Annual Recurring Revenue (ARR): A Vital Metric for Startups
What Factors Affect How You Calculate ARR?
ARR vs MRR: What is the difference?
A Founder’s Common Mistakes in Calculating ARR
Conclusion: ARR and MRR Enables Smart Decisions
Startups and ARR
Annual Recurring Revenue (ARR) is a crucial metric for SaaS companies. A company with a steadily growing ARR indicates they have found the market fit for their product.
Pressures to raise funding in the early stages of a start-up are typical. Internally, the need to secure funding is felt urgently in order to develop a sound product under reasonable conditions. After funding has been raised, the demand continues from investors eager to see capture of market share and rapid growth in top-line revenue.
Mighty Startup cautions founders against prioritizing top-line growth over nurturing a sustainable business model. The decisions you make early on will have a profound impact on future development.
To ensure long term viability in a business model, it’s important to consider rounded metrics and indicators of company health. ARR is an ideal metric archetype for founders to reference. ARR not only provides a holistic view of your business’s health, but for startups, it is a key metric to showcase predictable revenues to investors. A healthy ARR is your best advantage when you’re ready to secure funding.
At Mighty Startup, we believe measuring business performance and monitoring key performance indicators (KPIs) drive better decision making. Clean, unobstructed data is the foundation of reliable financial planning and is critical to building your successful business. Mighty Startup provides services to deliver clear ARR and expert support for our clients. Book a call with our team to learn more today.
What is Annual Recurring Revenue (ARR)?
ARR is a fundamental business metric for subscription-based companies that shows the expected recurring revenue on a macro level. It is an annualized MRR or Monthly Recurring Revenue.
How do you Calculate ARR?
The calculation of ARR can appear simple but will differ from organization to organization. There are several unique factors to consider when calculating ARR including pricing strategy and the complexity of your business model.
ARR is calculated by taking Beginning ARR + New ARR + Expansion ARR – Contraction ARR – Churn ARR = Ending ARR. It is usually calculated at a point in time and compared with other metrics to provide a full picture of the business. (i.e. read more about Burn Multiple here.)
Overall yearly revenue generated
+
Recurring revenue from add-ons or upgrades and any expansion revenue
–
Revenue lost from cancellations (Churn)
=
Your annual recurring revenue (ARR)
Note: Any non-recurring fees such as one-time options should always be excluded from the calculation.
For example: If your product is $15,000 for year 1, but includes $2,500 for the onboarding fee, the ARR for that specific customer would only be $15,000, with the $2,500 being excluded as it would only be charged once in that deal and the contract would renew for $12,500 in year 2.
What Factors Affect How You Calculate ARR?
| Customer revenue/year | Total revenue generated annually through subscription and renewal. |
| Add-on purchases | All purchases in addition to the annual subscription price (on an ongoing basis). |
| Product upgrades | Any upgrades that add on top of the annual subscription price (on an ongoing basis). |
| Product downgrades | Any downgrades that decrease the subscription price (on an ongoing basis). |
| Cancellations (Churn) | Any loss in revenue due to cancellations and customers lost due to churning. |
ARR vs MRR: What is the difference?
ARR and MRR are critical metrics to contextualize your company’s recurring revenue.
- MRR tracks a brief, specific period of time where changes can be assessed at a micro level. E.g. Product launch, changes to pricing strategy, or seasonal fluctuations in consumer behavior.
- ARR provides a macro level of insight for long-term products and core services. ARR is an ideal metric to consider when creating company roadmaps (especially for SaaS startups).
Measuring both ARR and MRR provides you with hyper-detailed data to support your most critical decisions. With ARR and MRR, you can optimize operations, provide a better customer experience, and forecast future growth and challenges—enabling preparation and agility.
Generally, early stage startups do not require annual contracts and tend to prioritize MRR. As the product matures, startups often begin to require annual term subscriptions. Investors will often prefer to consider ARR.
A Founder’s Common Mistakes in Calculating ARR
At the start of every venture, it’s not uncommon for founders to handle almost every aspect of the business. This often includes finances, which can be an easy place to make mistakes with lasting consequences.
Calculating Free Trials
Free trials should only be calculated in the ARR after it converts into a recurring subscription. Any free trials (no matter how long the duration) should be treated as one-off payments before converting and should not be included in the ARR calculation.
Counting Late Payments as Churn
Late payments do not indicate a customer has churned. Their contract should still be included in the ARR calculation. Customers with late payments should be assessed periodically to ensure that they are still valid customers. We recommend assessing quarterly so that you don’t have too much churn building up in your ARR.
Forgetting to Factor Promotions
Sales tactics, discounts, and incentives are a great way to establish partnerships. Such incentives can be confusing and it’s okay to treat this a few different ways. The key is to be consistent. One option is to reduce your ARR in year one by the discount amount. Another approach is to expense the discount under sales and marketing budgets to maintain higher topline ARR–especially if the discount ends after a set period and will auto-renew at a higher (undiscounted) rate. For example, a “first month free” promotion can be counted as operational expenditure from the sales/marketing budget. Then the contract should renew without the initial discount. How these discounts impact your sales quotas and commissions is a topic for another day. Subscribe here so you don’t miss out.
ARR and MRR Enables Smart Decisions
Reliable ARR and MRR calculations will equip founders with data to make smart decisions, plan for growth, and help showcase predictable revenue for investors. When you partner with Mighty Startup, we will define a clear annual recurring revenue for your company. We’ll interpret what your ARR is saying about your company’s health to help guide your next steps.
We’re here to provide support via consistent calculation and open communication so that you can focus on delivering value and your mission. Get started with us today.
