Understanding annual recurring revenue
Annual recurring revenue, or ARR, is the amount of money a company can expect to receive each year from subscription and contract agreements with its customers, as well as other sources of recurring revenue.
ARR is a particularly relevant metric for software-as-a-service (SaaS) companies that provide software to customers under subscription agreements.
Examples of SaaS companies on the ASX include Xero Limited (ASX: XRO), WiseTech Global Ltd (ASX: WTC), Pro Medicus Limited (ASX: PME), and ELMO Software Ltd (ASX: ELO).
SaaS customers receive cloud-based access to software in return for regular payments. This differs from the traditional selling method, where software is purchased outright by customers and installed on individual computers. ARR is one of the primary metrics used to measure the year-on-year growth of SaaS companies.
How is ARR calculated?
We measure ARR by aggregating revenue received from subscriptions, contracts, and other sources of recurring revenue. Although most commonly used by SaaS companies, ARR is relevant to any business that provides products or services under long-term contracts in return for recurring payments. It is used most commonly for business-to-business subscription models.
Many companies use their ARR also to calculate their dollar-based net expansion rate (DBNER). Both metrics are useful in understanding SaaS businesses.
While ARR measures the annual run rate of subscription revenue, DBNER measures the rate at which a company has expanded its revenue from existing customers by selling additional products and services.
If existing customers subscribe for additional products, ARR and DBNER should increase. ARR, however, is also impacted by cancellations from existing customers, which does not impact DBNER. Customers cancelling their subscriptions will result in a decline in ARR, but this is not counted in the DBNER calculation.
Why is ARR important?
ARR shows the money that comes in every year for the life of each customer subscription. SaaS companies aim to grow their ARR because it indicates the company is growing. ARR allows SaaS companies to understand their prospects regarding the future generation of revenue. This indicates the future viability and profitability of the company and feeds into the company's valuation.
For ARR to be relevant, a business must have term agreements with its customers that last for at least one year. ARR is a commonly used metric by companies with multi-year agreements. It should include only contractually committed subscription fees.
One-off payments are generally excluded from ARR as they are non-recurring by definition. For example, if Company A has a subscription agreement with a customer worth $1,000 a month, plus a one-off $10,000 set-up fee, the ARR will be $12,000. This is because the customer pays $1,000 x 12 to Company A annually. The $10,000 set-up fee is not included in the ARR calculation as it is non-recurring.
Let's look at an example
| Customer | Monthly subscription revenue | ARR |
| Customer 1 | $5,000 | $60,000 |
| Customer 2 | $2,000 | $24,000 |
| Customer 3 | $4,000 | $48,000 |
| Customer 4 | $7,000 | $84,000 |
| Total ARR | $216,000 |
In the above example, the company charges subscription fees monthly. To calculate ARR, we multiply the monthly subscription revenue from each customer by 12 and tally the results. In practice, many companies calculate ARR by breaking down the total figure into individual components of ARR. These usually include:
- ARR from new customers
- ARR from renewals from existing customers
- ARR from upgrades from existing customers
- ARR lost from downgrades from existing customers
- ARR lost from customers who have cancelled their subscriptions
SaaS companies frequently report ARR for each item, including incremental changes across time. This means total ARR can also be calculated by taking ARR at the beginning of the year, adding ARR gained from new and upgrading customers during the year, and subtracting ARR from customers cancelling or downgrading during the year.
While changes in a company's ARR rate are important, it is also essential to understand the individual components of ARR. Each of these components impacts total ARR. Suppose a company increases ARR by adding many new customers but is losing existing customers to cancellations faster. In that case, its overall ARR will be negatively impacted.
Why is ARR so powerful for businesses?
ARR is one of the purest revenue measures for an SaaS business, indicating whether momentum is building or waning over time.
It can quantify growth, evaluate subscription models, and forecast revenue. This feeds into financial projections and can help companies understand both short-term and long-term cash flows.
Tracking ARR allows companies to plan for both the short and long term, making business decisions to optimise total ARR.
Development teams in subscription businesses must focus on features designed to attract new customers and entice existing customers to upgrade, as well as on features designed to defend ARR against the impact of customer cancellations and downgrades.
A company can gain insight into whether its business decisions translate into financial results by comparing ARR over several years. Because ARR includes only subscription revenue rather than all revenue, it allows a company to ascertain its subscription model's success.
SaaS businesses often require a significant upfront investment but can achieve high margins later as the company can add new customers at a relatively low cost.
Benefits for investors
From an investor perspective, ARR can compare performance across similar companies and track an individual company's performance over time. Many SaaS businesses operate on a 'land and expand' strategy, whereby new customers are acquired, and the company increases the services sold to these customers over time.
ARR and its components can provide a good indication of how well different companies are executing this strategy. Investors considering ARR figures must understand how much of a company's revenue is recurring and how reliant the business is on subscription revenue. This is especially relevant to SaaS companies, where recurring revenue may be the primary source of revenue.
Many SaaS companies operating on recurring revenue models tend to have relatively high valuations. As cloud computing becomes more widely accepted, many SaaS companies are rapidly growing. Fast growth coupled with recurring revenue drives higher valuations because SaaS companies are valued on multiples of revenue.
While companies operating on recurring revenue models may not get hefty upfront fees, the lifetime value of customers can be greater, provided they can keep customers satisfied and minimise cancellations.
Long-term agreements with satisfied customers reduce the variability of these companies' earnings, leading to higher company valuations.
