Your Complete Guide to ARR
Your Complete Guide to ARR
The must-know revenue terms, metrics, and how to build ARR waterfall
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In the meantime, here’s a spicy guest post I did for my friend - a brilliant data scientist who writes the Data Analysis Journal. As someone who runs a BI team, it’s my go to for data based decision making. I encourage you to subscribe.
I was honored when Olga asked me to give you a lesson on the only language I speak other than English - Annual Recurring Revenue.
As a CFO at a tech company, most of what I do translates into some impact on our topline, which we measure as ARR.
ARR is powerful because it’s essentially an annuity stream the company gets to count on, as long as they don’t churn the customer.
And that brings me to my first major point - why not all Revenue is equally valuable…
Not all revenue is created equal
Not to throw anyone under the bus specifically, but it’s the Wild West these days on FinTwit (that’s finance Twitter, for those not talking LTV to CAC on weekends). Pop in, and you’ll see online marketplaces calling their GMV “Revenue” and service-based businesses calling their one-time Revenue “ARR”. Your aunt’s quilt business does not fall under ARR.
So, let’s set the record straight.
1/ Revenue
This is a GAAP or accounting-based view of topline. GAAP stands for "Generally Accepted Accounting Principles", which is like the super official handbook for bean counters.
Revenue gets spread out, or accrued, to match the delivery of the product or service. In SaaS, total Revenue will usually trail total ARR and total Billings as it gets accrued over time. You’ll see in the example below.
2/ Deferred Revenue
This is the opposite of accrued revenue and largely a balance sheet and cash flow item. It accounts for money that’s been prepaid for goods or services that have yet to be delivered. For example, in a 12-month SaaS contract, in month 4 there would be 8 months of deferred revenue left as a liability on the balance sheet. That means you received the money, but are still on the hook for the follow through.
3/ Remaining Performance Obligation (RPO)
RPO is all unrecognized contracted revenue. Deferred revenue goes out at most 12 months, so RPO was created to extend even further to capture all of a multi-year commitment. It includes both Deferred Revenue and any unbilled portion of a multi-year contract.
OK, let’s simplify that a bit - RPO is the future revenue customer’s have promised to give you, and is important for companies who sell their stuff in multi year contracts. RPO is a way to demonstrate you are de-risking the future.
For a 3-year contract, you’d have 12 months in deferred revenue and 36 months in RPO. Of the 36 months, 12 would be current RPO, and 24 months would be non-current RPO.
RPO is not a GAAP number and, therefore, does not appear on the balance sheet. Instead, companies report it in the Revenue from Contracts with Customers section of their public filings to make sure they get “credit”.
It’s really popular for consumption-based businesses where customers pre-pay or commit to lots of usage.
A 3-year SaaS deal in action
4/ Gross Merchandise Value (GMV)
Commonly used for marketplaces (Etsy) and payment gateways (Stripe) that charge a fee or take rate. GMV is not a true reflection of a company's revenues, but rather its through-put, as most of the revenue goes to the original seller.
5/ Annual Recurring Revenue (ARR)
ARR represents the annualized revenue run rate of all committed subscription contracts as of the measurement date. It assumes all contracts that expire during the next 12 months are renewed with existing terms.
Public service announcement:
1x purchases are not ARR.
Consulting services are not ARR.
Most ecommerce is not ARR.
Another, more nuanced, mistake is using the final year of a multi year contract, instead of the current year. Multi-year contracts with deep first-year discounting or volume ramps over time will drive deltas between the first and last year's ARR.
Many companies will claim the larger, exit year Contracted ARR (CARR) as ARR. But CARR will not track to current period GAAP revenue or billings.
Speaking of that…
If you want to trick investors, tell them about your CARR
What is CARR? It stands for Contracted Annual Recurring Revenue.