Annual recurring revenue (ARR) is one of the most critical metrics for SaaS companies, and it serves as a North Star for business viability and growth. You’ll often hear of individual deals spoken in the context of ARR, as well as overall company revenue. Growing SaaS companies almost always have monthly, quarterly, and yearly goals in order to attain a target ARR and ARR growth. Investors and analysts are keen on understanding ARR trends for SaaS companies as this gives a clear indication of where the company is heading.
In this article, we detail out what ARR is and how it’s relevant to SaaS companies, as well as address some common questions about ARR.
What is Annual Recurring Revenue (ARR)?
Annual recurring revenue, or ARR for short, is a metric that shows the amount of revenue that a business expects to generate on a yearly, repeating basis. This is a particularly important metric for B2B SaaS companies, as their revenue is predominantly based on recurring subscriptions, rather than one-off charges. Moreover, many of the customers a B2B SaaS business has may be locked into multi-year deals with varying subscription costs per year (e.g., $20,000 in Year 1, $25,000 in Year 2, etc.). ARR allows a SaaS business to crystallize yearly revenue into one simple figure and better understand the business’s financial health.
Why is Annual Recurring Revenue important?
ARR is important to SaaS companies for two primary reasons:
Serving as an indicator of financial performance and growth
For SaaS companies, the amount of revenue that is coming in on a recurring basis is key to the business’s survival and future prospects. The promise of SaaS businesses is that revenue compounds. If you close one customer for a multi-year deal, you can expect a certain amount of revenue from that customer for multiple years. And as you sign on more and more customers, you are booking revenue for not just the year in which you close a deal, but for the lifetime of the deal and potentially longer if that customer renews. Revenue will build over time, and ARR is the crucial metric to look at in order to understand how much repeat revenue your business generates on a yearly basis.
How ARR changes year over year is also an important measure of how well a business is doing. If ARR is growing at a healthy clip, that indicates that the business is adding on new customers while minimizing churn. On the flip side, if ARR stagnates or decreases, then it could mean that the business is losing customers at a faster rate than it is signing on new ones — not a good sign. In either case, ARR plays a key role in understanding the health and growth of the business.
Simplifying revenue into a repeatable, predictable metric
Revenue for a SaaS business can come in many forms, from subscription fees to implementation charges to service or consulting costs. Because these streams of revenue are so varied, it may be difficult to fully understand what revenue to expect on an ongoing basis if you’re looking at the business’s overall, total revenue. ARR helps to address this issue by focusing only on the revenue that reoccurs yearly, stripping out any one-time charges that may occur.
For example, you may close a 3-year deal that charges $20,000 per year for the subscription and an initial, upfront $40,000 implementation fee. In the first year of this deal, the total revenue you receive is $60,000 ($20,000 subscription fee + $40,000 implementation fee). However, in the second year of the deal the total revenue is only the $20,000 subscription cost. When looking at the yearly revenue for this deal, the drop from $60,000 to $20,000 year over year makes it difficult to forecast what revenue will look like in subsequent years. With ARR, however, you’re only looking at the $20,000 yearly recurring revenue, making revenue forecasting much more predictable.
How is Annual Recurring Revenue calculated?
ARR is the sum of all of your subscription revenue for the year, including recurring revenue from expansions (e.g., add-ons and upgrades) and excluding any one-time charges (e.g., implementation fees), and removing any recurring revenue lost from downgrades or churn.
Practically speaking, this amount can be calculated by summing the ARR for each of your individual customers. Because every customer’s contract term can be different — some may be on a 1-year deal and others on multi-year contracts — it’s important to take into consideration the value of each contract and each contract’s duration.
To determine the ARR from a customer, you divide the contract value by the duration of the contract in years.
Example: Suppose a customer signs a contract for a subscription plan with a total value of $120,000, and the contract duration is 2 years.
Using the formula:
This means that the ARR for this specific customer’s contract is $60,000 per year. This calculation gives you a clear understanding of the annual revenue contribution from this individual customer’s subscription. By calculating ARR for all of your customers, you can find the total ARR for your overall business.
What is the difference between SaaS revenue and ARR?
SaaS revenue generally refers to the total revenue from all revenue streams for a SaaS business, which would include revenue from subscriptions, one-time charges, expansions, services, and more. ARR refers to only the revenue that repeats on a yearly basis, so typically this refers to only your subscription revenues.
What is a good ARR growth rate in SaaS?
A healthy growth rate in ARR is impacted by a number of factors, including overall economic conditions, stage of company, funding, and more. It’s difficult to put out a blanket statement of what qualifies as a “good” ARR growth rate because, as much as you probably don’t want to hear it, the answer is, “It depends.”
Many companies, analysts, and investment firms have done studies, surveys, and other analyses to determine what the ARR growth rate is, on average, for various SaaS businesses. While the numbers vary widely, from 20% to 200%, there is one commonality — the earlier stage your SaaS business is in, the higher your growth rate should likely be. Over time, growth rates naturally decline, as SaaS businesses typically focus more on acquiring customers early on and, in later stages, shift the focus to retention and free cash flow.
A common benchmark often referred to in SaaS is T2D3, which stands for "triple, triple, double, double, double." What it refers to is the annual growth rate that will get you to $100 million in ARR, landing you a $1 billion valuation. The thought is for SaaS businesses sitting at the $1-2 million ARR range to aim for tripling ARR for two years in a row, then doubling ARR each year for the next three years. If your business is able to achieve T2D3, it would join the ranks of a handful of highly successful SaaS companies, including Salesforce, Marketo, and ServiceNow.
What is the difference between ARR and MRR?
Monthly recurring revenue (MRR) is similar to ARR, but instead of looking at repeat revenue over the course of a year, you’re looking at recurring revenue for a given month. MRR is the amount of revenue that a business expects to generate on a monthly, repeating basis. It includes subscription revenue and excludes any one-time fees.
For companies that sell subscriptions on a monthly basis, rather than focusing primarily on annual or multi-year deals, MRR is likely a more often used metric for evaluating business performance and revenue forecasting.