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.