Burkland - Start Smart, Scale Fast
The Smarter Startup

The Nuances of Measuring ARR at Early-Stage SaaS Startups

Are you undervaluing your SaaS startup by following an ARR formula better suited for more mature companies?

Two of the most important KPIs for evaluating a SaaS startup are Annual Recurring Revenue (ARR) and Contracted Annual Recurring Revenue (CARR). During a funding round you can expect these metrics to be among the first you’ll be asked about, and the numbers will likely be one of the main drivers that influence your company’s valuation.

It’s essential for any SaaS startup founder preparing for a funding round to have a firm handle on the company’s ARR and CARR, and to calculate these numbers in a way that aligns with industry norms and best practices. And, at first glance, they seem like very straightforward metrics. However, there are important nuances to ARR and CARR for early-stage startups that aren’t necessarily accounted for by the prevailing models.

The SaaS Metrics Standards Board is a relatively new organization that is working to establish industry-standards for calculating and reporting SaaS metrics. I applaud this group’s important work and I generally agree with much of their guidance. However, I think the board’s ARR and CARR formulas miss some important nuances for early-stage SaaS startups, and, if followed to the letter, can under-represent the value of these companies.

The SaaS Metrics Standards Board defines ARR as:

Annual Recurring Revenue (ARR) is recurring revenue, as defined by your revenue recognition policy, calculated on an annualized basis. ARR is the sum of subscription recurring revenue on an annualized basis. ARR should not include one-time fees or professional services even if they are recurring.

The standards board provides the following formula for calculating ARR:

ARR = (MRR x 12)
Where MRR is the most recent monthly recurring revenue

Simple, right? Just take your most recent month’s GAAP recognized recurring subscription revenue and multiply by 12. In reality, it is this simple for most mature, established SaaS startups. The challenge comes in for early-stage startups, specifically around MRR. Let me explain.

MRR Can Be a Tricky Number for Early-Stage SaaS Startups

GAAP Revenue Recognition rules state that you don’t start recording revenue until a contract goes live. Therefore, a $10K/mo enterprise SaaS contract that goes live mid-month would be recognized as $5K instead of $10K for the first month. Multiplied by 12, this suggests a $60K annual contract, which, in reality, should be reflected as a $120K/year annual contract. While this isn’t likely to be material for a large SaaS company with hundreds or thousands of contracts, it could have a material impact on the reported ARR for an early-stage SaaS startup. Because ARR is such a major factor in a SaaS startup’s valuation, it’s critical for these businesses to get full credit for their actual ARR.

For this reason, I prefer to use a “point in time” approach when calculating a startup’s MRR to plug into their ARR formulas. This simply means asking “as of the last day of the most recent month, looking forward to the next 12 months, what is the expected ARR?”. This small adjustment can tell a different and more accurate story of an early-stage startup’s true ARR and value.

CARR Doesn’t Account for Contracted Expansion

Another area where nuances need to be considered and accounted for is Contracted Annual Recurring Revenue (CARR), which takes into account revenue from contracted subscriptions that have not yet launched. Enterprise SaaS deployments may take months of implementation, customization, onboarding, etc., between the time a contract is executed and the official go-live date for the deployment. In the meantime, CARR provides a standard method for SaaS startups to track the related future revenue.

The standards board provides the following formula for calculating ARR:

CARR = (MRR¹ x 12) + Contracted but not yet recognized ARR²
¹ MRR is the most recent recognized monthly recurring revenue from subscriptions
² Not yet recognized ARR is contracted but not yet in production and/or recognized as GAAP Revenue – thus not recognized in current period MRR

It is interesting to note the SaaS Metrics Standards Board’s guidance around CARR in multi-year agreement with contracted pricing escalations. Many enterprise SaaS companies are able to negotiate multi-year contracts, and they often have pricing escalations baked into the agreement. For example, a SaaS startup may provide a new customer with a hefty discount in year-one, before increasing to full price for subsequent years. Other common examples relate to scaling deployments out to more users, locations, and business divisions. These pricing escalations are contractually agreed upon, but the SaaS Metrics Board suggests that current CARR should only take into account the pricing that will be in effect over the next year, and not future year pricing escalations. This could have a material impact on the reported CARR of an early-stage SaaS startup that has a large number of customer contracts still in their first year.

My recommendation here is to track CARR using the formula provided by the standards board, and also track a side metric which I call “Expansion Backlog CARR”.

Expansion Backlog CARR = Highest level of CARR achieved during the contract period minus current CARR

This metric takes into account the amount of legally contracted escalations which are not included in the standard CARR calculation. Tracking both of these metrics allows early-stage SaaS startups to track and receive credit for their contracted future expansion revenue, while retaining the ability to benchmark themselves against other SaaS startups in an apples-to-apples way.

As always, when working with SaaS KPIs it’s important 1) design a methodology that is right for your company, 2) be transparent with your investors and stakeholders on your approach, and 3) remain internally consistent in your methodology so that movements in your ARR and CARR over time will provide meaningful insights on business performance. It is fantastic that the SaaS Metrics Standards Board is tackling the lack of an industry standard definition for SaaS metrics, and this is a huge step forward in enabling companies to consistently measure themselves against external benchmarks. However, early-stage startups need to understand and address the possible pitfalls and nuances of these standardized metrics to ensure they are fully communicating their business performance.

Related resources: