Churn is the worst.
There’s no poorer feeling than missing your predicted growth and income targets through seemingly random cancellations and downgrades. Especially when there’s no warning and your customer satisfaction rate is generally high.
However, it’s a problem that many industry leaders have experienced. So it’s not surprising that more and more investors are paying close attention to the ARR of their potential investments, and it’s why you should be paying attention too.
What is Annual Recurring Revenue (ARR)?
Annual Recurring Revenue refers to the total income across all customers over the course of a one-year period. It’s a metric that’s most often used in the SaaS industry to help determine the health of your business.
ARR is related to monthly recurring revenue (MRR) since ARR is the 12-month accumulation of MRR. However, the two metrics are useful for different aspects of business planning and growth.
In particular, ARR can be tracked over the course of time in order to hone in on more realistic forecasting and determine long-term goals. Alternatively, MRR is more useful for tracking how the changes you implement actually make a difference, and for short-term decisions.
Common businesses that use ARR are subscription businesses. For subscription-based businesses, customer acquisition and retention hold two of the most important functions. ARR works with these common SaaS sales metrics in order to fulfill the ‘outputs’ of the equation, covering the ‘inputs’ through revenue gained by retained and new customers alike. ARR is also directly affected by churn rates, further speaking to the importance of the metric.
How to Calculate ARR
In order to determine ARR, you must first know a number of other statistics about your company across a 12-month period:
- Revenue generated by retained customers
- Revenue generated by new customers
- Expansion revenue (generated by upsells, cross-sells, etc.)
- Revenue lost to downgrading customers
- Revenue lost to churn (through cancellations)
The formula to calculate annual recurring revenue is as follows:
(1 + 2 + 3) – (4 + 5)
Aka, total revenue generated by retained and new customers, including expansions, minus revenue lost to downgrades and churn.
Let’s look at an example:
Company A has the following statistics:
- $25,000 generated by retained customers
- $8,000 generated by new customers
- $2,600 generated by expansion
- $1,200 revenue lost to downgrading customers
- $4,000 revenue lost to churn
ARR = ($25,000 + $8,000 + $2,600) – ($1,200 + $4,000) = $30,400
Since there are so many factors affecting ARR, things can get a little complicated. Plus, for some SaaS companies, the majority of your revenue is gained through a monthly-subscription model, rather than annual contracts. In this case, it might be easier to simply calculate the monthly recurring revenue (MRR) and multiply this by 12.
Why is Annual Recurring Revenue Important?
The primary reason to know your ARR as a SaaS company is to have a more realistic grasp of your growth and forecasting. For example, change in ARR (aka growth) is used in determining the valuation of a company. Typically, subscription-based businesses are sold at a rate of 5.7 times their annual recurring revenue, but those growing faster than average can fetch up to tenfold of their annual revenue figure.
Furthermore, since ARR is affected by so many other key sales metrics, it is one of the most accurate measures of the business’ health. The highly sensitive figure is formulated by momentum in the business, including both upgrades and downgrades. This highlights the performances of the sales and retention teams in producing expansion revenue and decreasing income lost to churn. Thus, ARR is key in helping the business run as efficiently as possible.
Clickfunnels, one of the industry leaders in the SaaS space, recently revealed their ARR to be $14 million. It’s not surprising then, that the company has focused on the importance of upsells and its pricing tactics in order to generate the highest revenue possible over just a 25-month average customer subscription.
How to Improve Your Annual Recurring Revenue
Since ARR is such a sensitive metric, there is a real range of things you can work on to improve it. In most cases, it’ll be about trying out a few different strategies, cutting what doesn’t work, and doubling down on what does.
More customers
Acquiring more customers is a key player in improving your ARR. Empowering your marketing and sales teams to attract and convert your ideal clients will enable them to create an efficient process. Really though, it could be time to assess your budget and commit more funding to your acquisition strategies. It’s a numbers game, after all.
Pricing strategy
One of the most immediate impacts to your ARR is through pricing strategy. In upgrading your price packages or setting a minimum subscription amount, you are increasing the amount of revenue per user. However, the drawback for customers if you boost the price by too much, you may lose them to cheaper competitors.
So, finding a good balance is important. One of our top tips here is to prove to the customer that they’re getting more value from your product and their subscription so that the price increase is justified.
Improve retention
Finally, improving your retention could be where you need to focus your strategy. In the SaaS industry, a “good” churn rate is considered to be between 3-5%. And it’s true that some cancellations or downgrades simply can’t be helped. However, if your business is teetering above that 5% mark, it might be time to introduce some new retention strategies.
For example, SaaS company Mixpanel improved their customer retention (and significantly reduced churn) by highly customizing their mobile app. This increased the feeling of instant gratification that their customers felt when logging in and reduced cancellations.
Have you been experiencing higher-than-average cancellations and downgrades?
Focusing on improving your ARR could be the broadest action you can take in order to fight the churn on every level. Plus, it directly interacts with so many aspects of your business. Whether you’re focused on acquiring new customers, retaining current ones, or expanding your product and pricing, ARR will be affected.
So take notice, because it’s the first thing that investors will use to decide whether you’re a safe bet! If you need help securing financing in order to facilitate your growth, get in touch with us at Fundsquire.
