incorrectly excluding or including in MRR, check out this blog post: You’re probably calculating MRR incorrectly. Here’s Why.
To summarize though, if you want a true, accurate look into the health of your business then make it a point to exclude the following items. You’ll find that the calculation is truly simple, but still has some nuances to handle.
Four Ways to Optimize Your ARR
MRR/ARR is the purest view into the revenue momentum you have in your business. The more recurring revenue you generate, the longer you can continue to grow and expand your plan of attack. Keep in mind that MRR/ARR is what feeds your SaaS machine and keeps the wheels turning.
Here are four actionable ways you can generate more MRR/ARR for your SaaS business:
Increase your net customer acquisition
You can create more MRR/ARR for your business by getting more qualified bodies through the door. Optimize your LTV/CAC ratio to a point where your customer acquisition cost is low and acquisition strategy efficient
Increase your expansionary revenue through upgrades and value metric
There’s a lot of money to be grabbed off the table from current customers. Give them incentive to upgrade within your product by aligning the product with your value metric. Here’s a bit more on how to find and optimize your SaaS Value Metric.
Increase your retention to boost your LTV
Retaining customers means that your product is aligned properly with a value metric you are in tune with your customer personas. This naturally paves the way for more MRR/ARR by expanding the width of retained customers as well as expanding the length of the customer lifespan.
Reduce your customer acquisition costs
SaaS business models are normally low cost from the start, and typically reducing costs is only a big deal for cost heavy industries. However let this be a last resort if you’ve already done everything else and still need to tweak your MRR/ARR metric to bring in more value through the door. Also keep in mind that because your costs aren’t in your MRR calculation that this won’t physically move your MRR number. Instead, a reduction in CAC will allow you to be more efficient with your MRR.
Annual recurring revenue (ARR) FAQs
Is there an ARR formula you can use to calculate annual recurring revenue?
ARR formula is pretty straightforward: add to your total number of yearly subscriptions the total amount gained from expansion revenue, and then subtract the total amount lost due to customer churn (customers who cancelled their subscriptions). You can also multiply your MRR by 12.
Why is ARR important for SaaS?
ARR is one of the most important metrics for SaaS and subscription businesses, as it helps forecast their revenue for the coming year. Annual recurring revenue also aids in measuring the growth of your business and calculating customer churn.
What is ARR vs revenue?
ARR refers to the annual recurring revenue from subscriptions, while revenue as a general term encompasses all types of business income, regardless of whether or not it’s recurring.