The Ultimate Guide To ARR

Cloud computing and SaaS have gone a long way in a very short period of time. Software as a Service (or SaaS) provides software as a service through the Internet. 

SaaS startups can measure the amount of revenue they are generating per year. This is thanks to the Annualised Recurring Revenue system. It is imperative that you know what an ARR is and how it can be calculated. Most freshers tend to confuse the terms ARR and sales. 

This blog will serve as a proper guideline to the basics of the most used business metric. 


What Is ARR?


Annual recurring revenue is the linchpin of SaaS business metrics in many respects. That's because it shows how much recurrent income a company may expect to earn. Recurring income includes money earned through annual software subscriptions or service contracts.

ARR should reflect the amount of subscription-based items for SaaS firms. Consider a software firm that sells anti-virus software. Contracts include installation, training, and expansion packs for an extra price. The total cost of those services supplied as a package is included in that company's ARR.

How is ARR Calculated?

The ARR metric is conceptually equivalent to the annualised MRR of subscription-based businesses. This can be calculated in the following way:

Monthly Recurring Revenue (MRR) x 12 Months = Annual Recurring Revenue (ARR).

The ARR computation considers profits from: 

  • subscription fees
  • ongoing income from upgrades or add-ons
  • losses from downgrades or terminated subscriptions

One-time fees such as set-up fees, professional service (or consulting) fees, and installation costs must be excluded from the calculation because they are one-time/non-recurring.

How is ARR used for SaaS Businesses?

ARR is a SaaS metric that shows the value of the contracted recurring revenue components of a company's term subscriptions over a one-year period. It is most commonly used by B2B companies that use subscription billing models to bill their customers for their services.


Amp Up Your ARR With These Models


The recurrent revenue business model is a revenue model in which vendors provide customers with access to a service while charging a repeating cost. This cost may be, which is monthly, quarterly, or even yearly. This business model has spawned subscription and membership services. Now that you've familiarised yourself with the ARR concept let us look at the various types of ARR business models that can add to the Recurring Revenue for multiple startups.

Auto-Renewal Subscriptions

This business model collects revenue per se until consumers end their subscriptions. Auto-renewed subscriptions are also evergreen subscriptions because they can continue indefinitely. Examples include streaming services like Hulu and Netflix.

Hard Contracts

In this approach, clients receive a service over a specific time for fixed fees. It protects the company's future sales from unforeseen cancellations and delays.

You and your clients have a close relationship with complex contracts till the contract time finishes. If they intend to leave early, they must pay a cancellation charge.

Sunk Money Consumables

Customers pay for a platform that contains certain exclusive access to services when they subscribe with sunk money. Since customers have already paid for the platform, it encourages users to renew their subscriptions.

The Nespresso coffee machine is a prominent example. To continue using the machine after purchasing it, the consumer must buy compatible coffee capsules.

Freemium

Customers have free access to the product or service under a freemium model. But, they must upgrade to a premium plan to access extra features. For instance, you can create playlists and listen to songs for free using Spotify. Yet, you must upgrade to the subscription plan to access more services like ad-free listening.


Considerations for Calculating ARR


Considering that ARR is a calculated form of all recurring subscription charges in a given time, there are some elements that one must include in the ARR calculation.

Recurring Invoices

Recurring invoices involve all the recurring subscription revenue which includes recurring fees like recurring subscription charges per user.

Downgrade Revenue

When a customer moves from a higher value plan to a lower value plan, it leads to a MRR churn. It is imperative to include this into the ARR calculation as it decreases the recurring revenue generated from that particular customer

Upgrade Revenue

In case a customer shifts from a low value plan to a high value plan, it is usually due to an upsell. This will increase the customer’s recurring revenue. Therefore, it is important to include this in the ARR calculation as well. 


Why is monitoring Annual Recurring Revenue crucial for SaaS companies?


Annual Recurring Revenue is a crucial business metric that measures the health of a subscription business. It is able to predict the future growth of a company since it is the amount of revenue a company expects to repeat. 

Moreover, it is a practical metric for measuring the vigour in sectors like new sales, upgrades and renewals as well as the immobility due to downgrades and lost customers.

Increase Revenue

Monitoring relationship changes provides you with insight into what your clients want and need, and it encourages cross-selling and up-selling, which leads to increased revenue.

Retain Top Talent

Tracking ARR encourages a company to focus on individual distribution channels in order to determine what is functioning properly and what needs to be altered. Paying for productive job performance results in lower turnover and lowers new employee training costs.

Attract Investors

Investors prefer the subscription economy's contractually obligated revenue, predictable sales models, and accurate revenue forecasting to one-time sales. Owners of subscription businesses with ARR can sell predictably and systematically, allowing them to thrive.

Clarify Company Health

ARR measures a company's efficacy in specific sectors, indicating where revenue is increasing or decreasing and why. Understanding your ARR can help you make better decisions about employee evaluation, compensation, operational planning, and financing, which can help you improve your bottom line and increase company efficiency.


Typical Errors to Avoid When Interpreting ARR


Misinterpreting ARR for Cash

ARR does not equal cash. Mistaking ARR for cash can create a distorted picture of how much money a company has.

Excluding Late Payments

Every business has late-paying customers. You can keep late payments in check by implementing a dunning mechanism, but remember to include late dollar amounts in your ARR calculations.

Not Accounting Discounts

Customers who have received discounts or coupons are not paying the full price of the subscription. When calculating ARR, it is critical to account for discounts.