ARR Demystified

Annual Recurring Revenue or ARR — is one of the key ways to measure subscription businesses and one that I am sure you as an entrepreneur get regularly asked about.

This might seem like a very logical and simple metric but I am surprised to see how often even sophisticated and repeat entrepreneurs get this wrong. So here is an attempt to explain this along with other revenue related metrics that go along with ARR, using a simple example designed to highlight the differences between these metrics.

Firstly ARR is not the same as Revenue — a really important point. And neither of these is the same as Bookings. Also none of this shows when you actually receive cash from your customers which is what is really needed for running your business.

Also note that Revenue is a GaaP metric while ARR and Bookings are not. The two other metrics that are important to capture esp. for early stage startups are Cash Collected (remember cash is king!) and Deferred Revenue.

The reason why ARR is a very important metric for subscription businesses is that it shows how much revenue can be generated on a recurring basis if the startup were to just keep going as is and not do anything differently. So a $1M ARR on Nov 17, 2020 should mean that a $1M in revenue should have been generated a year from now, and another $2M in two years and so on and so on. This is assuming no churn — i.e. no customers have stopped renewing the subscription. Of course this is never the case and even the best products assume a “gross” churn of at least 10%. If you sign up more customers (called new ARR) or expand revenue from existing customers (called expansion ARR), then you add to your ARR . Subtracting expansion in renewals from gross churn lowers your overall effective churn — this is called “net” churn. All successful companies aim for a negative net churn. Expansion in ARR from existing contracts can happen either because you were able to up-sell more of the same product or cross-sell other products to the same customer. An example of up-selling a product that charges by the number of users would be to have more users from the same customer sign-up. Metrics driven businesses do a good job of breaking down their ARR by what proportion of it is coming from new bookings vs. renewals vs. expansions enabling them to strategize on their go-to-market efforts.

Needless to say that for a successful business, overall ARR should be increasing over time.

If all of this is getting confusing, I don’t blame you. The best way to understand it to take some simple examples.

But one final and really important point before we do that.

ARR is a point in time metric for example ARR as of Nov 17, 2020. It doesn’t make sense to say what was the ARR during a period of time. It would make sense to say what is the ARR at the end of a period of time such as ARR ending Q4, 2020.

On the other hand (GaaP) Revenue and Bookings are metrics for a period of time.

The following would be a perfectly valid statement as an example:

“We signed 5 new contracts in Q3, 2020 for a total bookings of $500K. Our revenue in Q3, 2020 was $800K and ARR at the end of the same quarter was $3.0M “

So onwards to our example. Assume software subscription business.

Assume 0 revenue to date.

Company executes contracts with the first 10 customers on Oct 1, 2020. (first day of Q4, 2020)

This is an annual subscription with automatic renewal for $12K / year / customer.

Assume 30 day cash collection.

Now also assume that no more contracts are signed in 2021 except for renewals of the existing contract and that there is no churn.

The following chart shows the value of these metrics at/by different dates. ARR is always at the given date (or at end of Quarter / Year) as it is a point in time metric. All other metrics are Year to Date or for given duration (quarter or year)

Salient Points

1. ARR at end of 2020 is $120K though revenue (realized monthly) is only $30K.
2. You have already collected $120K in cash and $90K of it is deferred revenue at end of 2020, as you have only realized $30K.
3. $120K renews on Oct 1, 2021 and so FY 21 revenue catches up with ARR as you had a full year at that run-rate

Now let’s take this a step further. Assume next year, one out of the 10 customers up for renewal does not renew. But one of the existing customers buys two additional licenses (up-sell of $24K) and another existing customer is cross-sold a new product that you built meanwhile (also costs $12k/ year). You also sign up 3 more new customers for $12K / year / customer on Oct 1, 2021.

The same table now will look as follows.

Salient Points

1. On Oct 1, 2021, one customer churns ($12K). The renewal ARR should have been $120K but is now equal to previous ARR ($120K) less the gross-churn ($12K) i.e. $108K.
2. Expansion ARR is $36K: $24K from up-sell and $12K from cross-sell. Hence the net churn is $12K-$36K = -$24K
3. New ARR is $36K. So the total ARR is now previous ARR + new ARR — net churn = $120K+$36K-(-$24K)=$180K

Validating the rest of the metrics is left as an exercise for the reader.

Sufficient to say that ARR, Net Churn and new customer growth can provide a very healthy and complete view of the top-line.

Advanced Concept (Multi-Year Bookings): Note that bookings here can be also broken up by bookings from renewals and new bookings. This may be important as you may compensate your sales persons differently on renewals and new bookings. Also the YTD bookings is the same as ARR in the above example. This is because all contracts are Annual Contracts. If the contracts are monthly or multi-year, the bookings will be different than ARR. Let’s take a multi-year contract as an example. Suppose, you sign a three-year contract for $300K ($100K / year). The Total Contract Value (TCV) Bookings will be $300K. However ARR addition will be only $100K. While the multi-year booking will not change your ARR or GaaP revenue numbers vs. a single year booking, the multi-year booking shows a healthier / lower risk business to an investor and this sometimes gets lost in the ARR metric alone. Here are the benefits of multi-year bookings.

1. If the customer has paid up-front for multiple years, you have collected more cash. Cash is king! You will also have more deferred revenue on your books now. This shows more confidence and better predictability on revenue forecast.
2. It shows more customer confidence in your product or solution and lesser likelihood of churn.

Of course, there are risks too. You need to make sure that there are no penalties for early termination of multi-year contracts otherwise the deferred revenue can be a significant liability.