What it means
ARR answers a simple question: if nothing changed, how much predictable revenue would the business earn over the next twelve months? It only counts income that repeats, such as software subscriptions, support contracts and memberships.
One-off items like set-up fees, consulting projects and hardware sales are left out. Investors and boards like ARR because recurring income is easier to forecast and is usually valued more highly than irregular income.
A software company with $5,000,000 of ARR is generally seen as more stable than a project business with the same annual sales. It is also the base on which valuation multiples are often applied.
ARR is related to MRR, monthly recurring revenue, and the two are linked by a simple factor of twelve. Companies with monthly billing usually track MRR day to day and report ARR to the board and to investors.
Annual contracts are counted at their yearly value, and multi-year deals are divided by the number of years. ARR is not the same as revenue recognised under accounting rules.
It is a management metric, so there is no single official definition, and companies differ on whether to include usage-based charges or customers on free trials. When comparing two companies, check how each one defines it.
The movement in ARR is as useful as the total. Teams break it down into new business, expansion from existing customers, contraction and churn (customers who cancel), so the net change shows whether the base is growing or leaking.
ARR also feeds into other measures that boards watch closely. Dividing sales and marketing spend by net new ARR shows how efficiently the company is buying growth, and comparing ARR with the number of customers gives the average revenue per account.
These ratios are far more informative than the headline number on its own.
In practice
Real-world examples
Example 1
A cloud accounting provider has 2,000 small-business customers on a $40 monthly plan. Its MRR is $80,000, so its ARR is $960,000. The board uses that figure to track progress towards a $1,000,000 milestone.
Example 2
A cybersecurity firm signs a three-year contract with a hospital group worth $450,000 in total. The company records $150,000 of ARR from the deal, being the total divided by three years. The sales director is paid commission on that annual figure.
Example 3
An online learning platform sells annual memberships for $300 each and also runs paid live workshops. Only the memberships count towards ARR. The finance manager reports workshop income separately as non-recurring revenue. The cost of the platform is tracked against the memberships, so the team can see whether each new member is profitable.
Think of it
ARR is your annual subscription revenue run rate-MRR projected across a full year.
Formula
Calculation
ARR = Monthly recurring revenue x 12
Net new ARR = New ARR + Expansion ARR - Contraction ARR - Churned ARR
Suppose a software company has 400 customers, each paying $250 a month. MRR = 400 x 250 = $100,000. ARR = 100,000 x 12 = $1,200,000. During the year the company also earned $60,000 in one-off set-up fees, which are excluded from ARR. If it adds $300,000 of new ARR and $50,000 of expansion, and loses $80,000 to churn and $20,000 to contraction, net new ARR = 300,000 + 50,000 - 20,000 - 80,000 = $250,000.Case study
Seen in the real world
Cedarpoint Software is an illustrative, fictional company selling scheduling tools to dental clinics. It started the year with $2,000,000 in ARR and told investors it hoped to reach $3,000,000.
By the end of the year it had added $1,400,000 of new ARR but lost $600,000 to cancellations, leaving $2,800,000. The founders were disappointed until the finance lead showed that most cancellations came from clinics on the cheapest plan, while larger clinics were expanding.
The company reduced its focus on the cheapest tier and invested in onboarding for larger customers. In this illustrative case, the next year's churn fell sharply, showing that looking inside the ARR movement matters more than the total alone. The board adopted a rule of reviewing ARR by customer size every quarter, so that a rise in total ARR could never again hide weakness in a particular segment.
Watch out
Common mistakes
- Including one-off fees, such as implementation or training charges, in ARR, which overstates the predictable income.
- Counting a signed contract as ARR before the customer has started, when many companies only count it once the subscription goes live.
- Multiplying one unusually strong month by twelve, when ARR should reflect a normal level of ongoing income.
Questions
People also ask
Is ARR the same as annual revenue?
No, annual revenue includes all income recognised in the year, while ARR counts only the recurring portion and looks forward at the current run rate.
How do you calculate ARR for multi-year contracts?
Divide the total contract value by the number of years, so a $300,000 three-year deal adds $100,000 of ARR.
Does ARR include usage-based fees?
Practices differ, with some companies counting a committed minimum and excluding variable usage, so the definition should always be stated.
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