What comes to your mind when you read the letters ARR?
Well, if you’re in the financial market you may refer to the NYSE:ARR stock, if you’re a tech guy you may think of Application Request Routing; but for us SaaS professionals, ARR means two things only: Annual Run Rate and Annual Recurring Revenue.
Although both metrics are related to your business revenue, they mean two very different things.
What makes things confusing is the fact that there is no standard definition for many SaaS related financial terms. Even the big names in the business have their own interpretation of different things. That’s why you’ll come across different versions and explanations of the same thing. However, regardless of how you calculate important metrics such as ACV and ARR, all business units should be on the same page when measuring them.
Annual Run Rate
Annual Run Rate is a term used to describe annualized earnings extrapolated from a shorter time frame. We usually use the run rate to estimate future revenues or to represent the size of a business in terms of annual revenues.
Let’s say your company had $100,000 in earnings in January; you could
say predict that your annual run rate for that year would be $1,2000,000 by simply multiplying $100,000 * 12.
But run rates may cause inaccurate projections. If the time period used to calculate the run rate is not indicative of normal revenues, then the annualized earning could either be overstated or understated. For instance, some retailers experience higher sales during the holiday seasons and lower sales during the summer months. If a retailer uses December sales as the basis for the run rate, sales will be overstated. If the retailer uses July sales as a run rate, sales will be understated.
The same thing applies if a company relies too much on large deals, that might be closed once or twice a year.
Finally, run rates often fail to account for sales growth. If the company has the ability to grow sales during a year, then annualizing the revenue for an average time period will fail to take into account that revenue growth.
Annual Recurring Revenue
Recurring means there’s a subscription in place and the customer is charged on an ongoing basis, rather than a one-time purchase. As we’ve discussed on this article, Annual Recurring Revenue would simply be your Monthly Recurring Revenue multiplied by twelve months.
Just like MRR, ARR will include only committed and fixed subscription or recurring fees. ARR always excludes one-time fees and usually excludes any subscription consumption or variable fees.
Unlike MRR, which is a metric that can vary dramatically from real monthly revenue due to the variance in days in the month, ARR can correlate well with actual revenue if your subscriptions are in annual or true multi-year intervals.
You may see some sources refer to Annual Recurring Revenue exclusively for multi-year contracts only. That can make sense for scenarios where customers can subscribe to whatever-they-want month intervals, but not much for SaaS where monthly and yearly plans are more of the norm.
Annual Recurring Revenue = Monthly Recurring Revenue * 12
If your company’s earnings come only – or mainly – from subscriptions, you may think Annual Run Rate and Annual Recurring Revenue are not that different, but let’s see why that’s not true. In SaaS and subscriptions businesses in general, we tend to use accrual accounting.
Accrual accounting recognizes revenue as it is earned, rather than when it is paid to the company.
It’s an accounting method that measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur.
The general idea is that economic events are recognized by matching revenues to expenses (the matching principle) at the time in which the transaction occurs rather than when payment is made – or received. This method allows the current cash flow to be combined with future expected cash flow to give a more accurate picture of a company’s current financial condition.
This is the opposite of cash accounting, which recognizes transactions only when there is an exchange of cash.
A practical example
Here’s a sample of data to help you understand these metrics in a practical way.
Considering we’re using the accrual accounting method, let’s analyze the following data set:
More details on this sample data set here.
The first thing to notice here is that Billings don’t really make any difference for us. If we were using the cash accounting method we’d recognize the sum of billings as our earnings, but since we’re using accrual accounting it can be ignored.
Annual Run Rate
If you sum up the revenues you can state that our Q1 earnings were $920, and therefore our Annual Run Rate will be $3,680 (Q1 earnings * 4). Notice that we’re considering that the performance of the next three quarters will be exactly the same as the first quarter of the year.
Annual Recurring Revenue
ARR is fairly easy to calculate a generally agreed upon metric. It’s the term subscriptions normalized (recurring revenues) to one calendar year. For example, a subscriber buys a $40,000 subscription for four years. The normalized value for one year or ARR would be $40,000/4 = $10,000.
A simple way to calculate the Annual Recurring Revenue would be $540 * 12, which is $6,480. Of course, this number will change as you book more revenues and your recurring revenue grows over the year.
Notice that it makes no difference if your customers are subscribing to monthly or yearly plans since the yearly subscriptions are recognized ratably over the time of the subscription – and at the end – we’re working with monthly values only.
Annual Contract Value
A lot of confusion surrounds ACV because of the difference in interpretation and similarity with other metrics such as ACV bookings. ACV is generally referred to as the average annual value of subscriptions, often including one-time fees that providers charge along with recurring fees. ACV is a momentum metric and although it might seem very similar to ARR, the value can differ when dealing with multiple customers. On the other hand, ARR shows how much recurring revenue a company can expect annually after normalizing multi-subscriptions to one year.
Another important annualized metric to keep track of is the Annual Contract Value or ACV.
ACV measures the value of the contract over a 12-month period. So let’s say a customer commits to a 24-month contract of $120,000. Considering this money will be recognized as revenue ratably, we’ll have $5,000 in MRR and therefore $60,000 as your ACV.
ACV booking is another term related to ACV, but it has a different meaning. It refers to the total value of term contracts. Compared to ACV which is an average, ACV bookings are calculated for one year and added together. For more than one year, TCV is used.
The value of both ARR and ACV often mirrors, which is why these metrics are regarded as cousins. ACV is an average amount that refers to the average revenue generated from subscriptions for a specific year OR revenue generated from one subscription for one calendar year. Calculating ARR and ACV is pretty straight forward and the same when calculated for one customer. But things can become a little more complicated when calculating total ARR and ACV.
Total Contract Value
TCV, on the other hand, is the total value of the contract and can be shorter or longer in duration.
An important thing to notice is that TCV is not only about recurring revenue. It should also include the value from one-time charges, professional service fees, and recurring charges.
Let’s say a customer commits to a 6-month subscription plan of $100/mo, your TCV would be $600. Now if the customer commits to a 24-month subscription, your TCV would be $2,400.
The main purpose of calculating TCV is to analyze the total value generated by multi-year contracts. For single-year contracts most businesses prefer using ACV bookings. Subscriptions with no well-defined end are not considered part of TCV.
There are quite a few ways to spin different SaaS metrics, but the important thing is that all business units stay on the same page regarding their calculations and how amounts are measured. Calculating the exact value of metrics usually depends on the level of granularity and how you package your subscriptions.
Some businesses consider all the related fees as part of the final agreement, including one-time fees e.g. training and onboarding fees, while others treat recurring and one-time fees differently. That’s why many prefer including Churn and expansion revenue while calculating ACV, which in this case equals to New subscriptions + Expansion revenue – Churned customers.
Although ACV is often an underestimated and overlooked sales metric, but it can provide valuable insights into business performance when compared against other metrics. However, like other metrics businesses should also not sleep on ACV and use it as a stand-alone metric.