Recurring Revenue for SaaS
What is ARR? Most SaaS CFOs define it as MRR x 12. That definition works well for simple business models with 1) a single subscription product, 2) hosted in the cloud, 3) sold with an annual contract. However, a growing number of SaaS providers don’t have a simple business model. Many SaaS providers have many different product offerings (software, support, and professional services), many different pricing models (one-time, fixed fee, and variable/usage-based fees), many different payment options (monthly, quarterly, annual), and many different deployment models (on-premise subscriptions and hosted, multi-tenant offerings). For complex SaaS business models, the approach to calculating ARR can vary depending upon a number of factors.
Finance organizations need to consider the different options for ARR and define an approach that best illustrates the financial health of the business. Below are 13 questions that SaaS providers should answer to define an approach to ARR.
1) Discounts
Should discounts for new customers be represented in ARR?
Many SaaS providers offer discounts on year one subscription fees (or multiple years of an initial contract term) with the expectation that upon renewal the customer will pay full price. In these scenarios, some SaaS providers will take a long term view and report on ARR at the expected renewal (full) price. Others will report on the actual discounted ARR for these new customer contracts.
2) Start Date
Should discounts for new customers be represented in ARR?
When does the ARR from a new customer contract start to be included in the company’s total ARR? Do you begin to include new logo business upon contract signature (“contracted ARR”)? Or do you wait until the customer goes live? If the SaaS application is automatically provisioned and the customer gains access to the service immediately, these dates are one in the same. However, some SaaS applications are more complex with an implementation process that takes 60, 90, or 180 days. In other cases, the go live may be delayed because the customer is not ready to start the process. Using a contracted ARR approach leads to higher numbers faster, but can be misleading about the true state of the business.
3) Proof of Concept
Should fees from a proof of concept be included in ARR?
Customers seeking more complex and expensive SaaS implementations will often request a proof of concept (POC) prior to making a long-term contract commitment. The POC may last 30, 60, 90 days or longer. At the end of the POC, the customer has the option to end the project and discontinue the relationship or to convert the pilot into a longer-term contract. Should ARR from proof of concept projects be included in the company’s total ARR?
4) End Dates
When should a canceled customer be removed from ARR?
When does the ARR from a customer who canceled their contract begin to be excluded from the company’s total ARR? Do you remove ARR when a customer notifies you of their intent to cancel a contract? Or do you continue to report the ARR for the canceled customer until the end of their contract term? The approach to ARR end date can have a significant impact on retention metrics as it will impact Net Dollar Retention, ARR Churn, and other related metrics as well.
5) Late Renewals
When should expired contracts be removed from ARR?
Sometimes a customer does not explicitly renew a subscription before it expires, but the SaaS provider allows them to continue to use the service while negotiating the new contract. Should ARR from these late renewal scenarios be included in the company’s total ARR? Many SaaS providers do include ARR from contracts that have expired, but are expected to renew. What about accounts that have not indicated an intention to cancel, but are not actively negotiating a renewal? If so, how long after the contract expiration date should a late renewal be included in a company’s total ARR? 30 days? 60? 90? Or 180 Days?
6) Month-to-Month
Should fees from customers on month-to-month payment terms be included in ARR?
While many B2B SaaS providers only offer annual contracts, others will allow new customers to pay month-to-month. Should customers on a pay-as-you-go model with no long-term contract be included in the company’s total ARR? What if the month-to-month accounts bill via credit card and have a relatively high renewal rate? The industry has mixed views on pay-as-you-go. Some SaaS providers include ARR generated from month-to-month accounts while others do not.
7) Usage-Based Pricing
Should variable fees from usage-based pricing be included in ARR?
Increasingly, SaaS providers are leveraging usage-based pricing as their primary model or for “add on” services. Should variable monthly fees from products with usage-based pricing be included in ARR? The revenue from an individual customer may not be consistent month-to-month. However, the aggregate revenue from usage-based pricing across the customer base might be predictable and recurring in nature.
See examples of how public companies report ARR for usage-based pricing
8) On Premise Subscriptions
Should term subscriptions for on-premise installations be included in ARR?
Software vendors that are in the process of transitioning to SaaS from a perpetual license model may have a mix of revenue from on-premise and cloud-based subscriptions. Should term licenses and subscriptions from software run on premise be included in ARR calculations? Or should ARR be limited to only cloud-based services?
9) Maintenance and Support
Should maintenance and support revenue from perpetual licenses be included in ARR?
In addition to term licenses and subscriptions for on-premise, some software providers might have maintenance and support contracts for perpetual licenses. The revenue from maintenance and support services is recurring with annual (or multi-year) contracts paid upfront and no termination for convenience clause. Should the revenue from perpetual license maintenance and support contracts be included in ARR?
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10) Support Services (Cloud)
Should premium support for cloud-based offerings be included in ARR?
Some SaaS providers charge separately for premium customer support for their cloud-based offerings. With more complex applications and services, customers may want access to a designated account representative, higher case volumes, or a specified number of support hours. The revenue from premium support services is recurring in nature with annual (or multi-year) contracts typically paid upfront. Should the revenue from premium support services be included in ARR?
11) Professional Services
Should fees from professional services engagements be included in ARR?
Revenue from professional services typically is reported separately from subscription revenue on the income statement. Nonetheless, some SaaS providers include it in their ARR calculations – especially if it is recurring in nature. Additionally, SaaS providers that calculate ARR as TCV divided by the days/months in contract are including contracted professional services in their ARR reporting.
12) Products to Exclude
Should you exclude fees from legacy or non-core products from ARR?
Products which are not a traditional subscription model may or may not be appropriate to include in ARR. Above we discussed the most common examples – usage-based, on premise, support, and professional services. However, there may be additional products that you may want to exclude – even if they are subscription based. For example, legacy products that are expected to decline in revenue over time as customer’s transition away may lead to a drag on ARR.
13) Customer Segments to Exclude
Should fees from non-core customer segments be excluded from ARR?
There may be certain types of customers that should be excluded from ARR. For example, if the majority of your revenue comes from middle market and enterprise accounts, you may want to exclude small businesses from ARR. Small businesses tend to churn at a disproportionately higher rate to larger accounts and could provide a drag on ARR and net retention metrics. Another example to consider is a SaaS provider whose business model is primarily B2B, but has some consumer-oriented subscriptions. The consumer offerings may be less relevant to the overall financial health and future growth potential of the business.
