The definition of ARR seems to have become a point of friction between startups and VCs over the past couple of years, but why?
The root of this friction probably began with a change in how the typical SaaS business bills its customers. While the first generation of SaaS companies (Marketo, Pardot, Workday, etc) might have typically charged annually (or multi-year), the second (Zendesk, Intercom, MailChimp, etc) and current generation (Notion, Zoom, ChartMogul, etc) embraced monthly billing as standard.
This shift means your typical SaaS startup (launched in the last ~8 years) makes the majority of their revenues from month-to-month subscriptions.
This “mostly-monthly” approach has rendered the traditional meaning of ARR, “Annual Recurring Revenue,” almost meaningless for these companies.
What is Annual Recurring Revenue?
ARR originally stood for “Annual Recurring Revenue,” which had a rather strict definition of only looking at recurring contracts with a service length of one year or more (and discarding everything else).
Annual Recurring Revenue is calculated by dividing any multi-year contracts by the number of years in each contract and adding those to the value of all the annual contracts. Any contract less than 12 months in length should be excluded from this definition of ARR.
Annual Recurring Revenue is a helpful metric if your business makes the vast majority of its revenues from annual or multi-year contracts. Annual Recurring Revenues are contracted revenues, so there is a high level of certainty that this money will be collected.
However, for many modern SaaS companies this isn’t a very relevant metric if the majority of revenues are from monthly contracts. There’s just not a whole lot of point in talking about Annual Recurring Revenue if only 20% or 40% of your revenues are from annual contracts.
Enter Annualized Run Rate, a different metric, calculated in a different way, but with the same acronym 🤯. Bear with me…
What is Annualized Run Rate?
Annualized Run Rate, (or Annualised Run Rate for those who prefer British English) is a way of annualizing a company’s revenue run rate. In SaaS this is generally done by taking the MRR and multiplying it by 12.
Hence, Annualized Run Rate (ARR) = MRR * 12.
It’s often also referred to as simply “Annual Run Rate”, or lengthened to “Annualized Revenue Run Rate”.
For most modern SaaS companies whose revenue mix consists mostly of monthly subscriptions, this definition of ARR is much more meaningful, because it takes into account all of their recurring revenues.
Looking at your annualized revenue run rate is helpful for decision making. It’s hard to think about $416,667 of MRR, what does that buy you? Convert that into ARR and you have $5M in forward looking recurring revenues ($5M ARR), a much easier number to think about when planning and talking about your business both internally and externally.
Relying on Annualized Run Rate does have its negatives however, which I’ll talk about further down.
Annualized Run Rate is winning the acronym battle
Due to the fact that most SaaS companies have a big chunk of their revenues from monthly subscriptions, Annualized Run Rate has naturally become the more popular metrics in recent years, and therefore the more popular usage of ARR today. This was also probably helped by Subscription Analytics companies like ChartMogul baking that metric and definition of ARR into their products.
It’s not just startups doing this, Zendesk defines ARR this way in their investor reports “Zendesk determines the annual recurring revenue value of a contract by multiplying the monthly recurring revenue for such contract by twelve.”
Why do some VCs object to ARR being used to mean Annualized Run Rate?
The industry is moving in a different direction.
I think the dislike is twofold: (1) many VCs came up when ARR only meant Annual Recurring Revenue, and it now creates confusion for them when comparing companies to have two metrics sharing the same acronym. So they end up comparing apples to oranges so to speak.
(2) The more legitimate reason for disliking Annualized Run Rate is because it’s started being abused, e.g. it’s used by subscription companies with high monthly churn, such that the declared ARR will never actually materialize, because the average customer will cancel before 12 months of fees will ever be collected (and this can be obfuscated by the layering on of new customers down the line). Worse still it’s also been used by transactional businesses who don’t sell subscriptions at all to inflate their revenue number and sound more “SaaSy”, e.g. by taking their most recent “best” month of sales and multiplying it by 12.
I would argue that Annualized Run Rate should only be relied on when a company has net negative churn (Jason Lemkin seems to have concluded the same), because only then will a company actually collect the ‘claimed’ ARR. Anything below negative churn and they won’t actually collect MRR x 12 from their existing customers.
We should all listen to Matt Quinn, just clarify what definition of ARR you’re using and all will be fine:
In the ChartMogul app, ARR is defined as Annual(ized) Run Rate, MRR x 12. This is the most popular meaning of ARR, and the most broadly useful one today.
I hope that clears things up, two metrics, one acronym.
$83,334 MRR * 12 to the moon 🚀🌑 ;-)