The most ambiguous term in startup land
A couple of weeks ago, I caught myself in a meeting using the wrong definition of ARR. I called it Annual Recurring Revenue instead of Annual Run Rate. And the reality is that most people aren’t that familiar with the correct definitions of ARR and MRR (Monthly Recurring Revenue), and other related metrics such as collections or bookings.
Just have a look at the most popular searches on Google on MRR:
As we do a small session on this topic with most of our SaaS startups in their early days, I decided to write a post about it. Enjoy!
What is the difference between ARR and MRR?
The critical difference is that ARR is a forward-looking metric, and MRR is not. ARR projects your revenue over the next 12 months based on the Monthly Recurring Revenue (MRR) you have today. It is as simple as ARR = 12 x MRR. But here is the trick. While the definition of MRR is Monthly Recurring Revenue, ARR does NOT mean Annual Recurring Revenue.
There is, of course, always an exception to the rule. If you sell monthly contracts or a mix of monthly and annual contracts, you use the definitions of MRR and ARR as described above. But, if a company would ONLY sell annual contracts (which I have personally never seen...), you could theoretically use the definition of Annual Recurring Revenue for ARR.
I am a big proponent of consistency, so I suggest you stick to the first definition that applies to 99% of subs businesses. The way I calculate MRR and ARR is as follows. If you sell an annual subscription deal, just divide it by 12 for the purpose of 'monthly recurring'. Using Annual Recurring Revenue for all customers would be wrong because you have monthly deals that may churn in the next twelve months. Therefore, to calculate your ARR, take your MRR every month and multiply it by 12. However, as annual plans are a sign of strength and have a clear positive impact on a company's financial health (see here my post on this topic), founders should always cite the % mix of monthly vs annual plans (see this post about what is considered a good mix).
Also, MRR calculation should only include the true recurring revenue that your business is generating. Therefore, you should include discounts and custom deals in your MRR. Without it, you won’t have a full view of how your company is doing. If a customer is going to be paying EUR 100/mo for the first 3 months and then switch to paying EUR 500/mo after that, then those are the numbers that should go in your MRR. One-off consulting and setup fees are excluded from the MRR calculation.
Finally, customers change their subscriptions over time and this impacts MRR in different ways. They can buy new features (new MRR), upgrade to a more expensive plan (upsell MRR), downgrade to a cheaper plan (contracted MRR), reactivate an expired subscription (reactivated MRR), or cancel altogether (churned MRR). It is crucial that we track these 5 MRR movements early on. It allows us to focus on different segments (customer types, geographies, etc.), understand what is driving their behavior, and where to focus on to grow.
For SaaS founders, MRR is their north star metric after their first 12 months or so in business. The other kick-ass metric, especially when it comes to growth, is the magic number (read here to learn more about it). They reflect everything about your company - strategic decisions that have been taken, hiring, and even culture.
Why is ARR such an important metric?
Because ARR and ARR Growth drive the valuation of private SaaS companies. These two pieces of data will get you 75% of the way to an answer regarding what your business can be worth. Three or four internal metrics that we will cover in another post get you the rest of the way there. In private markets, high growth SaaS companies are priced based on a multiple of their ARR. And private market investors look at what multiples public market investors pay. This is especially true for later-stage companies. Early-stage multiples usually get discounted because of the higher risk. It is important to stress out though that this approach is not entirely accurate, but serves more as a guideline. Public market investors use a slightly different metric to measure the topline of SaaS businesses. They look at NTM (next twelve months) revenue multiples, summing the revenue over the next twelve months or LTM (last twelve months) adding revenue over the last twelve months. The Nasdaq cloud index with regularly updated metrics of public SaaS companies is a great resource for benchmarks.
Let's have a look at the evolution of public B2B SaaS markets. The emergence of the subscription model has made the software business so much better. Think about it. In the old upfront license fee model, public software companies would trade at 2-4x revenues. Now they trade at >10x revenues!
ARR Growth is the other key driver of SaaS valuations. In the chart below, high growth is considered >30% projected NTM growth, mid growth 15%-30%, and low growth <15%. The impact on multiples is huge. So, make sure to pick the right timing to go fundraising...
Finally, ARR multiples tend to be higher in the private B2C SaaS space vs. B2B, mainly because once a consumer product hits product-market fit and some mass appeal, growth can be much higher.
Ok, but what about collections and bookings?
The second most ambiguous terms, only bested by ARR, are probably collections and bookings. Let's have a look.
Subscriptions can be paid monthly or annually, most often at the beginning of the period. So, cash comes in before most of the revenue is recognized. This cash represents collections.
Bookings are the amount of money customers have committed to spend with the business. In most cases, they did not pay yet but will do so over the length of their contract. The sum of total future spend is booked in the month a customer signs a contract but not recognized yet as revenues as the customer did not pay yet. Companies with only twelve-month contracts can report ACV Bookings (Annual Contract Value). Companies with other contract lengths, both shorter and longer, report TCV Bookings (Total Contract Value). Ideally, startups normalize TCV into an annual number to report ACV to be more transparent.
Let's put all of this in a mixer and illustrate with an example (see here for more details). Imagine a B2B SaaS company that sold a three-year contract of EUR 36k paid quarterly in advance. In the first month, the bookings (equal to the TCV) coming from that customer are EUR 36k, the ACV is EUR 12k, MRR of that customers is EUR 1k, the ARR is EUR 12k, and cash collections (coming in the first month of every quarter) are EUR 3k.
It is precisely this visibility into the future months of revenues that makes companies with subscription-based revenue models great public companies. These metrics are tricky, so please feel free to reach out in the comments section below or on Qoorio.
Last week, we held our first-ever virtual shareholder meeting. Covid-19 forced us to replace an awesome in-person event we had planned for a long time with our entrepreneurs and shareholders in Barcelona earlier this year.
But, despite the challenges to equip and sync online with our friends from all over the world, this has been A LOT of fun! Here a sneak peek from one of our behind the scenes moments... 😉
While digital doesn't replace in-person gatherings, it also has its advantages. For the first time, we can share this extremely valuable content beyond our firm's family. So, stay tuned! We will share more on this with you in the coming weeks.
Life is awesome,
Other content I've found useful
- Do you want to talk to one of Europe's top founders? Check out our founder Justas' latest call to action here, download his app, and reach out to him. Good luck!
- Great insights in Forbes Magazine by my friend Dan Adika, the founder of our incredible portfolio company Walkme: 'I think it’s very realistic that soon we will transition to an almost completely contact-less economy.'
- My friend Andris from Change Ventures argues here that PR can be one of the most leveraged marketing activities for a startup. I do agree. Check out his thoughts.
Subscriber growth bounced back after initial onset of COVID-19: After a setback in Q1, where net subscriber growth slowed to 3.2%, growth rates increased to 12% in Q2, even surpassing rates in the second half of 2019
Subscription businesses used discounts to retain customers: Subscribers receiving discounts grew by 10% in the first 2 quarters of 2020, while the average discount was 18% higher compared to 2019
Evergreen renewals helped subscriptions grow: In Q2 2020, subscription companies utilized evergreen renewal models more than 9X more than monthly renewal models
While growth in revenue per account slowed for subscription businesses, it remained positive overall: ARPA growth slowed from Q1 to Q2 2020 from 9% to 5%
- Find here your next cool Zoom background. Our company Tailorbrands made some very ones, so you can show off your personality in style.
- Here a great interview with Daniel Ek, including some rare insights into how he thinks and acts. Daniel has been very forthcoming and open with his answers.
- A brilliant guide to marketplaces by VersionOne, featuring B2B marketplaces, APIs as a marketplace, and more. Check it out.