👋 Hi, it’s CJ Gustafson and welcome to Mostly Metrics, my weekly newsletter where I unpack how the world’s best CFOs and business experts use metrics to make better decisions.
ARR (Annual Recurring Revenue) is like a living, breathing organism. Let’s get into the anatomy lesson.
What you’ll learn:
How ARR goes up
How ARR goes down
Red flags to watch out for
How to build your own waterfall (with template)
OMG there’s so much ARR in here
Your ARR moves every day. It’s because of all the underlying dynamics of customers joining, upgrading, canceling, or downgrading. You can break down your ARR movements into:
ARR Gained Components
New Business:
A net new logo
Expansion:
Upgrade plan
Increase usage
Add new products
Raise prices (lol, my fav!)
Reactivation:
Come back from the dead, in a full, partial, or larger capacity than before
ARR Lost Components
Contraction:
Less licenses
Less usage
Get rid of some, but not all products
Price decrease (yea right!)
Churn:
Customer leaves entirely
What to watch out for:
Not fully understanding contraction
This is also called “shrink”. If you are in a subscription based business, it will be more obvious when customers decrease their license counts upon renewal. But if you are in a usage based business, you’ll have to peel out which parts of contraction are due to a degradation in the customer’s underlying health vs what parts are due to normal seasonality. For example, Snowflake, a usage based company, always sees a contraction in usage during the holidays when people are not at their desks querying their data lakes.
Whenever someone says “Data Lake” I think of Lake Lucerne in Switzerland. What lake do you think of?!
Another red flag is if customers stay at the same overall total ARR value with your company but ctrl + alt + delete one of the products they currently hold for a net new one. If your company sells, say, five products, customers may only have room in their budget for at most three, and will pick the three most critical out of the bunch. You should note which of your products get cannibalized for others.
This is always a hard one to look at - it’s difficult to admit that not all your kids are equally your favorite. But customers speak with their feet.
Over indexing on price increases
The easiest way to increase the expansion bucket is to hike up prices over time. The only issue is this is more of a temporary lever. After a while, you are bleeding a stone. There’s a natural ceiling on how much someone will realistically pay for an Asana license.
You should track how much of your expansion year-to-year is derived from price increases vs customers actually buying more of your stuff. I’ve seen companies get overly enamored with their expansion success, only to later realize that it was a fleeting moment with limited runway.
Consistent reactivation
“Guess who’s back, back again”
-Eminem / Customer who churns and comes back for the fifth consecutive quarter
An unintended consequence of how a product is priced and packaged vs how consumers use it is what I’ll call “consistent reactivators.”
The easiest example I can think of is the ten times I’ve churned and came back from LinkedIn Sales Navigator. Another example could be when your marketing team churns and reactivates from an online webinar platform or automated email software, making sure to only pay during times there are specific events.
You’ll notice this funny thing in monthly (vs annual) subscription businesses or free-to-use usage products (like interchange rate arbitrage payment products) where you can count on a “reactivation engine” for a pretty predictable number of customers each period.
For example, you may have 10,000 monthly active users (MAUs) and 1,000 of them are consistently previous customers who have used within the last six months, but not in the last month.
This tells you that you’re sorta sticky and top of mind, but probably an event driven point solution and not a core component of day to day operations.
Below is the “classic” ARR bridge that you’ll see investors put into their decks. Here’s a template for all those trying to build their own ARR waterfall:
As a final sanity check, you should be able to “run” all your ARR out to a natural point in which it collides with GAAP revenue. If the gap (not GAAP, lol) just keeps getting bigger, then there’s an alligator in your model and you’re taking credit for more than you should.
