Annual recurring revenue (ARR) means everything to subscription-based businesses. Recurring revenue comes from ongoing payments for continued access to a product or service. This is the steady income a business can count on receiving at regular intervals—it makes financial planning and investing in growth initiatives possible.
The popular pay-as-you-go approach is not only reliable but also allows businesses to predict their earnings and make smarter decisions in staffing, marketing, and innovation. Increasingly, investors are focusing on ARR per full-time employee as a valuation trend, with a company at scale expected to have an ARR per full-time employee of at least $200,000, according to a 2023 OpenView report.
Beyond the numbers, customer relationships truly thrive under this model. Each payment cycle is a chance to deepen trust and loyalty and ensure that customers stay with the service longer. For those businesses that get it right, this steady revenue stream is just the start. Consistent customer relationships mean businesses gain valuable insights into their customers and can scale their operations with more certainty.
ARR is top of mind for businesses that deal with recurring revenue—and it’s much more than a number. Below, we’ll dig into what you need to know about ARR: what it is, how it’s calculated, why it matters, and how to optimize it.
What’s in this article?
- What does ARR stand for?
- How is ARR calculated?
- Why is ARR so important for businesses?
- Best practices for improving ARR
- How Stripe can help
What does ARR stand for?
ARR stands for annual recurring revenue. It represents the predictable, regularly occurring revenue that a company expects to receive from its subscription-based products or services on an annual basis.
How is ARR calculated?
To calculate ARR, add up the recurring revenue generated from subscriptions or contracts over a one-year period. Here’s the formula to calculate ARR:
ARR = (Monthly Recurring Revenue) x 12
To calculate ARR, you need to know the monthly recurring revenue (MRR), which is the total revenue generated from subscriptions or contracts on a monthly basis. Once you have the MRR, you multiply the number by 12 to get the ARR for one year.
Here’s an example: imagine a company has an MRR of $5,000. To calculate their ARR, do the following:
ARR = $5,000 x 12 = $60,000
In this example, the company’s ARR is $60,000, which represents the expected annual revenue from its subscription-based services.
Why is ARR so important for businesses?
ARR is one of the most informative metrics for businesses, especially for those that operate on subscription-based models. Here are some of the mission-critical applications of ARR:
- Stable revenue predictions: ARR offers a clear picture of the income a business might expect over a year, assuming no changes in the customer base. This stability allows for more accurate forecasting and budgeting: companies can plan their investments and expenses with greater confidence if they know what their baseline revenue should be.
- Customer retention insights: Monitoring ARR closely helps businesses understand customer retention and churn rates. A rising ARR indicates good customer retention, while a declining ARR can signal problems with customer satisfaction or product relevance. This metric can prompt businesses to identify areas that need improvement in order to keep customers engaged and satisfied.
- Valuation and investment attraction: For startups and companies seeking investment, a strong ARR is often a key indicator of health and growth potential. Investors look at ARR to gauge a business’s scalability and long-term profitability. A growing ARR can make a company more attractive to investors and play an important role in negotiations and valuation.
- Performance benchmarking: ARR also serves as a benchmark for internal performance evaluation. It helps businesses set goals and targets for sales and marketing teams. Teams can measure their performance in real time and adjust strategies to ensure they’re on track to meet or exceed their ARR targets.
- Market positioning and growth opportunities: A consistently growing ARR can also indicate a strong market position and open up opportunities for expansion. Companies can use this positive trend as leverage to explore new markets or invest in product development.
ARR is not just a financial metric, but a multifaceted indicator of a company’s health, potential, and customer relationship quality. Investors will appreciate how ARR can be used to support various aspects of business operations and strategic planning.
Best practices for improving ARR
ARR speaks to the overall health of several important aspects of your business, including acquisition and retention efforts, conversion funnel efficiency, upselling and cross-selling tactics, and product-market fit. Efforts to maximize your ARR should focus on improving every aspect of your business that’s reflected in this metric. Here’s what that could look like:
- Deepened customer engagement: Beyond retaining customers, it’s important to increase their engagement and reliance on your product or service. Businesses can achieve this through regular updates, personalized content, and proactive customer support. By making your product an integral part of your customer’s daily operations or routines, you can secure your place in the market and reduce the likelihood of churn.
- Strategic pricing models: Pricing shouldn’t be static. Conduct regular market research to understand what customers are willing to pay and adjust your pricing models accordingly. Consider tiered pricing structures to cater to different customer segments. Also, analyze the lifetime value of customers to determine how much you should invest in acquiring and retaining different types of customers.
- Expanded service offerings: Evolve your product or service offerings to meet changing customer needs and market demands. This could mean adding new features, enhancing existing ones, or entering into strategic partnerships to offer bundled services. Expansions like these can increase the perceived value of your service, encouraging customers to upgrade their subscriptions.
- Data-driven decision-making: Use analytics to understand customer behavior, preferences, and pain points. This data should guide your decisions in product development, marketing, and customer service. Use predictive analytics to identify potential churn risks so you can take proactive measures to retain those customers.
- Focused customer acquisition: Rather than casting a wide net, target your customer acquisition efforts toward segments that show the highest potential for long-term value. Tailor your marketing strategies to these segments to attract high-quality leads that are more likely to convert into long-term subscribers.
- Enhanced customer success: Invest in customer success initiatives that help clients get the most out of your product. This includes comprehensive onboarding processes, regular training sessions, and resources for best practices. When customers see tangible results from your product, they’re more likely to continue their subscriptions.
How Stripe can help
Stripe’s suite of payment solutions intersects with many of the areas that affect ARR, including how a business interacts with customers, gathers and uses payment data, and protects and refines its approach to payments. Stripe offers several features and tools that can help businesses optimize their ARR, including:
- Streamlined subscription management: Stripe provides robust tools for managing subscription-based billing, which include the ability to set up recurring payments, handle upgrades and downgrades, and manage trial periods. By automating these processes, Stripe reduces the administrative burden and potential errors, ensuring a smooth billing experience for the business and its customers.
- Flexible payment options: Stripe supports a variety of payment methods, including credit cards, digital wallets, and direct bank transfers. This flexibility makes it easier for customers worldwide to pay using their preferred method, potentially increasing a business’s customer base and ARR.
- Dunning management: Stripe helps manage failed payments and dunning processes. It retries failed payments automatically, sends out payment update requests to customers, and manages subscription cancellations if needed. This feature helps reduce involuntary churn related to payment issues.
- Data-driven insights: Stripe offers detailed reporting and analytics features. Businesses can track revenue growth, understand payment patterns, and identify trends in customer behavior. This data is invaluable for making informed decisions around marketing strategies, customer engagement efforts, and price optimization.
- Global expansion support: For businesses looking to expand globally, Stripe’s support for multiple currencies and localized payment methods is essential. This capability allows businesses to enter new markets easily, broadening their customer base and increasing ARR opportunities.
- Fraud protection and security: Stripe’s advanced fraud protection tools help minimize chargebacks and fraudulent transactions. This security not only protects revenue but also builds trust with customers, which is essential for sustaining and growing ARR.
- Integrations with other tools: Stripe’s ability to integrate with a wide range of other business tools (like CRM systems, accounting software, and ecommerce platforms) allows for seamless management of the customer lifecycle from acquisition to retention.
- Customization and scalability: Stripe’s API and customizable elements allow businesses to tailor the payment experience to their own needs. This flexibility benefits businesses as they grow and their needs evolve.
Learn more about Stripe Payments.