Oct 3, 2023

Annual Recurring Revenue (ARR)

Arc Team

Go-To-Market

Annual Recurring Revenue (ARR) provides insight into the consistent and predictable revenue a startup can expect to receive each year. Understanding and tracking ARR is important for forecasting revenue, making informed business decisions, and monitoring the health of your startup and its recurring revenue. Whether you’re a founder, or employee of a growing company, a strong understanding of ARR is essential for success.

What Is Annual Recurring Revenue?

Annual Recurring Revenue (ARR) is a financial metric that measures the expected recurring revenue or cash flow from a company’s customer base on an annual basis. It represents the predictable and consistent revenue a business can expect from its customers yearly based on their subscriptions, recurring billing agreements and renewals, and add-ons. ARR helps forecast long and short-term future revenue and monitor the company’s growth of its recurring revenue streams.

Uses Of Annual Recurring Revenue

Annual Recurring Revenue has several key uses:

ARR helps startups forecast future annual revenue and plan their budget accordingly.
By understanding ARR, startups make informed decisions about product development, marketing, and sales strategies.
ARR tracks the growth of a company’s recurring revenue streams and identifies trends over time.
ARR is a key metric for investors, providing insight into a company’s predictable and recurring revenue.
ARR can calculate the cost of acquiring a new customer and the lifetime value of a customer.
Startups can compare their ARR to industry benchmarks to assess their performance and identify areas for financial improvement.

What To Include In Annual Recurring Revenue Calculations?

When calculating ARR, you should include all recurring revenue streams a company can expect to receive annually. This typically includes:

Subscription revenue from customers who have signed up for a recurring billing agreement, such as a monthly or yearly subscription.
Recurring contract-based revenue is from customers who have signed a contract for recurring services, such as software as a service (SaaS startups) or managed services.
Recurring product-based revenue is generated by customers who regularly purchase products, such as consumables or spare parts.

ARR calculations should only include recurring revenue streams that are predictable and consistent, and one-time or non-recurring revenue streams should not be included in ARR calculations. Additionally, you should exclude revenue from customers expected to churn or cancel their long or short-term subscriptions. It is important to consider ARR and add-ons, expansion revenue, one-time fees, and CAC when evaluating the performance of a business, as they provide different but complementary perspectives on the company’s revenue and financial performance.

Add-ons and expansion revenue are from additional products or services offered to existing customers, while one-time fees refer to revenue generated from single transactions. The Customer Acquisition Cost (CAC) is the cost of acquiring a new customer, including marketing and sales expenses to bring a customer on board.

How To Calculate Annual Recurring Revenue?

To calculate ARR, follow these steps:

Determine the total number of customers signed up for a recurring billing agreement, such as a monthly or yearly subscription model, or have signed long or short-term contracts for recurring services or products.
Calculate the average amount of revenue a company expects to receive from each customer on an annual basis. It can be calculated by dividing the recurring income by the number of customers.
Multiply the average revenue per customer by the number of customers to give the total ARR for the company.

An example of an ARR formula:
If a company has 100 customers and the average revenue per customer is $100 per month, the total ARR would be:
$100 (average revenue per customer) x 12 (months over a one-year period) x 100 (number of customers) = $120,000
In this example, the company’s ARR is $120,000. This represents the recurring revenue the company can expect from its customers each year.

Common Pitfalls To Avoid When Calculating Annual Recurring Revenue

When calculating ARR, it’s important to avoid common pitfalls to ensure accuracy and avoid misinterpretation of results. Here are some of the most common pitfalls to avoid:

ARR should only include predictable and consistently recurring revenue streams. One-time or non-recurring revenue streams should not be included.
The churn rate, or customer cancellation, can significantly impact ARR calculations. It’s important to factor in expected churn and exclude revenue from customers who are likely to cancel services.
Changes in pricing or billing cycles can significantly affect ARR. It’s important to take these changes into account when calculating ARR.
Upsells or down sells, where customers upgrade or downgrade their subscription plans, can also impact ARR calculations. It’s important to factor in any expected changes in revenue per customer when calculating ARR.
Changes in customer behavior, such as increased or reduced usage, can impact ARR if you have a usage-based pricing model . It’s important to adjust ARR calculations accordingly.

Annual Recurring Revenue Vs. Monthly Recurring Revenue

Annual Recurring Revenue (ARR) and Monthly Recurring Revenue (MRR) are metrics for the recurring revenue generated by a company.
ARR is calculated by multiplying the average annual revenue per customer by the number of customers and is usually expressed in yearly terms.
MRR is calculated by multiplying the average revenue per customer by the number of customers in a given month. MRR is useful for tracking changes in recurring monthly income and identifying trends over time.
ARR and MRR are important metrics for startups, as they provide insight into the recurring revenue streams of a business. However, ARR focuses more on the long-term stability and predictability of a company’s recurring revenue.

Annual Recurring Revenue Vs. Topline Revenue

Annual Recurring Revenue (ARR) and Topline Revenue measure a company’s financial performance. Topline Revenue, also known as gross revenue, represents the total amount of revenue generated by a company in a given period without deducting any expenses. The first line item in a company’s income statement represents its total sales before subtracting any costs. While Topline Revenue provides a broader picture of a company’s overall revenue, ARR is more focused on the stability and predictability of a company’s recurring revenue streams.

How Do You Improve Your Annual Recurring Revenue?

Improving Annual Recurring Revenue (ARR) is an important goal for many startups. It helps to increase the stability and predictability of their revenue streams. Here are some strategies that startups can use:

Retaining existing customers is often less expensive than acquiring new ones, and keeping customers can help increase ARR by generating predictable and recurring revenue. Startups can improve customer retention by providing excellent customer service, offering incentives for customers to renew their monthly and annual subscriptions, and continually improving their products and services.
Offering existing customers additional products or services can help to increase ARR. Startups can identify opportunities for upselling and cross-selling by analyzing customer behavior and preferences.
Diversifying revenue streams can help increase the stability and predictability of revenue. Examples of revenue stream diversification are offering new products or services, expanding into new markets, or forming strategic partnerships.
A well-designed pricing strategy can help increase ARR by attracting new customers and generating more revenue from existing ones. Startups can improve pricing strategies by regularly reviewing and adjusting pricing, offering different pricing models, and conducting customer research to understand customer preferences and willingness to pay.
Streamlining operations can help to reduce costs and increase efficiency, which can, in turn, increase ARR. Startups can streamline their operations by automating processes, reducing waste, and optimizing resources.

Annual Recurring Revenue And Startup Valuations

Annual Recurring Revenue (ARR) is an important metric for startups, as it can affect the company’s valuation. Startups with a high ARR are considered more valuable than those with a low ARR and a predictable and stable revenue stream. Investors and venture capitalists use ARR as one of the key metrics when valuing startups. A startup with a high ARR and a track record of consistent growth is less risky than one with a low ARR and inconsistent revenue streams. This is because a high ARR indicates the company has a large and loyal customer base (a good indicator of future growth).

In addition, startups with a high ARR can use this metric to negotiate favorable terms when raising capital. Investors may pay a higher valuation for a startup with a high ARR, as it indicates more confidence in the company’s ability to generate consistent total revenue.