About Brian DeChesare
Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.
Annual Recurring Revenue (ARR): Definition, Calculations, and Real-Life Usage
In this tutorial, you’ll learn what “Annual Recurring Revenue” (ARR), also known as Annualized Recurring Revenue, means for Software-as-a-Service (SaaS) companies, and how to calculate it for companies large and small.
Annual Recurring Revenue (ARR) Definition: ARR represents the expected yearly revenue a software-as-a-service (SaaS) company might earn from its subscription-based services. It’s calculated based on the subscription revenue from the most recent month or quarter and multiplied by 12 or 4 to get an annual figure.
ARR is a common metric for Software-as-a-Service (SaaS) companies and arguably one of the most important ones, as it directly measures the growth of their core business.
However, it’s not universally useful for all companies, and it may not be much different from standard “Revenue” or “Revenue Growth,” especially for large companies growing at modest rates.
Investors like ARR because they tend to value recurring revenue at higher valuation multiples than non-recurring revenue, such as sales of one-time licenses and consulting services, as recurring revenue is more predictable.
Some sources use ARR to benchmark SaaS companies and see how their “true” growth rates compare; one example is the Bessemer Ventures’ “Emerging Cloud Index”:
While you can do this, ARR tends to be more useful when you’re analyzing and valuing startups and small businesses.
These firms are often losing money or burning cash at high rates, so it’s critical to assess the sustainability of their growth and their future budgeting needs.
For example, if one firm’s ARR growth is higher than another’s, it might indicate that they need to budget for additional customer support or infrastructure over the next year to support their new customers.
Here’s the Excel file and slide presentation for this tutorial:
Annual Recurring Revenue (ARR) – Simple Examples (XL)
Annual Recurring Revenue (ARR) – Presentation Slides (PDF)
AvePoint – 10-K Filing with ARR Definitions and Estimates (PDF)
Video Table of Contents:
1:32: Part 1: What is Annual Recurring Revenue (ARR)?
3:52: Part 2: How Do You Calculate ARR?
6:01: Part 3: From Customers to ARR
9:24: Part 4: What Does ARR Mean in Real Life?
11:50: Recap and Summary
Annual Recurring Revenue vs. “Revenue”
“Revenue” is a broader term that includes all the income streams of a company, including non-subscription sources like professional services, license sales, and installation fees.
By contrast, ARR focuses on the predictable subscription-based income, annualized from a specific recent period. Here’s an example calculation for Everbridge:
It’s fairly simple: We take the Subscription Revenue from one quarter and multiply it by 4 to get the annualized number.
We exclude the Professional Service and Perpetual License revenue because they are non-recurring and require customers to make separate purchases each time rather than renewing their existing subscriptions.
In this case, ARR and Revenue appear to be growing at similar rates, so the ARR metric doesn’t add much:
ARR Formula and ARR vs. MRR
Just as we calculated the Quarterly Recurring Revenue above, you can also calculate the Monthly Recurring Revenue (MRR) if you have the company’s monthly numbers.
Take the Total Revenue and subtract the non-recurring income from services, perpetual licenses, and other sources to get the Monthly Recurring Revenue.
Once you have the Monthly Recurring Revenue (MRR), multiply it by 12 to determine the Annual Recurring Revenue:
ARR = MRR * 12.
For example, if the Monthly Recurring Revenue from the past month was $50,000, the Annual Recurring Revenue is $50,000 * 12 = $600,000.
These numbers assume the company has annual, monthly, or quarterly contracts.
If the company has contracts that last more than 1 year, you would divide the total contract value by the number of years to calculate the ARR for just that contract.
For instance, a 3-year contract worth $150,000 would have an ARR of $150,000 / 3 = $50,000 per year.
How to Calculate Annual Recurring Revenue for a More Complex Company
With large, public companies, one complexity around the ARR calculation is which type(s) of revenue to count as “recurring.”
AvePoint, which has 5 different revenue sources, is a good example of this issue:
In some sense, Maintenance and “Termed Licenses and Support” are recurring because if the customer wants to continue receiving the service (software updates and maintenance), they have to renew their contracts.
On the other hand, a Termed License and Support contract is a bit different from a subscription that renews automatically, as it may require the customer to opt for another year (or years) of service.
We find the answer in the company’s 10-K, where they give this definition of Annual Recurring Revenue:
Based on that, we calculate the ARR as follows:
From Customer Contracts to Annual Recurring Revenue
One challenge with calculating ARR is that small businesses and startups may provide you with customer-level data rather than formal financial statements.
In these cases, the typical approach is to start by excluding all non-recurring revenue sources.
Then, start with this Recurring Revenue in a previous period (the last month, quarter, or year), and do the following:
- Add: Recurring Revenue from New Customers
- Add: “Expansion ARR” (Upsells and Price Increases from Customers)
- Subtract: Downgrades from Existing Customers
- Subtract: Cancellations (“Churn”)
This will get you the Ending Recurring Revenue for this period. If it’s a month or a quarter, you can annualize by multiplying it by 12 or 4.
You can see the setup for Procyon, a company in our Venture Capital & Growth Equity Modeling course, below:
The trickiest part of this setup is that we need to use SUMIF and SUMIFS functions in Excel to make the calculations based on the underlying customer data, which looks like this:
For example, for the “New Customers” ARR, we need to find customers with positive revenue for the most recent fiscal year (FY 22) that had no revenue in the year before (FY 21), so we use this SUMIFS formula:
We can use similar formulas for the others; the “Upsells and Price Increases” one, for example, is based on the sum of revenue in the current period for customers with positive revenue in both the current and previous periods.
We used annual numbers for this company because we only had the annual data, so it was not possible to take one quarter or month and annualize based on that.
If we had this monthly or quarterly information, we might base the ARR on these shorter periods and annualize each period’s results to calculate the ARR over time.
Annual Recurring Revenue in Real Life
In real life, some people pair ARR with Enterprise Value to turn it into a valuation multiple: TEV/ ARR. You can see an example in the Bessemer Cloud Index above.
This can be useful if the comparable companies in your set have widely varying percentages of recurring revenue, and you want to normalize their performance.
As with other valuation multiples, companies that grow their ARR more quickly should trade at higher ARR multiples (in theory).
ARR is also useful for benchmarking companies’ operations and determining which companies grow due to their core business expanding vs. sales of ancillary services.
For example, SAFE Note investors and venture debt investors might look at ARR when deciding on the terms they offer to startups that need funding.
Finally, ARR is useful for high-growth startups because it indicates possible hiring needs and how those needs might affect the company’s fundraising requirements.
For example, if ARR is growing quicky, but the company is losing money, it might need to hire more sales reps and customer support reps to manage the growth, which might cause it to raise outside funding earlier than expected.
For many large companies growing at modest rates, though, ARR is not necessarily more useful or insightful than simple “revenue.”
That’s because ARR growth and revenue growth are often close, as was the case with Everbridge and AvePoint above:
It would be more useful here if the companies had more revenue from non-recurring sources, such as over 50% from services, hardware, or license sales, or one company’s growth rate had changed significantly in a recent period.
The bottom line is that while ARR is a key metric for SaaS companies, it is not exactly “the one metric to rule them all” – at least, not for all companies in the sector.
