What is ARR? It’s not as simple as you think

The definition of ARR seems to have become a point of friction between startups and VCs over the past couple of years, but why?

The root of this friction probably began with a change in how the typical SaaS business bills its customers. While the first generation of SaaS companies (Marketo, Pardot, Workday, etc) might have typically charged annually (or multi-year), the second (Zendesk, Intercom, MailChimp, etc) and current generation (Notion, Zoom, ChartMogul, etc) embraced monthly billing as standard.

This shift means your typical SaaS startup (launched in the last ~8 years) makes the majority of their revenues from month-to-month subscriptions.

This “mostly-monthly” approach has rendered the traditional meaning of ARR, “Annual Recurring Revenue,” almost meaningless for these companies.

What is Annual Recurring Revenue?

ARR originally stood for “Annual Recurring Revenue,” which had a rather strict definition of only looking at recurring contracts with a service length of one year or more (and discarding everything else).

Annual Recurring Revenue is calculated by dividing any multi-year contracts by the number of years in each contract and adding those to the value of all the annual contracts. Any contract less than 12 months in length should be excluded from this definition of ARR.

Annual Recurring Revenue is a helpful metric if your business makes the vast majority of its revenues from annual or multi-year contracts. Annual Recurring Revenues are contracted revenues, so there is a high level of certainty that this money will be collected.

However, for many modern SaaS companies this isn’t a very relevant metric if the majority of revenues are from monthly contracts. There’s just not a whole lot of point in talking about Annual Recurring Revenue if only 20% or 40% of your revenues are from annual contracts.

Enter Annualized Run Rate, a different metric, calculated in a different way, but with the same acronym