As part of your SaaS go-to-market plan, you should understand ARR, or Annual Recurring Revenue. This figure describes how much income your business generates over a 12-month period, and it lets you know how much money each customer brings your company over the course of a year.
To better understand what ARR is and how it affects your company’s growth, we have to first look at some important definitions, then learn how ARR stacks up against other types of revenue.
ARR Definitions and Background
Before we dive into the details, we have to define ARR, as well as ARR vs MRR (Monthly Recurring Revenue) and ARR vs GAAP revenue. GAAP stands for Generally Accepted Accounting Principles, which describe a set of standards that companies can use to manage their finances.
ARR: Annual Recurring Revenue
Not to be confused with the Accounting Rate of Return, this figure represents how much a company is set to earn through subscription contracts in a 1-year period. In order for this metric to be useful, you need to have your contracts set for at least 12-months, or the majority lasting at least 1 year or longer.
MRR: Monthly Recurring Revenue
Monthly recurring revenue dictates how much a company earns each month. Companies with monthly subscription services will use MRR over ARR, but companies with 12-month, 24-month, and even 36-month contracts can still generate their MRR if clients pay on a 30-day billing cycle.
LTV: Life-Time Value
The LTV of a customer is how much they will pay a company over the entire duration of their contract.
ACV: Average Contract Value OR Annual Contract Value
ACV can reflect the average contract value for a business, or it can reflect how much a contract generates per year. You can choose which figure is ideal for your accounting based on the type of analysis or forecasting you’re performing.
ARPU: Average Revenue Per User/Unit
ARPU reflects how much money your company earns on average per user or software license.
CAC: Customer Acquisition Cost
The CAC reflects how much your company spends to gain a new customer. This metric can be helpful as you plan and refine your SaaS digital marketing strategy.
CRO: Conversion Rate Optimization
Improving your CRO means increasing the number of visitors to your website who become customers. In marketing, when a lead becomes a customer, they convert.
Churn: The annual percentage rate at which customers stop subscribing to a service
You’ll have to understand your churn rate to optimize your ARR. A high churn rate causes your business to lose revenue, especially if you are not recouping your CAC through each customer’s LTV.
MVP: Minimum Viable Product
The minimum viable product is the version of your software that provides just enough features for it to be usable by the public. Optimizing your MVP through customer feedback allows you to continually improve your product while still generating revenue through contracts.
PMF: Product-Market Fit
A product-market fit describes where your software’s features align with customers’ needs and goals in the existing marketplace. For example, someone who wants to create a streaming service will have to identify a need in the market. Without a clear fit within the streaming marketplace, they will not be able to successfully differentiate themselves from the competition and generate sustainable revenue.
T2D3: Relating to ARR, this stands for triple, triple, double, double.
It’s a metric-driven method that requires tripling your annual revenue for two years, then doubling it for three years.
MQL: Marketing-Qualified Lead
Leads differ in marketing, and what matters most for your business’s growth is generating leads that are ready to move on to sales, and convert quickly. A MQL is a lead that your marketing team has approved of and is ready for the next stage of the sales cycle.
SQL: Sales-Qualified Lead
A sales-qualified lead has moved through the top of the marketing funnel, and they are now ready to interact with the sales team in hopes of converting them into an active customer.
LVR: Lead Velocity Rate
This metric measures the growth rate in the number of MQLs your pipeline generates.
TAM: Total Addressable Market
The TAM, or total addressable market, refers to the total opportunity available to your business. It is the total amount of money a business can earn in a marketplace.
SAM: Serviceable Available Market
The serviceable available market is the maximum amount of revenue you can earn based on your unique target audience.
SOM: Serviceable Obtainable Market
The SOM is a realistic percentage of the SAM that your business is capable of converting.
Now that we have fundamental definitions covered, we can move onto exploring ARR and its role in SaaS growth.
What is the difference between ARR and MRR?
The biggest question SaaS startups have about finances is ARR vs MRR. They want to know how each metric affects their forecasts, and what steps they can take to optimize their company’s growth.
ARR and MRR both reveal how much money your business stands to earn. The difference is that ARR measures revenue over a year, while MRR measures revenue over the course of 30 days.
In its simplest form, your ARR is your MRR times 12. Of course, we also have to consider that your MRR can change each month depending on the number of new subscriptions minus the number of cancellations.
Speaking of which, your ARR is a flexible number that will vary based on your CAC, LTV, and ACV. These three figures, along with your churn rate, affect how profitable a SaaS company is. When you are able to understand your ARR better, you can start making changes to other areas of your business that maximize revenue while lowering your expenses
You will always have to spend some money to acquire new customers. The goal is to ensure that you are not only recovering what you spent but generating profit continuously on top of that cost.
This is part of the reason why a subscription model can be such a profitable business. As long as you can keep clients satisfied, you can increase annual subscriptions and grow your business steadily.
What is SaaS ARR (Annual Recurring Revenue)?
ARR in SaaS is a fundamental accounting metric. For most businesses, contract value is considered the most important figure. In eCommerce, a single transaction is usually much lower than what a SaaS company earns per conversion.
In SaaS markets, clients may pay hundreds or thousands of dollars upfront, or agree to pay on a monthly basis for a set period of time. Regardless of how their contract is structured, there is a total amount they will pay for the length of their service, i.e. the lifetime value of their contract
Think about ARR like this:
If you have 1,000 customers paying $10 a month for your product, your MRR is $10,000. Assuming those customers continually pay for a 12-month period, your ARR is $120,000.
What is SaaS MRR (Monthly Recurring Revenue)?
SaaS companies sometimes use MRR and ARR interchangeably.
So, you might see a company with 500 customers paying $120 a month refer to their ARR as $60,000.
What’s most important to note is that ARR doesn’t account for new customers. Because your company operates on a subscription model, calculating ARR is really an ongoing process. You will have to repeatedly factor in new contracts to have an accurate ARR/MRR.
MRR really refers to the amount of revenue a company stands to gain each month based on its current number of active subscriptions. You can also calculate your MRR, then deduct your cancellations at the end of the month to determine how much you really earned.
Let’s say your SaaS startup currently has 3,000 customers who signed a 12-month contract with an ACV of $4800.
If the ARR is 3,000 x $4,800, the MRR is that figure divided by 12. It’s how much each client pays per month for service.
Companies that allow clients to purchase 12-month software licenses upfront will need to consider how this impacts their monthly revenue and operating costs. You will also have to factor in deferred revenue for advanced payments. Deferred revenue is money that you receive for services that have not yet been provided/attained.
With such influential variables to consider, it’s best for your accounting team to routinely assess your ARR. Only considering your monthly contract values can you get an accurate depiction of your business’s growth.
How do you calculate ARR for SaaS?
The interesting thing to note about ARR is that it can be calculated differently depending on your goals. For example, one method of calculating ARR is using the following formula
Number of Contracts x ARPU (Average Revenue Per Unit) = ARR
Another option for finding your ARR is adding your yearly subscription cost to your expansion revenue, then subtracting churn losses. That formula looks like this
ARR = Yearly subscription cost (ACV) + expansion revenue – churn
Your expansion revenue is any money that your company earns in addition to a customer’s base contract value. So, if they decide to purchase additional features for their product, then this income is considered a type of expansion revenue
It’s not uncommon for SaaS companies to have scalable packages. By allowing customers to convert at a low initial price point, they can generate recurring income through expansion. As customers who purchase “basic” subscriptions build upon their contracts, the company gradually increases its ARR.
Switching From MRR to ARR
Both MRR and ARR are key metrics for any business with a subscription model. The value of your service contracts directly influences your company’s growth over time, especially if those contracts tend to vary on an annual or monthly basis.
In order to effectively determine how much revenue your SaaS business is generating over the course of a year, you have to think about the long-term value of your yearly contracts.
You can also use your MRR to calculate ARR as long as you are able to retain a specific volume of customers for at least 12 months.
Every company has its own method for determining ARR. As it is not a GAAP, there is no set formula or criteria for calculating the figure or implementing it. But that versatility is what makes ARR such a valuable metric to know. It grows with your business, and adapts to your needs.
One of the biggest benefits of ARR vs MRR is that ARR reflects long-term growth. MRR can change drastically from one month to the next, but ARR is based on yearly or multi-year subscriptions. As such, you have a much clearer picture of where your company is headed and how its finances will look going forward.
Ultimately, you have to decide which metric is best for your business. If you are a B2B SaaS company that operates on yearly contract terms, then you’ll find an ARR growth rate to be a valuable metric as you transition through different stages.
The first few stages of a SaaS startup are solely dependent on metrics like MQL, SQL, and PMF.
Once you establish a customer base, you can begin factoring your ARR into the equation. As you continue to gain new subscribers, your ARR will increase, and you will also be able to project how much you’re likely to gain over the course of the year based on your current marketing stats.
As you can see, ARR and marketing go hand-in-hand. A solid digital marketing strategy supports a strong sales playbook. When you are able to use both of them wisely, you can strategically increase sales while setting healthy benchmarks for your business.
ARR vs GAAP Revenue
GAAP revenue measures historical data, i.e. how much money your company has made so far. You can look at your sales figures in the last year, for example, and compare it to your current contracts to assess your growth.
ARR is a type of projection that reveals how much you will earn within a year. It’s possible to even use ARR as a hypothetical figure to calculate projections for potential growth. For example, you could use ARR to calculate how much money your company could make in a year if it increased its contracts by 200 new users in the next month.
Why is ARR important to SaaS?
With any subscription model, growth through recurring revenue requires continual forecasting. ARR allows you to easily calculate how much money your company is on track to earn. Rather than wait until you’ve generated income through completed contracts, you can determine your likely earnings based on the current value of your existing customers.
What is ARR momentum?
ARR momentum occurs through expansion revenue. As you incorporate add-ons to your products, customers increase the value of their contracts. This, in turn, means your business earns more than initially anticipated.
If you’re exploring how to increase ARR, expanding services and bundling packages is one of the best options. The goal is to keep customers engaged throughout the length of their contract. In addition to attracting new customers, you can get existing clients to increase their investment through optional add-ons.
What is a good ARR for SaaS?
A good ARR will reflect your company’s history. Growth benchmarks vary depending on how long you’ve been in business. A company that generates less than $1 million per year will need an ARR of at least 30% to be in the 20th percentile of its competitors. You would need to generate an ARR of 120% to be in the 75th percentile, and 242% to make it into the 90th.
What is a good ARR for a B2B SaaS?
According to Rory O’Driscoll, co-founder and partner of Scale Venture Partners, once a company reaches $10 million ARR, growth should range between 80% and 85% of the previous year.
He says that a company with a $100 million ARR run rate at the time of initial public offering (IPO) will need to increase by at least 25% the next year. Let’s tackle how your business can approach its ARR and growth at every stage of its SaaS journey.
MVP to PMF
You’ll need an MVP that’s proven to be useful. You have to be certain that there is a demand for your product, and that you have the ability to give customers exactly what they’re looking for in this type of offering.
Once you have developed a strong MVP, you can move onto your PMF. This validates your idea and ensures that there is room in your target industry for a business to take off. It’s one thing to start a company but another entirely to succeed. The PMF stage ensures that a SaaS startup has viability.
Once you’ve become certain about your PMF, you can start attracting your earliest customers. Then, you’ll be ready to start calculating your ARR.
PMF to T2D3
At this stage of the game, your goal should be acquiring new subscriptions quickly while minimizing your CAC and lowering your churn. You want to get as many new people to sign up as possible without spending a fortune or losing contracts early on. Prioritize your LTV here to ensure that clients stay onboard as long as possible.
You’ll also want to focus heavily on SQLs, which will make it easier for you to connect with the right people and acquire new contracts
Your ARR here will help you determine the actual value of your contracts. Avoid focusing solely on subscription numbers. While establishing a user base is important, it’s even more important to ensure that these contracts present long-term value and security for your company.
T2D3 to 40%
If you want to achieve sustainable success as a SaaS company, you will have to try and achieve $100 million ARR within 5 years. That’s a lofty goal, but with the right techniques, you can create a strategy for success.
Because SaaS companies profit from ongoing services, they will eventually peak. When new subscriptions begin to plateau, growth stalls. Your ARR may decline if you have a high churn rate, or if you aren’t increasing sales enough to account for higher operating costs and company expansion.
To ensure you keep an ARR of 40% or more, make sure that you aim to keep costs low, cut overhead, and streamline workflows.
How to Increase ARR
Last but not least, let’s cover some tips on how to increase ARR. These suggestions will help you craft a strategy that’s relevant to your current stage of growth, and evolve your plan to suit your company’s needs.
Prioritize Low CACs and High LTVs
With a low customer acquisition cost, you gain more from every new contract. By reducing CAC as much as possible, you can make each new user more valuable for your business.
Be Flexible in Your Sales Goals
Companies don’t necessarily have to sell the biggest packages for maximum profit. Gaining $100,000 from 100 new customers is just as good as gaining it from 10,000. What matters is 1) how satisfied your customers are, and 2) whether your company’s growth is consistent or not.
Improve Your MQLs
Don’t lose time, money, or productivity on low-quality leads. Make sure that your digital marketing strategy is optimized to support the greatest prospects for your business. You can start your journey by learning 8 of the best B2B digital marketing strategies for SaaS companies on our blog!