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What is ARR in SaaS: Importance, Calculation, and Impact on Growth

by 

Lauren O'Bryan

Last updated: September 9th, 2024

In B2B SaaS, understanding the financial health and growth potential of your business is crucial for success. A key metric that provides valuable insights is Annual Recurring Revenue, but what exactly is ARR and why is it so important?

Let’s delve into the fundamentals of ARR, explain how to calculate it, and uncover just why it’s so important in B2B SaaS. We’ll also give you some helpful pointers that you can take away and actionable steps to improve your ARR, so let’s dive in.

What is ARR?

ARR, which stands for Annual Recurring Revenue, measures the yearly revenue a business can expect from its recurring subscriptions. It’s particularly important for SaaS businesses that use recurring subscription-based billing methods, as it provides insights into the predictability and stability of their revenue streams.

Different Types of ARR

To calculate your ARR, you must know the four main types of ARR metrics:

• Gross ARR: The total annual recurring revenue before accounting for cancellations and discounts.
• Expansion ARR: This incorporates the additional revenue generated from upsells and upgrades. It reflects an increase in revenue from existing customers.
• New ARR: The revenue generated from customers who have recently subscribed. This can show improvements in customer acquisition.
• Churn ARR: This measures the ARR lost due to canceled subscriptions.

ARR vs MRR

Both ARR and MRR are used to measure recurring revenue, but MRR is measured monthly. Because MRR is a short-term metric, it’s best used for monitoring and making quick adjustments to new campaigns, whereas ARR is better for making strategic decisions and long-term business forecasting.

Why ARR is an Important Metric for SaaS

B2B SaaS businesses often use subscription payment systems that run over a long period of time, which can make financial planning difficult. ARR comes to the rescue by providing a clear picture of long-term financial outcomes.

Another benefit of monitoring ARR is that companies can track growth over time, assess customer acquisition and retention effectiveness, and evaluate expansion strategies. ARR has always been a metric assessed by investors when they are considering a company’s growth potential and its ability to generate consistent revenue. In addition to early-stage funding, ARR is also important for Series B and later rounds of funding.

How to Calculate ARR

ARR is calculated by adding up the value of all recurring revenue generated by all active subscriptions within a year and subtracting the losses due to cancellations or downgrades. The formula looks something like this:

ARR = Total Annual Subscriptions + Annualized Monthly Subscriptions + any Add-Ons or Upgrades − Cancellations

The total annual subscriptions are the total revenue from subscriptions that are billed annually and the annualized monthly subscriptions are the monthly subscription revenue multiplied by 12. If you have any add-on packages or upgrades, include this as well, and then subtract the amount lost from canceled subscriptions.

For example, a SaaS company that has an annual subscription cost of $1,200 and a monthly subscription of $110 will calculate their ARR like this:

1. 20 customers with annual plans = $24,000 per year
2. 50 customers with monthly plans, multiplied by 12 = $66,000 per year
3. 2 annual plans were canceled to the value of $2,400
4. 7 monthly subscribers canceled to the value of $9,240

Therefore, the calculation will be (A + B) – (C + D) or ($90,000) – ($11,640) = $78,360 ARR

When talking about ARR you will also hear the term ARR growth rate, which is an equally important metric. To calculate the ARR growth rate, subtract the previous year’s ARR from the current ARR and then divide that by the previous ARR. This will give you the ARR growth rate as a percentage.

ARR Benchmarks: What is a Good ARR for SaaS?

In B2B SaaS, a good ARR is often evaluated using the Rule of 40. The Rule of 40 indicates that a healthy and profitable business should have a combined ARR growth rate and profit margin that exceeds 40%. Increasing ARR year over year is a sign that a SaaS has a good product-market fit and is a safe investment.

According to MetricHQ, the median YoY ARR growth rate for companies earning 1-5M yearly is 52% – 59%. For SaaS companies earning 5-15M yearly, the median YoY ARR growth rate is between 46% and 55%.

Another growth model that many SaaS startups aim to align with is T2D3. The goal is to triple ARR for two consecutive years and double ARR for the next three years. This kind of growth skyrockets a business to $100M ARR. However, most SaaS startups take over two years to make $1M ARR. High-achieving SaaS startups, on the other hand, could reach that figure within as little as 9 months.

Of course, the more competitive your market is, the higher your growth rates may need to be to remain profitable and competitive.

How ARR Impacts Business Strategy and Planning

ARR allows both growing and established SaaS businesses to assess their financial health and growth potential, helping them make crucial strategic decisions.

Performance and Optimization

ARR growth directly indicates how well a business scales operations, acquires new customers, and retains existing customers. By monitoring ARR, businesses can better understand customer retention rates and the impact of customer churn. These insights help develop strategies to reduce churn, enhance retention, and optimize marketing efforts.

Forecasting and Growth Planning

Accurate funnel forecasting is essential to making smart budget decisions. Understanding long-term revenue helps businesses manage cash flow, invest in growth initiatives with confidence, and make informed decisions about hiring new staff, launching additional products, adapting pricing strategies, and creating new marketing campaigns.

Investor Relationships and Funding

When investors evaluate funding decisions or check in on a portfolio company, the first thing they want to see is the ARR. A higher ARR indicates a stable and scalable business model, which means their investment is secure.

The Limitations of ARR for B2B SaaS

One thing to remember is that although ARR is a very useful metric and highly regarded by SaaS businesses and investors alike, it does have some limitations.

It revolves around financial growth but doesn’t indicate the efficiency of operations or any other aspect of business health. Similarly, while subscription cancellations can indicate retention issues, they don’t offer a complete picture of underlying problems. To gain a comprehensive understanding, you’ll have to look at other metrics like customer churn rate, expansion revenue, or CAC. Analyzing your business data more closely will help you pinpoint exactly where problems stem from.

Actionable Steps to Improve ARR

If you’re wondering what you can do to improve ARR, here are some actionable steps that any B2B SaaS can implement.

1. Enhance customer acquisition: Improve audience targeting and customer acquisition to reduce the cost of customer acquisition and increase returns and revenue. A good starting place is looking at inefficiencies in your marketing funnel. Boosting the efficiency of your marketing funnel will improve the quality of the customers you attract.
2. Enhance customer retention: If subscription cancelations are high, then it’s time to look at solutions to enhance customer retention. Typically, these solutions include improving onboarding and customer support. Better onboarding and customer support will prevent customers from hitting roadblocks that might lead to frustrations with your product. A smart way to assess customer churn is to use predictive analytics to identify at-risk customers based on behavior and engagement levels. Developing email sequences for different customer segments is a great way to be proactive about lead nurturing and preventing churn.
3. Increase revenue per customer: Increasing the average revenue per user is another strategy to improve ARR. To do this, explore upselling and cross-selling opportunities, implement loyalty programs, and offer tiered pricing plans with additional features or benefits for a higher price tag. Additionally, train your sales and customer success teams to recognize high-value customers.
4. Optimize user experience: Prioritize improving your product’s user experience. You can do this using customer feedback, a competitor analysis, or market trends. Focus on adding features that provide significant value to your customers or make it easier to navigate the platform. A more intuitive and user-friendly product can lead to higher customer satisfaction and retention rates.
5. Improve brand awareness and customer loyalty: Optimize your content marketing to align with your marketing funnel and the buyer awareness matrix. This will result in content directly focused on user intent and more effective at grabbing attention and building customer relationships. You can also use customer testimonials and case studies to build credibility and showcase the success of your product. A strong brand can attract more customers and build trust.

Case Study: How We Increased ARR for Structure Studios

When Structure Studios approached us, they were experiencing slow business growth despite offering an innovative solution to landscaping contractors. We worked with them to supercharge growth and raised millions in ARR.

We got straight to work with our Predictable Growth Methodology and identified that the problem boiled down to haphazard marketing without a clearly defined strategy. They didn’t have content targeting leads who are interested but not yet ready to buy – those at the top and middle of the funnel. The solution for Structure Studios revolved around improving customer acquisition and building brand awareness.

So, we focused on improving content marketing quality to better match user search intent and target customer pain points more clearly. We also improved the content offers for middle and top-of-the-funnel leads by including a landing page with video testimonials promoting the benefits of the software. These efforts paid off, and they ended up landing number 1 for their target keyword within 90 days. All these tactics combined created a powerful demand generation that brought in a cycle of new qualified prospects and increased ARR by 50%.

If you want to know more about our content marketing or other services, don’t hesitate to get in touch.

Wrapping Up

Now that you have all the facts about Annual Recurring Revenue (ARR) and how to calculate it, you can assess its impact on your business and strategize for long-term success.

But ARR is just one piece of the puzzle. To scale and optimize your business growth, you need additional insights. Take our easy, free SaaS scalability score self-assessment to understand how scalable your business is in its current state.

FAQs

What is Annual Recurring Revenue (ARR)?

Annual Recurring Revenue (ARR) represents a business’s total yearly revenue from subscription-based services. This metric factors in all subscription-based income from plans, upgrades, and add-ons while removing any subscription cancellations from the total.

How is ARR Calculated?

ARR is calculated by adding up all income over a 12-month period from subscriptions (both annual and monthly), plan upgrades, and add-on packages. Subscription cancellations are then subtracted from that total to give the current ARR.

Why is ARR an Important Metric for SaaS Businesses?

For one, it allows businesses to easily assess the financial health and profitability of their SaaS, which results in accurate funnel forecasting and good budget decisions. Additionally, ARR is a key indicator for investors assessing long-term business viability and profitability, often influencing funding decisions.

What Methods Will Enhance ARR Growth?

Some methods to improve ARR include optimizing content marketing tactics, improving customer acquisition and retention rates, and fine-tuning revenue opportunities per customer.

How Does ARR Impact Business Forecasting?

ARR assists business forecasting by providing a predictable and stable measure of recurring revenue. It helps identify trends in customer retention, growth, and churn, enabling better strategic planning. Consequently, ARR aids in setting realistic revenue targets and budgeting decisions, which are essential for long-term business success.