Businesses have increasingly adopted subscription-based business models in recent years. According to financial services company UBS, the value of the subscription economy is expected to reach $1.5 trillion by 2025. Businesses are increasingly interested in options such as recurring revenue financing that allow them to benefit from their recurring revenue while avoiding equity dilution and some of the challenges of traditional loans..

Business leaders and decision-makers need to understand this type of financing. In this article, we'll explain how recurring revenue financing works, why it might be a good choice for some businesses, and the pros and cons of this type of financing.

What’s in this article?

• What is recurring revenue?
  
• What does ARR stand for?
  
• How is ARR calculated?
  
• What is ARR financing?
  
• How do ARR loans work?
  
• Pros and cons of recurring revenue loans
  

What is recurring revenue?

Recurring revenue is a consistent, predictable stream of income that a business expects to receive over time, typically as a result of long-term customer contracts or subscription-based models. This form of revenue is particularly attractive to businesses because it provides a stable foundation for financial planning and reduces the unpredictability associated with one-off sales or seasonal fluctuations.

There are many advantages to deriving a significant portion of business income from recurring sources. Such a predictable revenue structure can improve financial planning, allowing companies to allocate resources more efficiently, plan long-term strategies with more assurance, and potentially secure better terms on loans or credit due to reduced financial risk.

And valuation metrics often improve for businesses that bring in substantial recurring revenue, since it can indicate a strong customer base and a durable business model. When investors assess the health and potential of a company, they favor those that can forecast their income with confidence.

What does ARR stand for?

ARR stands for "annual recurring revenue." It represents the value of the recurring revenue that a business can expect to receive over a one-year period, often used in the context of subscription-based businesses or companies with long-term contracts. ARR provides insight into a company's financial stability and its potential for growth, as it excludes one-time and non-recurring revenue.

How is ARR calculated?

The calculation of ARR is straightforward for businesses: ARR is the annual sum of the recurring revenue from customer contracts. If you have monthly subscriptions, you'd multiply the monthly recurring revenue (MRR) by 12.

For example, if a company has 100 customers, each paying a yearly subscription fee of $1,000, the ARR would be $100,000. Similarly, if a company has 100 customers each paying $100 monthly, the MRR would be $10,000 and the ARR would be $120,000 (MRR x 12).

Factors to consider:

• Contract length: ARR is ideally calculated from annual contracts. For multi-year contracts, the total contract value should be divided by the number of years to determine the ARR.

• Upgrades/downgrades: Any change in the subscription pricing due to customer upgrades or downgrades should be accounted for in the ARR.

• Churn: Lost revenue from customers who cancel should be deducted from ARR.

• One-time fees: ARR only considers recurring revenue, so one-time charges or setup fees should not be included in the calculation.

• Discounts: Any discounts given to customers should be factored into the annual contract value.

When a business approaches a lender for an ARR-based loan, the lender will likely scrutinize the ARR calculation to understand customer churn, contract lengths, discounting practices, and any other factors that could affect the stability and predictability of the recurring revenue. This due diligence helps the lender assess the risk associated with the loan.

What is ARR financing?

ARR financing refers to a type of debt financing tailored specifically to SaaS (software-as-a-service) and other subscription-based businesses. Since these businesses have predictable revenue streams, lenders use the company's ARR as a key metric to determine the amount they're willing to lend and at what terms.

In ARR financing, the loan amount is typically based on a multiple of the company's monthly or annual recurring revenue. The specifics can vary, but often lenders might provide financing ranging from 3 to 12 times the MRR of a company.

The primary advantage of ARR financing is that it aligns with the company's revenue model, allowing businesses to secure funding without diluting equity. And as the company grows its recurring revenue, it might also become eligible for increased financing. This form of financing is especially appealing to companies that need capital to invest in growth but might not want to give away ownership stakes or are not yet ready or eligible for more traditional forms of bank financing.

How do ARR loans work?

ARR loans are made for companies operating on SaaS and similar subscription models, using ARR as a primary benchmark for determining loan eligibility and terms.

Here's a step-by-step overview of how these loans typically work:

• Determination of loan amount
  Lenders evaluate a company's ARR to determine the potential loan amount. Often, they will provide financing based on a multiple of the company's monthly or annual recurring revenue. For instance, a lender might offer a loan that's equivalent to 3 to 12 times the company's MRR.

• Application and documentation
  Companies seeking ARR loans would undergo a standard loan application process, which includes providing financial statements, ARR details, churn rates, customer acquisition costs, and other relevant business metrics.

• Evaluation
  Beyond ARR, lenders might also evaluate the company's growth rate, profitability, customer lifetime value (LTV), and overall market conditions. A steady or rapidly growing ARR is more attractive, as it indicates a stable and expanding customer base.

• Repayment structure
  ARR loans often have flexible repayment structures that align with the company's revenue pattern. This might mean monthly repayments that adjust with MRR or other milestones. The interest rates could be fixed or variable, depending on the agreement.

• Covenants and conditions
  Some ARR loans might have specific covenants or conditions attached, ensuring that the company maintains a certain growth rate or minimizes churn. Violating these covenants could lead to penalties or an increased interest rate.

• Potential upsizing
  As the company grows its ARR, it may become eligible for additional financing, allowing it to draw down more capital based on the increased recurring revenue.

• Term and maturity
  Like other loans, ARR loans have a defined term, at the end of which the loan should be fully repaid. Depending on the lender and the growth trajectory of the business, this term might range from two to three years.

• Exit or refinancing
  At the end of the loan term, or even before, a company might choose to repay the ARR loan in full, refinance it, or transition to another type of financing structure as the business scales and its needs evolve.

Pros and cons of recurring revenue loans

Taking out loans against recurring revenue offers a unique set of advantages and challenges. Here's a summary:

Pros of ARR financing:

• Alignment with business model
  ARR financing matches the subscription-based revenue model, ensuring that companies can borrow in line with their predictable revenue streams.

• No equity dilution
  Companies can access capital without giving away ownership stakes. This is especially beneficial for founders and early investors who wish to maintain control over the business.

• Flexibility in repayment
  Payments often align with the company's monthly recurring revenue, making it adaptable to the company's actual cash flow situation.

• Quick access to capital
  Given its specialized nature, the approval process can be faster than traditional loans, providing businesses with quicker access to necessary funds.

• Scalable funding
  As a company grows its ARR, it may be eligible for increased financing amounts. This feature allows companies to access more capital as they expand.

Cons of ARR financing:

• Potentially higher costs
  Depending on the lender and the associated risks, the interest rates or fees for ARR financing might be higher than traditional loans.

• Covenants and restrictions
  The loan may come with stipulations that mandate the company to maintain specific performance metrics, like a certain growth rate or churn rate. Breaching these can lead to penalties or revised terms.

• Shorter terms
  Compared to traditional long-term loans, ARR financing might have a shorter duration, necessitating quicker repayment or refinancing.

• Dependence on performance metrics
  While traditional loans might focus on broader financial health, ARR financing heavily weighs the company's ARR performance. If the ARR dips or becomes unpredictable, it might affect financing terms or eligibility.

• Limitation to specific businesses
  Companies that do not have a clear recurring revenue model might find it challenging to access or benefit from ARR financing.

ARR loans have become an attractive financing option for subscription-based businesses, especially those in the SaaS sector. This type of financing aligns with predictable subscription revenue streams, can provide faster access to capital, and avoids diluting company equity. While ARR loans are a solution for businesses with strong recurring revenue, they also come with a unique set of considerations. As with any financing decision, weigh the benefits against the challenges to determine suitability for your business.