ARR’s meaning and how to calculate it: A SaaS-focused guide

Did you know that the median valuation multiple for private SaaS companies in 2024 is 4.1x their ARR? This shows that ARR plays a massive role in how investors value SaaS companies.

In this guide, we'll explain what ARR is. We’ll also explore its importance in SaaS, and show you how to calculate it accurately.

You'll also learn:

• Why ARR is crucial for SaaS growth and scalability
• How to use ARR for effective financial planning
• Common pitfalls to avoid when calculating ARR
• How Orb, a billing platform, can help you manage your ARR

Let’s get started by going over ARR’s meaning, what it stands for, and why it’s a key metric in SaaS.

What does ARR mean?

ARR stands for Annual Recurring Revenue. It's the total revenue a business expects to get from all its subscriptions over a year. 

What does ARR represent?

You can think of it as the financial heartbeat of a company, especially for those with subscription models. It's a key metric for SaaS firms because it gives them a clear picture of their predictable income. ARR helps them make informed decisions about growth strategies.

Because ARR shows how much revenue is repeating, it's a good indicator of the company's stability. A company with a strong and growing ARR is often seen as a healthy business. Next, we’ll go more in-depth about how ARR relates to SaaS companies in particular. 

ARR’s meaning and why it matters for SaaS companies

In SaaS, ARR's meaning extends beyond just a number on a spreadsheet. It represents the predictable, recurring revenue that forms the foundation of a SaaS company's financial health.

Usually, SaaS businesses operate on a subscription model. Their revenue stream is dependent on customers paying for their services regularly. 

ARR provides a clear and concise way to measure this recurring revenue. It allows businesses to understand their current financial standing. Consequently, ARR helps them make better predictions about future income.

Here's why ARR is such an important metric for SaaS:

• Predictable revenue: ARR helps SaaS companies forecast their future income. Predictability is crucial for making data-driven decisions about everything from product development to hiring.
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• Growth measurement: ARR is a key indicator of a SaaS company's growth trajectory. Is ARR increasing? Then the business is likely thriving. Is it flatlining? Then it’s time to rethink the strategy.
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• Scalability check: ARR helps measure how scalable a SaaS business is. A high ARR with low churn suggests the company can handle growth effectively.
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• Investor magnet: When seeking funding, SaaS companies often showcase their ARR. Investors love to see strong ARR growth — it signals a healthy and promising business.

ARR in action: An example

Imagine a SaaS company that provides project management software. They offer different subscription tiers, and their ARR is $1 million. This means they can reliably expect to bring in $1 million each year from their existing subscribers.

Now, let's say they launch a successful marketing campaign and acquire a bunch of new customers. Their ARR jumps to $1.5 million. This increase shows growth but also indicates they're attracting and retaining customers.

Note: In this case, we’re not including the formula just yet. The idea of this example is to show you the impact that ARR can have on a SaaS business. In the next section, we’ll circle back to this example with a formula for calculating ARR. 

Beyond the basics

ARR is also valuable for:

• Product decisions: ARR can help determine which product features are resonating with customers. You can analyze which features are leading to upgrades and higher ARR.  This metric also helps you spot features that might need improvement.  
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• Pricing strategies: Analyzing ARR can guide pricing adjustments. Maybe it's time to introduce a new pricing tier or adjust existing ones to boost revenue. 
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• Customer success: Keeping a close eye on ARR can reveal churn trends. If ARR is declining, it's a sign that customers might be unhappy. In that case, it's best to focus on improving customer satisfaction.

How to calculate ARR

Here's the basic formula for calculating ARR:

ARR = (Total Subscription Revenue + Recurring Expansion Revenue) - Revenue Lost from Churn

Let's break down each part:

• Total Subscription Revenue: This is the bread and butter — the total revenue from all your annual subscriptions.
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• Recurring Expansion Revenue: This includes any recurring upgrades, add-ons, or expansions of existing subscriptions. Think customers upgrading to a higher-tier plan or adding more users to their account.
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• Revenue Lost from Churn: Not every customer sticks around. This part accounts for the revenue lost when customers cancel their subscriptions.

ARR in action: An example (revisited)

Let's see how the ARR formula applies to our project management software company from earlier. Here’s the same example but now with the formula included:

Initially, their ARR was $1 million. Let's say, before their successful marketing campaign, they earned $1.2 million from subscriptions, had $100,000 in expansion revenue, and lost $300,000 due to churn.

Plugging those numbers into the formula:

ARR = ($1,200,000 + $100,000) - $300,000 = $1,000,000

After their successful marketing campaign, their ARR jumped to $1.5 million. This means they likely increased their subscription revenue and/or expansion revenue, and/or reduced churn.

What ARR does not include

When calculating ARR, it's important to remember that it focuses solely on recurring revenue. This means certain types of income are excluded. Let's take a closer look:

• One-time fees: Think setup fees, onboarding charges, or professional service fees that are only billed once. These don't contribute to the recurring revenue stream, so they're not part of ARR.  
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• Variable revenue: This includes revenue that fluctuates unpredictably, such as usage-based fees or transaction fees. While these can contribute to overall revenue, they don't offer the same level of predictability as recurring subscriptions.
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• Non-recurring add-ons: These are one-off purchases or upgrades that don't happen regularly. For example, a customer might purchase a one-time training session or a specific feature add-on that's not part of their recurring subscription.  

Why exclude these?

ARR's meaning is tied to the stable revenue that comes from subscriptions. By excluding one-time and variable revenue, ARR gives you a clearer picture of a company's long-term financial health.  

Relying on one-time sales to gauge a SaaS company's success can be misleading. ARR provides a more reliable forecast by focusing on the recurring revenue that forms the foundation of the business.

Key benefits of tracking ARR

Let's explore three key advantages of keeping a close eye on this essential metric:

Key benefit 1: Evaluating company growth

ARR is a great tool for evaluating company growth. It helps you gauge revenue increases over time, providing a clear picture of your financial performance. By tracking ARR, you can see whether your revenue is growing, stagnating, or declining. 

This information is crucial for making informed decisions about your business strategy.

ARR also plays a vital role in setting benchmarks for business expansion. If your goal is to double your revenue in the next year, ARR can help you track your progress. It also helps you make necessary adjustments along the way. 

ARR provides a concrete measure of your growth trajectory. As a result, it helps you set realistic goals for future expansion.

Remember: For SaaS companies, ARR is particularly important because it reflects the recurring nature of their revenue streams. 

Unlike one-time sales, recurring subscriptions provide a stable and predictable income source. Tracking ARR helps SaaS businesses understand the long-term health of their business and make better decisions about growth initiatives.

Key benefit 2: Measuring customer retention and expansion

By analyzing ARR trends, you can spot patterns in customer upgrades and downgrades. This information helps you understand the effectiveness of your pricing strategies and identify opportunities to improve customer satisfaction.

Tracking ARR helps you understand the impact of churn on long-term revenue. Churn (the rate at which users cancel their subscriptions) can affect a SaaS company's financial health. By monitoring ARR, you can spot churn trends and take steps to improve customer retention.

ARR can also reveal expansion opportunities within your existing customer base. If you see a trend of customers upgrading their subscriptions or purchasing add-ons, it indicates a potential for growth within your current customer base. 

This knowledge allows you to focus on upselling and cross-selling opportunities — further increasing ARR.

Key benefit 3: Planning for the future

ARR is an integral tool for planning for the future. By forecasting ARR, you can align your revenue projections with your hiring and investment strategies. This approach ensures that you have the resources in place to support your growth trajectory.

Accurate ARR forecasting also helps you make data-driven decisions about product development, marketing, and other strategic initiatives. By seeing your future revenue potential, you can allocate resources and prioritize projects that will drive the most significant growth.

For SaaS companies, ARR's meaning in financial planning is paramount. It provides a solid foundation for making informed decisions about the future of the business. SaaS companies can confidently navigate the path to sustainable growth and long-term success.

ARR vs. other SaaS revenue metrics

Let's compare ARR to a few other SaaS revenue metrics and see how they relate:

ARR vs. Monthly Recurring Revenue (MRR)

ARR's close cousin is MRR, or Monthly Recurring Revenue. As the name suggests, MRR is the predictable monthly revenue from subscriptions. Essentially, ARR provides a big-picture view of your annual recurring revenue. 

MRR offers a more granular look at your monthly performance. You can often calculate ARR by multiplying MRR by 12, but remember to account for any variations in monthly revenue throughout the year.

When to prioritize which:

• ARR: Use ARR for long-term planning, financial forecasting, and investor presentations.
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• MRR: Use MRR for tracking short-term performance, spotting monthly trends, and making quick changes to your strategy.

ARR vs. Customer Lifetime Value (LTV)

Customer Lifetime Value (LTV) is the predicted net profit you'll earn from a customer throughout their entire relationship with your company. ARR focuses on the recurring revenue generated within a year. 

LTV looks at the total revenue generated over a customer's lifetime. Think of it this way: ARR provides a snapshot of your current revenue streams, while LTV helps you understand the long-term value of acquiring and retaining customers.

ARR can also complement LTV by helping you identify trends in customer upgrades and downgrades — which can impact LTV. By tracking ARR alongside LTV, you can gain a better understanding of your revenue generation and customer relationships.

ARR vs. Gross revenue

Gross revenue is the total revenue generated by your firm before deducting expenses. ARR specifically measures recurring subscription revenue. Gross revenue includes all revenue streams, including one-time sales, professional services, and other non-recurring income.

In SaaS, ARR's meaning is closely tied to the long-term success and sustainability of the business. By focusing on recurring revenue, ARR offers a more accurate picture of a SaaS company's growth trajectory and financial stability.

The problem with gross revenue is it can be influenced by various factors that might not reflect the core health of a SaaS company.

Common challenges with ARR in SaaS you should know about

Let's look at some hurdles SaaS companies might encounter when working with ARR:

Hybrid and freemium models

Calculating ARR can get tricky when dealing with hybrid or freemium pricing models. Let’s take a closer look at why:

• Hybrid models: These models often combine recurring subscriptions with one-time purchases or usage-based fees. It's important to accurately separate recurring revenue from other income streams to avoid inflating ARR.  
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• Freemium models: These models offer a free basic plan alongside paid premium plans. The challenge lies in determining how to account for free users who might eventually convert to paying customers.

It's key to develop a consistent methodology for calculating ARR in these situations. For example, one approach could be focusing on the ARR generated from paid plans only.  

Over-reliance on ARR for short-term decisions

Relying solely on ARR for short-term decision-making can be risky because it doesn’t always reflect immediate revenue changes. ARR provides a high-level overview of your annual recurring revenue, but sudden fluctuations in MRR might take time to show up in ARR calculations.

For example, losing $10,000 in MRR one month reduces ARR by $120,000 on an annualized basis, but if ARR is calculated quarterly or based on fixed annual contracts, this loss might not show up until later. That delay can mask short-term issues.

To avoid this, track additional metrics like MRR and churn rate alongside ARR to get a more accurate and timely view of your business performance.

Misaligned Customer Acquisition Costs (CAC)

High customer acquisition costs can eat into your ARR growth. If you're spending more to acquire customers than the revenue they generate, your ARR growth might be unsustainable.  

It's crucial to keep a close eye on your CAC and confirm it aligns with your ARR growth goals. If your CAC is too high, you might need to re-evaluate your marketing strategies or pricing models to improve your customer acquisition efficiency.

How Orb can help you manage your SaaS company’s ARR

We've explained ARR's meaning and why it's essential for SaaS success. To effectively track and manage your ARR, you need the right tools in place. 

That's where Orb comes into the frame. 

Orb is a done-for-you billing platform. We can help you simplify billing and invoicing, optimize pricing strategies, and improve customer engagement—all of which contribute to a healthy ARR.

Orb empowers you to:

• Gain accurate insights: Track and analyze your ARR in real-time with detailed reports and dashboards. Get a much clearer understanding of your revenue streams.
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• Optimize pricing: Experiment with various pricing models. Think usage-based pricing, tiered subscriptions, and more. We help you find the optimal strategy for maximizing ARR.
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• Boost customer retention: Identify at-risk customers early through usage monitoring. Then, you can proactively address churn to stabilize and grow your ARR.
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• Streamline billing operations: Automate recurring billing, invoice generation, and payment processing. Doing so can free up your team to focus on broader strategic initiatives.

Orb’s role and features for managing ARR in SaaS

Here's how Orb helps you achieve the goals we mentioned above:

• Real-time revenue recognition: Orb ensures accurate revenue recognition, even with complex pricing models. We help by automatically tracking all revenue components. You can keep accurate financial records and comply with ASC 606 standards with Orb’s help. 
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• Flexible pricing models: Orb supports a variety of pricing models, including usage-based pricing. Thanks to Orb's adaptability, you can tailor your pricing strategy to different customer segments and maximize revenue potential.
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• Proactive churn management: Orb's usage tracking capabilities help you find at-risk customers early on. This way, you can jump into action quickly and take steps to prevent churn and boost customer retention.
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• Automated billing and invoicing: Orb automates recurring billing and invoicing processes. We help SaaS companies reduce manual effort and guarantee timely and accurate billing.
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• Improved customer engagement: Orb provides self-service portals. We also offer clear, detailed invoices. These two elements empower SaaS customers to manage their subscriptions and understand their billing with more clarity. 

Ready to take control of your SaaS company's ARR? Consult our flexible pricing options to find a plan that fits your budget and overarching business goals.