What is Annual Recurring Revenue (ARR)?
Annual Recurring Revenue (ARR) is a key metric for SaaS (Software as a Service) companies that use subscription models. It estimates the predictable revenue a company expects to earn each year from customers who are on subscription plans or multi-year contracts.
Why ARR Matters:
ARR is a standard way for SaaS companies to measure revenue, especially those selling subscription services to other businesses (B2B) that last longer than a year. It gives a clearer picture of a company’s financial health and growth potential than traditional accounting methods because it focuses only on the recurring revenue aspect, which is crucial for a business that relies on ongoing subscriptions.
How to Calculate ARR:
ARR is calculated by multiplying the Monthly Recurring Revenue (MRR) by 12 months:
Annual Recurring Revenue (ARR) = Monthly Recurring Revenue (MRR) × 12
This calculation considers all revenue from subscriptions and any extra income from upgrades but excludes one-time fees like setup or consulting charges, as these aren’t recurring.
Example
Suppose a customer signs a four-year subscription contract worth $50,000. To find the ARR for this contract:
Annual Recurring Revenue (ARR) = $50,000 ÷ 4 Years = $12,500
This means the company expects to earn $12,500 per year from this contract.
Components of ARR:
There are six main parts to ARR, which help understand a company’s growth and customer engagement:
- New ARR: Revenue from new subscriptions.
- Expansion ARR: Revenue from customers upgrading their subscriptions (e.g., buying more features).
- Renewal ARR: Revenue from renewing existing subscriptions.
- Churned ARR: Revenue lost when customers cancel their subscriptions.
- Contraction ARR: Revenue lost when customers downgrade their subscriptions.
- Reactivation ARR: Revenue from customers who canceled before but decide to subscribe again.
Overall, ARR helps companies track trends, predict growth, and understand how well they’re retaining and expanding their customer base.