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Revenue vs ARR
Why angel investors need to understand the difference
A Typical SaaS Diligence Call
Here’s a pretty common interaction on startup diligence calls:
Founder: “Our annual revenue is $300K.”
Me: “Thanks, is that your current ARR, or total revenue for 2023?”
Founder: “That’s the current ARR, the 2023 actual was about $50K.”
$300K and $50K are VERY different numbers. That’s why today, I’m breaking down the difference between revenue and Annual Recurring Revenue (ARR).
The Observer Express
Don’t have time to read the entire post right now? No worries, here are the main points:
ARR measures the annual value of a company's recurring subscription revenue. In contrast, total revenue is dollars actually collected during a given period that show up in a firm’s financial statements.
ARR is a key metric for subscription-based businesses that normalizes recurring revenue to an annual amount and excludes one-time transactions.
Implications for angels: there can be a significant difference between ARR and recognized revenue, and it’s worth clarifying.
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Total Revenue ≠ ARR
Annual Recurring Revenue (ARR) and total revenue are two important but VERY different financial metrics for SaaS and other subscription businesses.
ARR measures the annual value of a company's recurring subscription revenue. Monthly Recurring Revenue (MRR), a similar metric, is calculated by simply dividing ARR by 12. ARR is forward-looking, in that it is a current snapshot in time of the total annual subscription value available to a business.
In contrast, total revenue is dollars actually collected during a given period that show up in a firm’s financial statements. It is a backward-looking metric describing historical financial performance.
Key Points on ARR
It’s a commonly used metric in software and other subscription-based businesses.
ARR only includes subscription-based recurring revenue, not one-time transactions.
Example: A Panera Sip Club subscription is ARR. A sandwich purchase by an in-store customer is not ARR but will contribute to total revenue during that period.
The individual subscription terms (monthly, annual, multi-year) get normalized to an annualized amount.
Example: Spotify’s monthly individual subscription is (currently) $11.99 / mo. ARR per subscriber would thus be $11.99 * 12 = $143.88.
It's a key valuation metric investors use to assess and compare subscription businesses
Instead of basing valuation on factors like EBITDA or Revenue, which is common in many industries, subscription-based businesses are often valued based on ARR benchmarks.
Changes in pricing, number of customers, churn, and expansion revenue directly impact ARR.
For example, if a company currently has 10,000 subscribers at $10 / mo, they’d be doing $1,200,000 ARR (10,000 * $10 * 12). If over the next month, they increase their price to $11 / mo and churn (or “lose”) 10% of their subscribers, their ARR would decrease to $1,188,000 (10,000 * 0.9 * $11 * 12).
Implications for Angels
As we saw from my opening example, all this means that there can be a significant difference between ARR and recognized revenue, especially for businesses with annual or multi-year contracts. ARR provides a more real-time picture of the current revenue run rate and growth trajectory, while historical revenue is a better measure of historical performance.
For angel investors, ARR is often the more insightful metric to focus on (though the importance of historical revenue is not to be ignored). It more clearly shows the growth potential and health of the business. I typically see investors use ARR to:
Project future cash flows
Gauge traction and growth trajectory
Compare the company to other SaaS businesses
Value the company using ARR multiples
Assess net dollar retention via changes in ARR over time
It’s worth digging into the details. How many customers does the current ARR represent? What is the mix of monthly vs annual vs multi-year contracts? How has new ARR trended? What are churn and expansion rates?
Two Caveats on ARR
It's not an official GAAP metric, so definitions can vary between companies (and often do - it’s worth asking about how a founder calculates their ARR).
It assumes constant churn/growth rates which is by definition unrealistic. Asking about churn is important.
Final Thoughts
While both ARR and total annual revenue matter, it’s essential for angels to understand the difference. Digging into the nuances of a startup's ARR can open insights for projecting future performance and determining valuation in early investment rounds while understanding historical revenue speaks to the hard traction they’ve been able to secure in recent months.
What Do You Think?
Do you tend to focus more on ARR or total annual revenue?
Weekly Observations: 3 Lessons Learned
“Buy to try” is often the cheapest research for busy decision-makers.🛒I’ve become cognizant of a reoccurring pattern in recent weeks. It seems like, when faced with a problem, busy leaders (myself included) would prefer to do the bare minimum amount of research/vetting and commit to a “trial” purchase instead of deeply analyzing a solution beforehand. We’re working on leveraging this insight to make it easier/cleaner/less friction-filled to try our product in a new use case.
Don’t count your chickens before they hatch.🐔🥚The simple truth I was reminded of this week: a deal isn’t done until it’s done.
75% selling, 25% scaling.💼A mentor encouraged me this week that the most important use of my time is 75% selling, 25% scaling. I like to get distracted by shiny things, so this reorientation was a helpful lesson.
Weekly Links: 3 Things I Found Interesting
Thanks for reading, have a great week.
-Andrew
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P.S. - I recently finished creating The Angel Network Toolkit: 90 Resources for Cultivating a Thriving Community of Pre-Series B Investors, and I’m sharing it with anyone who refers a friend.
How did I do this week?
About Me
I cultivate flourishing.
I'm also the CEO of PitchFact, where our mission is to cultivate flourishing specifically through efficient and collaborative early-stage diligence. I'm a proud husband, grateful father, and honest friend. My love languages include brisket, bourbon, and espresso.