The ARR formula is simple and will show you how to calculate your ARR: ARR = (Overall Subscription Cost Per Year + Recurring Revenue From Add-ons or Upgrades) – Revenue Lost from Cancellations.
ARR is an acronym for Annual Recurring Revenue, and it’s also a metric for subscriptions companies (SaaS). We’ve discussed ARR elsewhere, but suffice it to say that Annual Recurring Revenue calculations are important to your subscriptions business. It allows you to determine how well your company is doing, because it lets you see the value of your recurring revenue normalized over a year.
Typically, you only include fixed subscription fees in your calculations for your Annual Recurring Revenue (ARR). You’re determining those committed costs that are recurring. So, if your customer pays one-time fees for training or other service, you exclude those costs from your ARR. You also exclude any costs that fall outside that 12-month period, and you don’t count the fees that are not contractually guaranteed for the 12-month period of time.
For example, if the 3-year contract includes $56,000, but $20,000 of that cost is for other services and fees related to the subscription service, you only count the $36,000 when you look at the ARR. So, you are looking at $36,000 divided by 3 years, which you calculate at $12,000 for your ARR.
If your customer is contracted to pay $200 every month for 12 months, your ARR would be $24,000, excluding any one-time sign-up fees, or other professional service fees. The ARR is a way of measuring the revenue that you can reasonably expect to earn on an annual basis, based on the agreements that you’ve put into place with your customers. So, if your subscription service renews every month, you can only include the value for a subscription that is contractually obligated over the 12-month period. (That means, you just would not count that month-by-month subscription in your ARR.)
It can be a little confusing when you calculate your ARR, since you also may have upgrades or add-ons that you offer to your customers. For example, a customer started out with a single-user account, but then switched to a multi-user account, so the ARR does take into consideration that higher subscription rate for the annual calculation. Again, though, that value is taken into consideration when it is raked up on an annual basis. It must affect the annual subscription price your customer contractually agrees to pay.
It would be awesome if you never experienced any downgrades for your subscription service. That means a loss of revenue, but downgrades do happen, and you need to factor them into your ARR, when the downgrade is a change to the annual contract. Similarly, some customers may cancel their contract for whatever reason, and you also must take those cancellation numbers into consideration when you determine your ARR.
If it’s just one person looking at revenue and long-term projections, you can wrangle the numbers any way you want. When you start calculating the ARR and sharing those numbers with your partners, investors, and other key financial considerations in your company, you must make sure that you’re including the correct set of numbers in your calculations. If you’re including professional fees, training, or other monthly surcharges in your calculation, you’re contributing to a confusing and overzealous outlook on your company. It might look like your ARR is substantially higher than it really is. A false sense of the health of your SaaS company can lead you and your partners, investors, or other key personnel to make decisions and investments based on perceptions of positive growth projections.
Your accurate calculation of the ARR can also, conversely, tell you important details, even if your calculation is not as positive as you’d like to see. If your ARR is atrocious, at least you know that. By accurately calculating your ARR based on your current contractual subscriptions, you can take the next step to determine what you need to do to grow your business. If you determine that you need to double your subscription accounts that are under contract, for example, what steps do you need to take to make that happen?
You’ve got a contract in place with your customers, and that’s how you’re determining your ARR, but a very important part of that contract is your Terms & Conditions. You’re clearly stating what rules and conditions your customers must follow in order to use your service, but you can also include terms about when the customer can cancel or how the contractual agreement is handled. A month-to-month subscription can be a benefit and even a promotional draw for some customers, because they want to feel like they are not going to be tied to something that they don’t want or need for a long period of time. It’s that “cancel anytime” promotional blurb. You may want to test it out or use it as a special promo to draw in more subscription accounts, but “cancel anytime” accounts just don’t factor into your ARR calculations. With those terms, you really don’t have a metric to judge how long your customers will be subscribers. They could cancel anytime. That’s still not a guarantee that they will cancel, so the impetus is on you to help your customers to feel like the service is needed, of value, and a good investment. Of course, that focus should be something you’re helping your customers to see on a regular basis, even if they are contractually obligated to be a subscriber for a year, two years or beyond.
Yes, the ARR offers a good overview of your company’s health, but it does more than that. It allows you to make decisions about growth and changes to your company and your service offerings. If your ARR is stagnant or is showing slow growth, maybe it’s time to look at what you’re offering. If what you’re doing right now is not getting you the results you want and need—as demonstrated by your ARR calculation—what do you need to do in the coming days, months and years to inspire growth and excitement around your subscription service? One of the biggest factors in growth really is tapping into your existing customer base via referral generation.
Your customers already know you, and they love your services. When was the last time you asked your customers to share their great experience? Statistically, 83% of your satisfied customers would refer other customers to you and your services, but only 29% actually follow through. But, that’s really on you. Did you ever ask? If you never ask your most loyal customers for a referral, you really have no idea what the results will be. Just a few referrals from each customer could make a dramatic difference in your ARR.