This is a copy of an article I posted on LinkedIn in May 2022
For public companies, revenue is the most important top line metric, whereas for younger ones, the rate of growth is often of higher interest to investors. However, in startups and venture capital, you often hear subscription based companies quoting ARR (Annual Recurring Revenue) instead of revenue directly.
In my career working in finance and analytics at software companies, one of my primary responsibilities has been to report on and forecast the ARR of the organization. This has led to my becoming a go to resource for colleagues and giving many large group presentations on SaaS (Software as a Service) metrics. To help share this knowledge with a broader audience, here is a break down of what some might argue is the most important SaaS metric to understand.
First, a quick review of the subscription business model. You are likely already a customer of many subscription based products (Spotify, Netflix, etc) where you pay a fixed price each month (or year) for continual access to the company’s service.
We’ll use an example of you as a customer to explain ARR. Let’s say you travel a lot for work and like to watch movies while flying. You pay $10 per month to the (fictional) company JetFliks for access to their video streaming service, JetFliks Plus, where you can watch all the content from every video streaming service available while flying on a plane from any airline in the world. Along with your noise cancelling headphones, this will ensure you never again have to be alone with your thoughts or engage in conversation with the extrovert seated next to you 🙂
What is the ARR of you as a customer to JetFliks? Even though you pay monthly, and can cancel at anytime, your ARR is the annualized version of how much you pay. In this case, it is $10 per month x 12 months = $120 per year ~ $120 ARR.
Now that we know your ARR as a single customer, what is the ARR of JetFliks the company? To get this figure, all we need to do is add up the ARR of every paying customer. For simplicity, let’s say JetFliks only offers a single monthly plan at $10 per month and has 100,000 paying customers. The ARR of the company here would be $120 ARR per Customer x 100,000 Customers = $12,000,000 ARR.
Next, let’s drill down into the acronym A.R.R. and the assumptions embedded within it:
- Annual: As noted above, the ARR metric takes all customer subscription amounts and converts them into annualized values, and it does this for customers on all lengths of billing periods (monthly, annual, greater than one year). This helps put all customers on equal footing, but could over represent monthly customers who might cancel before the end of their first year.
- Recurring: One of the primary features of the subscription business model is customer subscriptions will continue to auto-renew until the customer explicitly cancels. This is a good customer experience for critical business software that you wouldn’t want turned off unexpectedly, but can also be a nuisance for non-essential consumer products. We’re all familiar with a subscription we stopped using some time ago, but forgot to cancel, and therefore have been paying for it ever since. So while it’s not guaranteed that all customers will always renew to the one year mark, the ARR metric makes this simplifying assumption.
- Revenue: An intuitive jump is that ARR equals revenue, but this is not the case. ARR rather is used as a leading indicator of revenue. They would only be equal in the unrealistic example of a company having constant ARR for an entire year. However, the real world is a bit messier. As noted above, you can cancel your monthly membership at anytime. Maybe you signed up for JetFliks in March 2020, then airlines cancelled all of their flights, so you cancelled your airline video service after only one month. In this case, while your ARR to JetFliks was $120 for all of March, they only received one month ($10) worth of revenue from you. This is why companies often offer a discount to sign up for an annual versus a monthly plan; like JetFliks offering their monthly plan for $10 or annual plan for $100 (~$8.33 per month). They would rather have a guaranteed $100 than hoping you don’t cancel before the breakeven point of 10 months.
One further point for putting ARR in its proper context. Unlike revenue or expenses which can be summed over an entire year, ARR is a snapshot of the total paying customer base at a single point in time. Since companies are always gaining and losing customers, across both monthly and annual subscription periods, and usually across multiple products at various price points, ARR is constantly changing.
For these reasons, it’s better to think of ARR as a rate or slope of a line, than a static value. The marginal signal given by ARR in isolation is another reason both companies and investors like to focus on the change in ARR over a period of time, also known as Net New ARR (NNARR). This can show how fast a company is growing its ARR base, which should eventually lead to recognized revenue increases as well.
Why do SaaS companies like to use ARR instead of revenue to measure top line growth?
On the pragmatic side, accounting rules for subscription business models create a delay between signing up a customer and recognizing that revenue on the income statement. Using the JetFliks example, let’s say you bought the Annual plan for $100 up front. This means that as long as the company provides you with the service all year, they are guaranteed $100 in revenue. However, accounting rules state the company can only recognize the revenue as the service is delivered. As each month passes, the company gets to recognize 1/12th of the annual price, in this case $100 / 12 months = $8.33 of revenue per month. After three months, the company will still have you under contract for at least the rest of the year at the $100 ARR rate, but will only have $25 of revenue to show for it. Therefore, SaaS companies can reasonably state that the $100 ARR rate is much more indicative of the top line of their business than the $25 in recognized revenue. In this sense, revenue is a delayed measure of ARR and in fast growing businesses where ARR is doubling every 3-6 months, the discrepancy between ARR and revenue will grow even larger.
On the public relations side, if ARR is always leading revenue and the annualized price of a monthly customer is 12 times larger, companies would much rather talk about a larger number than a smaller one. This helps in marketing the company to customers, investors, and employees. In startup fundraising, SaaS company valuations are often highly influenced by their ARR, adding another reason for focus on this metric.
Here we’ve reviewed the subscription business model, its revenue related metric of ARR, and why SaaS startups often use it as their primary measure of the top line. In future posts, I’ll dive deeper into revenue recognition, the different types of Net New ARR movements, and other top SaaS metrics. Looking forward to your comments and questions.