ARR (Annual Recurring Revenue)

What is ARR?

ARR (annual recurring revenue) refers to the revenue that a company earns from ongoing, recurringly billed customer contracts, annualised and measured at a reporting date. It shows what annual revenue follows from the existing contract base if no customer is added and none cancels. It is generally calculated as monthly recurring revenue (MRR) times twelve or as the sum of the annual values of all active contracts. A landlord calculates in a similar way: the monthly rents of all flats let today times twelve give the annual rent from today's portfolio. What was actually received in the previous year is not shown by this figure.

The metric comes from subscription business models, above all from software provided as an ongoing service (software as a service, SaaS). It is used in the pitch deck, the presentation for investors, in the financial model, in reporting and as a reference figure for revenue multiples, that is, for valuations as a multiple of revenue. ARR is not defined by law. As a management metric, it appears neither in the balance sheet nor in the income statement, and neither the German Commercial Code (Handelsgesetzbuch, HGB) nor tax law recognises it. The definition that applies is therefore the one the company sets itself, documents in writing and keeps across all periods.

Calculating ARR: what counts as recurring

Formula: ARR = MRR × 12 = sum of the recurring annual fees of all active contracts at the reporting date

The basis is the contract base at the reporting date, usually the end of a month or quarter. For each active contract, the recurring fee is converted to a year. A monthly fee of EUR 2,000 gives EUR 24,000 of ARR, an annual fee enters at its amount, and a three-year contract at the value of one contract year. The price actually agreed after discounts is to be used, not the list price: an annual contract with a list price of EUR 40,000 and a 10% discount enters at EUR 36,000. If the price rises contractually from year to year, the currently valid annual value is generally used and not the average over the term.

Components of ARR

• ongoing subscription fees for the use of the software, whether billed monthly, quarterly or annually
• recurringly agreed add-on modules and additional user licences
• contractually fixed ongoing fees for maintenance, support or operation
• for fees based on volume, for example per transaction or data volume, commonly only the contractually committed minimum purchase; anyone who includes more discloses the method

Non-recurring revenue

Not part of ARR are set-up and implementation fees, consulting, training, data migration, bespoke development, licences sold once and hardware. This revenue has to be sold anew with every customer. Free or only nominally paid pilot projects also do not count towards ARR as long as no regular contract has been signed.

Running and contracted ARR

A distinction is made between ARR from contracts that are already running at the reporting date and contracted ARR. The latter additionally includes signed contracts with a later start and deducts cancellations already given. The two figures must not be mixed: a contract that starts only in four months does not belong in running ARR.

ARR and revenue in the annual financial statements

ARR is a snapshot of the contract base. Revenue in the income statement (Section 277(1) HGB), by contrast, shows what was actually earned in the financial year. It is subject to the realisation principle (Section 252(1) no. 4 HGB), part of the prudence principle of commercial law: revenue may be reported only once the service has been performed. Subscription fees are therefore recognised pro rata over the service period, regardless of when they are invoiced or paid.

For prepaid terms, deferred income arises under Section 250(2) HGB. It records, on the liabilities side of the balance sheet, money received before the balance sheet date for a service that is performed only afterwards. If a customer pays EUR 36,000 in advance for twelve months on 1 October, EUR 9,000 is attributable to revenue and EUR 27,000 to deferred income at 31 December. In ARR, the contract stands at EUR 36,000 from the first day. The prepayment improves liquidity but does not change ARR.

ARR bridge and revenue retention

More meaningful than the closing balance is the reconciliation from ARR at the start to ARR at the end of a period, the ARR bridge. It breaks the change down into four movements:

• New customers: contracts with customers who were added in the period
• Expansion: additional revenue from existing customers through add-on modules, more users or price increases
• Contraction: decline in revenue from existing customers, for example through fewer users or cancelled add-on modules
• Churn: contracts that end through cancellation (churn)

Customers who return after a cancellation are sometimes shown as a separate movement (reactivation) and sometimes attributed to new customers. Two retention metrics follow from the bridge. Net revenue retention (NRR) relates the ARR of existing customers at the end of the period to their ARR at the start, including expansion. Gross revenue retention (GRR) leaves out expansion and shows what share of the opening base is retained without additional sales; more than 100% is not possible here. Both values become more reliable when analysed by customer vintage (cohort analysis).

ARR in valuation and due diligence

Revenue multiples

Software companies with a subscription model are often valued in financing rounds and in sales on a multiple of ARR (revenue multiple). The reason is predictability: recurring revenue is largely fixed at the start of the following year, while project revenue has to be won anew. How high the multiple is depends above all on growth, revenue retention, gross margin (the share of revenue that remains after the direct costs of the service) and efficiency. For fast-growing companies, this is often summarised in the Rule of 40: growth rate and profit margin should together amount to at least 40%. Every euro wrongly reported as ARR enters the valuation at the full multiple.

Rebuilding ARR in due diligence

In financial due diligence, the review of the financial figures by investors or buyers, ARR is not taken over but rebuilt. The starting point is a customer list with contract start, term, notice period, price and discounts at each reporting date. The reviewers compare it with contracts, invoices and cash receipts and reconcile recurring revenue to the revenue booked. The deferred income must match the prepaid contracts. Long-overdue receivables are viewed critically, because the contract is running but payment is not forthcoming.

In a sale, legal due diligence additionally examines whether important customer contracts can be terminated on a change of control, that is, the passing of the majority to a buyer. The ARR affected is weighted accordingly in the purchase price negotiation.

Worked example: ARR bridge and revenue retention over a year

A software provider for corporate customers reports ARR of EUR 2.0 million on 1 January. Over the course of the year, the contract base develops as follows. In addition, the company earns EUR 0.4 million from set-up and training.

• ARR on 1 January: EUR 2.0 million
• plus new customers: EUR 1.0 million
• plus expansion with existing customers: EUR 0.3 million
• minus contraction with existing customers: EUR 0.1 million
• minus churn: EUR 0.2 million
• ARR on 31 December: 2.0 + 1.0 + 0.3 minus 0.1 minus 0.2 = EUR 3.0 million, corresponding to MRR of EUR 250,000
• Growth in ARR: (3.0 minus 2.0) / 2.0 = 50%
• Net revenue retention: (2.0 + 0.3 minus 0.1 minus 0.2) / 2.0 = 100%
• Gross revenue retention: (2.0 minus 0.1 minus 0.2) / 2.0 = 85%

The EUR 0.4 million from set-up and training stays outside ARR but appears in revenue. If MRR rises evenly over the year, recurring revenue is around EUR 2.5 million, the mean of the opening and closing base. The income statement thus shows revenue of around EUR 2.9 million, and ARR at year-end is EUR 3.0 million. Both figures are correct but answer different questions: what was earned in the year and what the base lets one expect for the future. If the company included the one-off revenue in ARR, it would rise to EUR 3.4 million. At an assumed multiple of 6, the valuation would be overstated by EUR 2.4 million.

Distinction: ARR, MRR, ACV, ARPA, TCV and bookings

• MRR: the same figure on a monthly basis, for monthly management. Both rest on the same delimitation of recurring revenue.
• ACV: the annual value of a single contract. The sum of the ACVs of all active contracts gives ARR, provided ACV is calculated without one-off components and with the value of the current contract year.
• ARPA: the recurring revenue per paying customer, that is, MRR or ARR divided by the number of customers.
• TCV: the total value of a contract over its full term including one-off items. For multi-year contracts it is a multiple of the annual contribution to ARR.
• Order intake (bookings): the value of newly concluded contracts in a period, regardless of when they start. It measures sales performance, not the running base.

Common mistakes

• One-off revenue in ARR. Set-up, consulting and training raise the reported ARR and, through the multiple, the valuation. In due diligence they are stripped out, and the correction weighs on the credibility of the other figures.
• Known cancellations not shown. A cancelled contract stays in running ARR until the end of its term, but in contracted ARR it must already be deducted. Anyone who shows only running ARR ignores foreseeable departures.
• Changing definitions. If the calculation changes between two periods, growth rates are no longer comparable. A new method is disclosed and applied retroactively to earlier periods.
• Only the closing balance. Without an ARR bridge it remains open whether growth comes from the base or masks high churn.
• Short and long commitments mixed. Contracts terminable monthly and multi-year contracts count the same arithmetically but are not equally predictable. Their share of ARR is therefore shown separately.

Frequently asked questions

Is ARR the same as annual revenue?

No. ARR annualises the recurring contract base at a reporting date. Annual revenue per the income statement also contains one-off revenue and reflects the base as it changes over the year.

How is ARR calculated?

As MRR at the reporting date times twelve or as the sum of the recurring annual values of all running contracts, in each case after discounts and without one-off revenue. MRR of EUR 250,000 corresponds to ARR of EUR 3.0 million.

How much ARR is needed for a Series A?

There is no fixed threshold, and expectations shift with the market environment. Investors assess ARR together with growth rate, revenue retention, gross margin and the costs of customer acquisition. A smaller ARR with high retention often convinces more than a larger one with high churn.

Do maintenance contracts for perpetual licences belong in ARR?

As a rule yes, as long as they are agreed on a recurring basis with a fixed term. The perpetual licence itself remains one-off revenue. It is advisable to show maintenance revenue separately from subscription revenue, because it follows different termination and pricing rules.

The Roemer Capital view

In mandates, Roemer Capital derives ARR from the contract list and sets the reconciliation to the revenue booked alongside it from the start. If both are available at the start of the process, the data room can be provided within 24 hours, and deviations are explained before they are read as uncertainty.

In the financial model, Roemer Capital carries the ARR bridge and net and gross revenue retention as separate lines and calculates them in the base case, the cautious case and the optimistic case. For valuation discussions, it prepares which part of revenue is recurring and which is not, because the multiple is applied at this dividing line.