SaaS, ARR and Valuations.
ARR (Annual Recurring Revenue) is one of the most popular SaaS (Non-GAAP) metrics. It is also one of the most loosely used metrics, and is frequently misused.
What is ARR?
In its purest form, ARR is used by true SaaS business models to describe the aggregate annual value of the entire customer set. Customers sign contracts with annual subscription increments (one, two, three, etc. year deals), and the spend is predictable across the course of the contract.
At contract expiration these customers either
- Renew (sign another contract with same annual value),
- Expand (sign another contract with higher annual value),
- Contract (sign another contract with lower annual value), or
- Churn (stop being a customer and spend goes to zero).
Many laude the SaaS business model because ARR is inherently predictable — you know what your revenue will be over the coming 12 months, and sometimes even further out than that. On top of that, churn and expansion tend to be quite predictable with low volatility.
Enterprise software businesses strive for 90–95% gross retention (generally the percent of revenue that sticks vs churns altogether), with net expansion in the 120%+ range (the aggregate change in expansion — contraction — churned revenue). For SaaS businesses that target smaller SMB customer segments, gross retention is typically in the mid to low 80’s with net expansion in the ~105% range.
With stable gross retention and net expansion figures, it’s actually quite easy to model SaaS businesses. And the predictability into the future gives investors comfort.
Why is ARR a valuation multiple?
Many investors laugh (and some rightly so) at the fact that software companies’ valuations are often described as a multiple of revenue.
At the end of the day, shouldn’t profits / cash flow be the true valuation driver? Why do software companies get “credit” simply for revenue?
It largely has to do with what I described above. Software SaaS revenue streams (subscriptions) are generally highly predictable and long dated (a 90% gross retention implies your customers stick with you for 10 years on average). And once a customer has paid back the initial acquisition costs to acquire it, all future streams of revenue can loosely be described as a cash flow annuity. This all ultimately means that once software businesses transition from growth mode (i.e. majority of customers still paying back their CAC) to “maturity mode” (i.e. most customers have already paid back their CAC and are now spitting off profits) that the overall business will transition from high growth burning money, to lower growth generating profits. That’s at least the promise of SaaS that investors have bought into when valuing software businesses with revenue multiples.
Isn’t DCF a better attribute for valuation?
If you were to truly value any business (SaaS included!), you’d build a DCF (discounted cash flow) analysis. This analysis does two things. First, it models out the annual cash flow of a business (say 10 years out), and discounts the future value of those cash flows back to present value (this is why software businesses are sensitive to interest rates — as rates go up, so does the discount rate). Second — it will look at the terminal value of the business (say the cash flow in year 10), make an assumption around what top line growth will be and what FCF margins will be at maturity, apply a multiple to it, and discount that back.
What you’ll find for most Software businesses — the majority of the value of a DCF sits in the terminal value (our outer years of FCF). So, what are the true assumptions we’re making when valuing software companies with revenue multiples? It’s the assumptions in the terminal value. Namely, retention!!
The power of retention
Ok — so this was a long-winded intro all to say one of the biggest assumptions software investors make when valuing software companies is that RETENTION will be stable and revenue is RECURRING. And a big assumption around ARR is that RETENTION will remain stable!
What isn’t ARR?
So how is ARR misused? The biggest culprit is describing non recurring revenue as ARR. And there’s many flavors of this. The most egregious is to take truly one time revenue, “annualize” it, and call it “ARR.” Let’s look at consumption (sometimes called metered) revenue — this is also not technically recurring! It’s probably better described as reoccurring vs recurring. This is why the consumption players (Snowflake, Mongo, Confluent, Azure, AWS, etc.) show more variability in the macro slowdown.
Why it matters.
The reason it matters that ARR is misused, is that the biggest downstream effect of misused ARR is the retention. For true ARR, retention is usually stable and predictable, so it’s “ok” for most of the present-day valuation to be based on outer years / terminal value. For “fake” ARR, retention can vary wildly. And as I described above, a lynchpin of SaaS valuations lies in the retention, and assumptions made around it. If retention deteriorates, the terminal value may very well be 0.
The repercussions of misused ARR extend far beyond skewed valuation metrics; they jeopardize the stability and longevity of SaaS businesses. Inaccurate assumptions about retention rates can undermine the credibility of future revenue projections, casting doubt on the company’s long-term viability.
While ARR serves as a valuable metric for assessing SaaS companies’ performance, its misuse can have dire consequences. Operators and investors must exercise diligence and discernment, ensuring that ARR accurately reflects the company’s recurring revenue streams and customer retention rates. By upholding the integrity of ARR, investors can make informed decisions that drive sustainable growth and profitability in the dynamic world of SaaS.
Thanks for reading. I’m John McAuliffe and I help companies accelerate growth more consistently and with greater predictability.
I am a learner. I find myself constantly reading on a variety of topics with an insatiable appetite for continuous learning. My thoughts on business have been influenced by many. You may feel a bit of déjà vu in reading some of my thoughts because of this. When it comes to strategy and business management systems I follow the likes of Jim Collins, Roger Martin, Gino Wickman, Verne Harnish amongst others. On consumer insights, marketing and sales I am influenced by the likes of Adele Revella, John McMahon, Geoffrey Moore and many others. Thanks for reading.
