ARR, or Annual Recurring Revenue, is a financial metric that represents the predictable revenue a company expects to generate from its active customer subscriptions and contracts over a 12-month period. It is a key performance indicator, especially for software-as-a-service (SaaS) and other subscription-based businesses, as it provides a clear view of stable, recurring income to assess growth, financial health, and long-term success. So far the text book definition.
In reality, ARR is not a GAAP accepted metric. It is a forward looking metric that emerged in the early 2000s used collectively by venture capitalists and Saas entrepreneurs to measure company and portfolio performance. There is no official authority auditing ARR. Companies have to make sure their number reconcile and match GAAP, but ARR is not government audited.
Personally, I have always struggled with the idea of defining something as recurring before it actually recurred. After all, you are only mathematically certain a customer will come back, when he effectively comes back. So, as Software as a Service became increasingly popular, the ARR metric – instead of becoming more stable and balanced, became a more hollow metric.
Why ARR became hollow
As Saas became a more prominent phenomenon, ARR started to loose some of it’s meaning because of the following reasons
- The ARR growth trap: As Saas competition grew more fierce, VC’s raised the performance bar. The increased ARR growth pressure pushes entrepreneurs to include revenue into their ARR numbers that might not actually recur, like PoC licenses or development licenses. Suddenly ARR is not so truthful anymore.
- The MRR translation temptation: As annual subscription models evolve to monthly usage based models (monthly recurring revenue), some entrepreneurs are tempted to use their customers’ best MRR month as an indicator for what total annual recurring revenue will look like (rather than a straight average). And now ARR growth is not predictable anymore.
- The ARR wrapper challenge: Today, many Saas companies have built their subscription models on top of other Saas companies (who have built their business on top of other Saas companies). In such constructs (and especially if many of the Saas companies are brand new start ups), the actual COGS (Cost of Goods Sold) might be a lot bigger than the actual ARR value (start-ups tend to sell below cost). Add this up across a chain of Saas vendors, and the ARR metric looses it’s meaning, worse, it becomes an unstable metric.
It is no surprise many Saas companies today struggle to deliver stable ARR growth.
A shift ….
In response to ARR’s limitations, analysts these days demand complementary metrics to validate the quality of the recurring revenue:
- Net Revenue Retention (NRR): This is now viewed as a superior metric to ARR because it directly measures how predictable and sticky the recurring revenue is, factoring in upsells, downsells, and churn.
- Gross Margin ARR: A critique of simple ARR is often remedied by demanding the gross margin associated with the ARR, providing the true, scalable profitability of the revenue stream.
Finally, with GenAI waltzing over the IT industry, there are many voices that state that the subscription model is dead, and that tomorrow’s revenue models will be based on the delivery of outcomes, rather than just making the software available 24/7. And that could be the final blow for ARR as a metric. In a world where it is possible to build up a company/product in weeks/months and grow the company’s annual recurring revenue to over 100mio$ BEFORE IT HAS EVEN RECURRED ONCE, the sheer concept of ANNUAL RECURRING seems to have reached it’s limits.
In summary
In summary, ARR has gone through a fundamental shift over the last 25 years. It has lost some of it’s meaning because of the increased pressure by VCs and overall acceleration. Whilst ARR is still a core metric when Saas start-ups are being discussed, the metric should be interpreted with caution!
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