Annual Recurring Revenue (ARR) is a financial metric used by SaaS and subscription-based businesses to measure the predictable revenue generated from subscription contracts normalized to a 12-month period. It represents the value of the recurring revenue components of a company's term subscriptions.
Calculating ARR
The basic formula for ARR is:
ARR = (Total Subscription Value / Subscription Term in Years)
For example:
- A $12,000 contract for 12 months = $12,000 ARR
- A $30,000 contract for 24 months = $15,000 ARR
Components of ARR
- New ARR: Revenue from new customers
- Expansion ARR: Additional revenue from existing customers (upsells, cross-sells)
- Contraction ARR: Reduction in revenue due to downgrades
- Churned ARR: Lost revenue from canceled subscriptions
- Net New ARR: New ARR + Expansion ARR - Contraction ARR - Churned ARR
Why ARR matters
- Predictability: Provides visibility into future revenue streams
- Growth tracking: Year-over-year ARR growth is a key indicator of business health
- Valuation impact: SaaS companies are often valued as a multiple of ARR
- Cash flow planning: Enables more accurate financial forecasting
- Investor confidence: High and growing ARR attracts investment
ARR best practices
- Exclude one-time fees: Setup fees, consulting, or professional services should not be included
- Track movements: Monitor the components of ARR to understand business dynamics
- Segment analysis: Break down ARR by customer segments, product lines, or regions
- Benchmarking: Compare growth rates against industry standards (e.g., T2D3 - triple, triple, double, double, double)
ARR is one of the most important metrics for subscription businesses, providing a normalized view of recurring revenue performance that enables strategic planning and investor communications.
