If you want to trick investors, tell them about your CARR

👋 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.

So if you take the exit year’s value for all my multi year deals, and ignore any first year discounting, I’m really like a $10 million dollar business.

What is CARR? It stands for Contracted Annual Recurring Revenue.

You see, in software land, you can sell multi year contracts. And the first year may not be the same value as, say, the third year.

Many companies will claim the larger, exit year Contracted ARR (CARR) as ARR. However, CARR will not track to current period GAAP revenue or billings.

Why does this disconnect exist in the first place? There are a few reasons:

First year discounting: You offer a customer 25% off in the first year, and then return to the base price for the out years, decreasing the revenue you actually get in year one.
License ramp: You negotiate for the contract to increase in license count over time, with the objective of aligning to the customer’s anticipated headcount growth, hence increasing the revenue you get in the out years.
Embedded price increases: You add in a lever for inflation that kicks in during subsequent years, increasing future contracted revenue.

The net effect of all this is it creates a perverse incentive to quote the largest annual total of the bunch. It effectively overstates the amount of business you will actually collect cash on in the current year, as well as the actual GAAP revenue you’ll record and track to.

Buuuuuuut… it makes you look better than you are at the moment! Which is why companies who fundraise often do it. It increases both the total annual recurring revenue you can tell investors about, and it artificially boosts your year-over-year growth rate. You look all dolled up for the fundraising gala.

Now, CARR can be useful in the sense that it essentially shows you the revenue you’ve de-risked down the line. But savvy accountants would argue that you can just get that from RPO (Revenue Performance Obligation) and cut the crap. Speaking of that…

RPO

Source: Snowflake Second Quarter Fiscal 2024

For all those unfamiliar with this space man term, 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.

For a 3 year contract you’d have 12 months in deferred revenue and 36 months in RPO. Of the 36 months, 12 months 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.