Annual Recurring Revenue (ARR) is the most frequently used metric in SaaS. Even non-recurring revenue startups use ARR when they want to describe the size of their business (which makes little sense, but that is the topic of another post). ARR is a simple and beautiful metric because it is easy to understand and provides a clear sense of scale.
ARR is calculated by taking the latest month’s Monthly Recurring Revenue (MRR) and multiplying it times 12 to annualize it. ARR is a more relevant metric than GAAP revenue to describe the size of a SaaS business: revenue is, by definition, backwards facing and, in the case of SaaS, it does not even do a good job of describing the past because of the waterfall nature of how subscription revenue is recognized. ARR, on the other hand, describes the present. It is a metric at a point in time. Just like the cash on the balance sheet is a number tied to a date, ARR is a number that describes the current scale of the business.
Why ARR Growth is Misleading
The problem with ARR comes when you try to manage your business around ARR. It actually provides little insight into performance, growth, or execution. It is the wrong metric to focus the efforts of an on organization around and it can provide a false sense of progress — a vanity metric. Let me demonstrate with an example.
Assume in Year 1 a startup launches their product and grows to $2M in ARR. Great start! In Year 2, the startup finishes the year with $5M in ARR. Wow, 150% growth! In Year 3, the startup finishes the year with $9M in ARR. 80% growth in ARR!
I can hear the founder proudly stating how they grew 2.5x in Year 2 and continued rapid growth in Year 3, almost doubling the size of the business. But, I see a different story. I see a company that is growing fast, but not nearly as fast as the founder believes. I see a startup that grew its output by 50% in Year 2 and 33% in Year 3. Why? The output of a SaaS company is best measured by bookings. We can define bookings as: the annual contract value of NEW business (from new and existing customers). Ignoring churn to make the math easy, the bookings in the example above were $2M in Year 1 ($2M minus $0), $3M in Year 2 ($5M less $2M), and $4M in Year 3 ($9M less $5M). The bookings in each of these periods measures the NEW ARR (output) our startup was able to generate. This paints a very different picture of growth: 33% bookings growth as compared to 80% ARR growth in Year 3.