A Framework for Measuring ARR
It’s an exciting landmark moment when a founder shares with us that they have earned their first revenue dollar. A customer has validated that the product is intrinsically valuable and worth paying for. The startup is off to the races, and its founders rush to scale revenue. With a lot of hard work and a little bit of luck, the founders gain traction and amass dozens of monthly subscriptions, half a dozen annual subscriptions, and get a few enterprise contracts in the works.
This is a natural point for investors to ask for an updated annual recurring revenue (ARR) number. ARR is the simplest way for an investor to understand how the business is progressing. It helps them cut through the noise and focus on the real and predictable streams of cash flow. However, sourcing an accurate ARR number is not always straightforward for founders. In fact, it’s more art than one might expect.
Time and time again, we find ourselves asking founders, “Is this the right ARR figure?” because at this early stage, defining ARR isn’t black and white. While the concept itself isn’t so complicated, the grey area is in the framing of revenue(s) in a manner consistent with the way that investors (especially investors in the SaaS space) view it. ARR should only reflect confirmed, recurring, cash-in-bank revenue from fully executed contracts.
ARR should only reflect confirmed, recurring, cash-in-bank revenue from fully executed contracts.
One-time usage spikes, unverified gross payment volume before failed transactions are filtered out, or pipeline deals still awaiting signature are all scenarios where a founder could easily overstate ARR through optimistic assumptions rather than defensible evidence.
Let’s take a deeper look at a few of these scenarios.
Scenario 1: Usage Credits ≠ Recurring Revenue
A customer buys $1K in usage-related credits in their first week. The founder sees that the payment settled and reports to their investor that their ARR increased by $52K. Is this ARR?
In most cases, it’s not. There’s no promise that the purchase is recurring, and even if so, at a weekly cadence. The customer may have bought the credits expecting to use them for the whole month. The customer may have expected to budget that much for a week, but ends up using way less and doesn't need to buy more. They may end up using the credits but decide not to continue, etc, etc.
Instead, it would be fitting for the founder to frame the usage revenue as a projection or run rate in discussions, e.g., run rate of $4K this month.
Scenario 2: Gross Signups ≠ Net ARR
A startup noticed 20 new accounts bought paid service subscriptions through their website. Each subscription costs $10 monthly, so they surmise that their ARR increased by $2.4K and reported such in their KPI submission. Is $2.4K the correct ARR number?
Again, most likely not. We’ve seen up to 30% of B2C subscription payments fail at the gate (meaning ARR is 30% lower, not even factoring in churn). Bad credit card numbers and bounced payments are incredibly common, especially if the users originated from a new paid acquisition channel or from an influencer. Kaplan states transaction failure rates can reach 15% of total transactions in certain sectors. As mentioned, we’ve seen 30%+ in certain scenarios
A few tips here:
- Payment platforms can be confusing because they offer multiple “revenue” metrics (e.g. MRR, Gross Volume, Net Volume). Don’t just take those at face value; double-check what is included in the figure.
- Ensure you filter out payments that are pending/unpaid. Revenue has to make it into the bank account to be relevant. And if the noise from bad payments is too high, implement stricter fraud payment controls.
Scenario 3: Pipeline ≠ Booked ARR
A founder is negotiating a $50K deal with a potential enterprise customer. They’ve progressed through many meetings, and the contract is out to the customer for review and signature. Negotiations have been smooth so far, and the founder reasonably expects the deal to close. Can the founder include the deal as part of their existing ARR?
No. Not until the contract is fully signed and executed. No matter how smooth the process has been so far, wait for pen to paper to celebrate. Until then, the nominal remains in the pipeline.
Instead, provide a reasonable judgment of the likelihood that potential deals in the pipeline close, e.g., an 80% chance that the XXX deal for $100K closes in the next month.
Measuring ARR is part science, part art
There are many other scenarios where we can debate what should be included in ARR because it’s not an exact formula. But if you recognize the pattern here, we tend to lean towards caution when making judgements. It’s very easy to pass on to investors an ARR formed from flawed methodology, and it’s very easy for investors to miss the flaw. There aren't many data points for investors to verify against, and the number has an inherently high p-value. An investor’s visibility is limited to waiting for the actual cash inflow to hit the bank, which can lag in the form of Net 30, Net 45, etc.
At OCV, we’ve developed multiple lines of defense over time to protect against incorrect ARR reporting. Ultimately, the best defense is educating founders on conducting proper due diligence when measuring ARR.
Founders are eager to show growth. As investors, we understand this, but ARR should be defensible with clear evidence. It’s better to err on the conservative side if a founder is not sure whether something qualifies as ARR. Investors would be happier spending time discussing revenue upfront than getting a flag down the line.