Company strategies made using performance data can be the difference between success and failure, and this is particularly important for Software as a Service (SaaS) startups as these companies startups face unpredictable markets. Thus, it’s crucial to analyze key metrics, such as Annual Recurring Revenue (ARR). Understanding ARR helps decision-makers to make better choices. While analyzing ARR has become easier thanks to the various options of tools available on the market, it’s still vital for startups to understand the basics of ARR. This guide will focus on ARR and evaluate its components, why it matters and how to measure performance using this valuable metric.

What Is ARR

SaaS companies have several revenue streams to choose from, including one-time set-up fees, upsells, and advertising costs. However, monthly, annual or multi-year subscription fees are often a main source of income for SaaS companies. Different SaaS company models are compatible with some revenue streams but not others. Yet, all SaaS companies need to understand how much predictable revenue they can receive each year. That’s where ARR is useful for SaaS startups.

ARR is the amount of revenue a company can expect to make each year going forward. It includes your Monthly Recurring Revenue (MRR)—the sum of your monthly revenue—multiplied by 12. Take the SaaS company and team collaboration platform Slack for example. The company had 95,000 paid customers by the end of their first quarter in 2019 with a minimum paid subscription rate of $6.67 per month billed annually. If all of these paid customers subscribed to Slack’s standard Teams plan at $6.67 per month, their MRR would be $633,650. When you multiply this figure by 12 months, you get an estimated projected figure or ARR of $7.6 billion. Slack’s ARR increased by 84 percent exceeding $100,000 in annual revenue over the fiscal year based on 645 paid enterprise customers, as of April 30th, 2019.

The focus is on recurring revenue, which is what investors prefer over once-off revenue. While some users will unsubscribe, new ones may join. The idea is to determine the average number of subscribers the SaaS platform should expect in a given year going forward. This calculation should take growth into account.

If the SaaS platform has regular advertisers, then any expected payments over a year will be a part of ARR. YouTube is a social media site on which regular users do not pay any fees. However, advertisements are regularly featured and repeat advertisers contribute towards ARR. If customers use a software platform to buy goods or services on a regular basis, that can be considered ARR. Postmates is one such app which will feature repeat customers, who spent almost $1 billion on the app yet do not need a subscription.

Experts often debate whether ARR should include sign-on or joining fees. It is important to note that growth in SaaS companies plateaus at some point. This was the case with SaaS companies like WhatsApp as measured by new app installations. When a SaaS company like WhatsApp reaches as many as 91 million users worldwide, their ability to grow is bound to decrease. It is easy to overestimate future expected ARR if one does not consider future growth reduction. As other users drop the service for various reasons, new ones replace them. After the initial growth spurt, a SaaS company could be able to predict how many new users it gains each year as others drop out. It may be able to maintain a steady revenue stream from once-off joining fees as part of their ARR.

Why ARR Matters

SaaS startups have upfront costs, such as office space, databases, servers and developers. These activities need upfront cash from investors or a loan from credit institutions to help mitigate the significant upfront and recurring costs they face. But since investors and creditors typically would not get involved with companies that seem risky, it’s also crucial that SaaS companies control their risk perception. They can accomplish this and attract investors and creditors by proving they have a sustainable revenue model. That is why ARR matters: ARR accounts for most of the proof of the sustainable revenue model.

Having high revenue figures does not mean that a company isn’t risky. A very low component of recurring revenue can make SaaS companies appear risky even when they have a high amount of total revenue. It is impossible to determine, with certainty, how a company will perform in the future. Revenues can either go up or down. However, the performance predictions of companies with a high percentage of recurring revenue tend to have a lower margin of error than of those with a lower percentage of ARR. Thus, having a large portion of total revenue coming from recurring revenue makes a company less risky. Adequate ARR is a way to show that a SaaS company can reward its investors while meeting its obligations to debtors. Failing to convince investors and creditors is a major reason why many startups fail.

How to Measure Performance Using ARR

Because startups differ in size and industries, their ARRs are very different. So, it’s crucial to measure performance by using ARR. A good way to estimate performance is to consider two ratios. The first ratio takes ARR as a percentage of total revenue. If this value is too low, the company is overly relying on once-off revenue and should give further consideration to its revenue model. The second is a ratio of ARR to the value of total assets, which measures the efficiency of the use of the company’s total asset in terms of recurring revenue. This is similar to total asset turnover except only including recurring revenue. However, higher ratios are always better. For instance, SaaS startups averaged 11.5 times ARR in 2018. Thus, it would be beneficial to exceed this number but less than three times would be considered too low.

Know Your ARR

The survival of a business depends on its risk profile and the strength of its earnings. Risky businesses do not get financial investments and a startup is a risky business if it does not have strong ARR. Entrepreneurs should aim to identify where their recurring revenues will come from and aim to strengthen those activities.

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