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Your ARR may be wrong, and it could cost you

Oct 05, 2023·Authored by Chris Price

So many companies are unable to provide closing-ready reports that pass investor scrutiny on the most basic of SaaS metrics, like annual recurring revenue (ARR).  All too often, SaaS companies take a haircut on their expected enterprise value – or worse, the investors walk away – because of the skeletons that are unearthed in their ARR reporting during financial due diligence.

The inability to consistently and accurately track movements in ARR isn’t just a problem when it comes time for funding; it’s an ongoing issue that inhibits business leaders’ ability to monitor and take action on emerging trends in the business. But how can this be so difficult? ARR is just monthly recurring revenue (MRR) x 12, right? 

Well, yes, but it’s important to remember that MRR and ARR are non-GAAP measurements. Their purpose is to measure the normalized, ongoing value of customer relationships that can be reliably used by SaaS businesses to predict future revenues and monitor growth trends. Unfortunately, many companies make the mistake of utilizing monthly GAAP recognized revenue as the basis for MRR and then extrapolating that value to report ARR.

With GAAP revenue principles applied in accordance with ASC606, this approach can lead to significant distortions and misstatements in ARR that confuse business leaders, create headaches in monitoring SaaS metrics for finance teams and may cost you millions with investors. The following are just a handful of examples of where GAAP revenue-based ARR analyses fail, and how a contract based ARR approach leads to superior results. 

If you want to avoid these pitfalls and automatically deliver the holy grail of recurring revenue– committed annual recurring revenue (CARR) – make sure to read to the very end.

Two very different approaches for calculating ARR

GAAP revenue-based

This type of analysis defines MRR as the amount of revenue recognized within a particular month related to recurring-type services (e.g. subscription services) contracted with a customer in accordance with GAAP principles. That month’s recognized revenue is then multiplied by 12 to calculate the ARR value of the contract.

This approach may also be referred to as “recognized ARR” or “implied ARR.”

Pros: ARR can be calculated based on existing GAAP accounting activities used to recognize revenue each month. This also means that the underlying MRR can be directly tied back to P&L revenue in a given month and may not require additional data tracking.

Cons: ARR can be misstated, swing wildly and inaccurately depict the ongoing value of customer relationships. Month-to-month fluctuations in recognized revenue inhibit analysis of customer subscription trends and distort retention-related metrics. Requires data manipulation to unwind the effects of GAAP revenue recognition to overcome reporting obstacles.

Contract-based

This type of analysis defines MRR as a calculation of the transaction price for any recurring-type services divided by the number of months in the subscription term.

This calculated MRR amount is then multiplied by 12 to derive the ARR value of the customer contract.

This approach may also be referred to as “bookings ARR.”

Pros: ARR is consistent and more accurately represents ongoing customer value. It supports valuable customer subscription trend analysis, precision in retention-related metrics and insightful operational reporting without data manipulation.

Cons: MRR may not directly tie back to P&L revenue, and may require additional data tracking or explanation to close the gap between MRR and recognized revenue in a given month.

In partial period situations revenue is recognized based on the proportional time for which services are delivered in a given month. This reduced amount of recognized revenue in the period understates the ongoing ARR value of the customer relationship in the prorated period and subsequently leads to an artificial expansion effect in the following period. If not specifically controlled for, this will also inflate metrics like expansion ARR and net revenue retention.

Partial period revenue table

Under a daily rate revenue recognition methodology, the per-day rate of revenue is calculated by taking the total revenue divided by the number of days in the contract term. In this approach, months that contain more days will be allocated additional revenue, while months with fewer days will be allocated less. 

So, while there’s no change in the value of the underlying relationship with the customer, the amount of revenue recognized in each period fluctuates, creating a constantly moving target of ARR.

These movements result in month-to-month artificial expansion and contraction swings making analysis of net and gross revenue retention unmanageable.

Daily rate revenue recognition

Under ASC606, revenue should be recognized as performance obligations are satisfied.  In the case of delayed delivery of subscription services, such as situations where setup or implementation takes longer than anticipated, GAAP provides adjustment methods for managing the recognition of previously held revenue. In these situations, the absence of revenue recognition that occurs during the delayed period understates ARR value of the customer relationship.

Once delivery has occurred, and prior period revenue is available to be recognized, both adjustment methods lead to a distortion in the ARR value - either temporarily in a drastic fashion or less dramatically but elongated across the remaining subscription term:

1. Catch-up method

Multiple months of prior period revenue are posted in the month of delivery. This dramatically overstates MRR – and by extension ARR – in that period, and generates an artificial contraction effect in the subsequent period when revenue returns to the normal monthly amount.

2. Distributed method

Multiple months of prior period revenue are distributed across the remaining subscription term. This method overstates the ongoing, expected ARR value of the customer relationship during the remainder of the current subscription period and then generates an artificial contraction effect at the next subscription renewal event – even when there’s no change to the subscription.

These artificial contraction events – either midterm or at renewal – will negatively influence metrics like net and gross revenue retention and ARR growth rate.

Delayed delivery of subscription services table

Similar to delayed delivery, in late renewal situations – where customers are no longer in an active subscription period but services have not been turned off – revenue cannot be recognized for their continued use of the product until they renew their subscription. Due to the lack of revenue being recognized, this results in an artificial contraction or churn ARR effect of customers in periods for which the company is still negotiating the terms of their renewal.

This problem is then exacerbated by the overcompensation of catch-up adjustment revenue recognition that typically occurs in the period for which the customer finally renews. In these situations, SaaS companies suffer whiplash due to swings in ARR which impact metrics like net and gross revenue retention and churn rate, which can cascade and negatively affect a number of other SaaS metrics.

SaaS late renewal table

Per GAAP standards, revenue recognition should be distributed across the contractual term with the customer, inclusive of any free months. Therefore, if a customer purchases your software as an annual subscription for $1,000 per month, but with three months free as an incentive, GAAP requires that you recognize the value of the contract over a 15-month term period.

As a result, the revenue recognized over the subscription term will typically understate the ongoing, expected ARR value of the customer relationship, especially since most free month incentives fall off after the initial subscription term.

When the customer renews at the same price the next year, and the free month incentive is no longer provided, this generates an artificial expansion effect, creating the illusion that the customer’s value to the organization has increased, driving up net revenue retention.

SaaS free months table

Sometimes concessions – typically in the form of credits – are necessary to keep customers happy in situations where software or subscription services have underperformed. These one-time credits issued as concessions for lackluster prior-period services can offset, eliminate or supersede recognized revenue in a given period.

This temporary reduction in revenue will result in the appearance of a contraction or churn effect of ARR in the period, which is not representative of the ongoing value of the customer relationship. In turn, if not controlled properly, the subsequent period will experience an unwarranted expansion effect, creating a seesaw motion in net and gross revenue retention across periods.

SaaS credits for concessions table

Under ASC606, the contractual value of multi-year deals with a pricing ramp (i.e. incremental increases in pricing for the same services in future years) should be recognized ratably over the contract term.

The effect of this revenue treatment erases the contractual uplift events baked into the subscription term in an ARR analysis. Furthermore, the recognized revenue in the final year is understated compared to the value of the terminal (exit) ARR for the contract, which best represents the ongoing value of the customer relationship.

When the customer renews at the final year’s pricing – as is typical – the understatement of terminal ARR will create a mistimed, aggregate expansion effect distorting SaaS metrics like net revenue retention and net revenue renewal rate.    

SaaS multi-year with price ramp table

To be in compliance with ASC606, companies that engage in contracts that contain multiple products or services (referred to as “multi-element arrangements” [MEA]) must allocate the transaction price of the contract to the relevant performance obligations for revenue recognition purposes. This process is referred to as an MEA allocation.

For SaaS companies, often MEA allocation is subscription value being allocated away from recurring revenue to one-time revenues – such as implementation services – that were sold below their standalone selling price.

In these situations, this reduction in recurring revenue resulting from an MEA allocation understates the ongoing ARR value of the customer relationship, since customers typically renew their subscriptions at the original transaction price but there are no implementation services after the initial term. Therefore, at the time of renewal, no such MEA allocation is necessary, and the subscription retains the entirety of the transaction price. This has the effect of producing an artificial expansion of ARR at the time of renewal.

To make matters worse, when additional modifications occur against those customer contracts, it may require follow-on reallocation events which re-shift revenue between the performance obligations. These reallocations further muddy the waters around ARR expansion and contraction activity and create unnecessary noise that disrupts any meaningful analysis of ARR trends.  

SaaS ASC606 MEA allocations table

In the case of multicurrency transacting, base currency revenue recognition is dictated by the exchange rate established on the invoicing event to which the revenue is tied. If a multicurrency customer has a one-year subscription invoiced quarterly, the amount of recognized revenue in the base currency will vary quarter-to-quarter contingent on the applicable FX rate as of the date the invoice was issued for each quarter.

This creates arbitrary variances in base currency recognized revenue which produces artificial expansion and contraction swings in ARR and further complicates analyses.

Annual or multi-year deals with monthly invoicing arrangements exacerbate this issue, making any kind of recurring revenue trend analysis untenable.

SaaS late renewal table

Committed annual recurring revenue (CARR), provides all of the same benefits as the contract based ARR approach, except it goes even one step further. Instead of reflecting ARR as of the start date of the subscription term, CARR provides immediate visibility to the recurring revenue effects of customer decisions as of the date of the commitment.

In the context of new customer deals or expansion activity, that’s typically the booking date (i.e. the date of execution of a new contract or contract modification). This approach enables business leaders to accurately measure the effect of growth initiatives by assessing the results directly within the periods of performance and aligning costs of those initiatives to generate more accurate efficiency metrics such as CAC ratio or magic number.

ARR vs CARR

Closing-ready SaaS metrics at your fingertips

Don’t make the mistake of relying on GAAP revenue based ARR as the method to measure the health or value of your SaaS business. Avoid the inaccuracies, manual effort, headaches and costly due diligence surprises.

SaaS Intelligence by Baker Tilly Digital is built to automatically manage the complexities of subscription businesses – delivering real-time, closing-ready CARR analyses and insightful SaaS metrics to support data-driven decision-making, attract investors and protect enterprise value. Learn more about how SaaS Intelligence and Baker Tilly Digital can help you maximize your SaaS business journey.

 

Chris Price
Director

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