Definitions and background
Let's start with a quick review of the vocabulary we'll use today, so we're all on the same page.
- ARR: Annual Recurring Revenue. Not to be confused with the Accounting Rate of Return.
- MRR: Monthly Recurring Revenue
- LTV: Life-Time Value
- ACV: Average Contract Value OR Annual Contract Value.
- ARPU: Average Revenue Per User/Unit
- CAC: Customer Acquisition Cost
- CRO: Conversion Rate Optimization
- Churn: the annual percentage rate at which customers stop subscribing to a service
- MVP: Minimum Viable Product
- PMF: Product-Market Fit
- T2D3: Relating to ARR, Triple twice, Double thrice. SaaS growth path to hit $100M ARR and $1B valuations.
- MQL: Marketing-Qualified Lead
- SQL: Sales-Qualified Lead
- LVR: Lead velocity rate measures the growth rate in the number of MQLs your pipeline
- TAM: Total Addressable Market
- SAM: Serviceable Available Market
- SOM: Serviceable Obtainable Market
What is ARR in SaaS?
Annual Recurring Revenue (ARR) totals the value of revenue earned by your subscriptions in a year. ARR is often used in valuation conversations (ARR multiples as an investment valuation tool) as opposed to MRR, which is more often used as an operating metric.
How to calculate ARR in Saas?
A simple Google search will yield all sorts of answers. For our purposes today, we care more about the concept of ARR and ARR growth than the accounting and calculations aspect.
The most important tip here is to make sure that you clarify with everyone else which definition/formula you're using and to stay consistent with it.
To get you started, you can use the following:
Number of Paying Users x ARPU = ARR
Another good tip is that oftentimes one-time payments are excluded from "recurring" calculations like ARR. ARR can also exclude recurring payments with a contract length shorter than the relevant term (i.e. subscriptions under a year could be excluded from ARR calculations). We say "could" because some ARR calculations simply try to average a company's recurring revenue through other methods.
Another tip, keep in mind the distinction between 'booked/earned/contracted' revenue and 'acquired/received/cash-in-bank' revenue.
Other formulas that can be useful:
ARR = MRR x 12
ARR = Yearly subscription revenue + expansion revenue - churn loss
In short, keep in mind that any ARR talk is more about metrics and decision-making. If we're talking accounting, let's stick to GAAP (if in the USA) revenue definitions.
SaaS business model
Software-as-a-service companies famously use a subscription-based pricing model. Yes, we're really starting from the top!
SaaS companies aren't in the software-selling business; they're providing a service. A software-backed service, usually delivered over the internet.
That means customers expect onboarding and customer support, as well as updates and ongoing improvements. In return, a SaaS company gets a more stable and long-term revenue stream (but needs to ensure it doesn't veer too close to becoming a professional services company).
This is worth highlighting because the worst mistake you can make is only focusing on one or two metrics and forgetting about others. The recurring nature of subscription-based revenue involves multiple parts that are all worth optimizing. Without getting into the accounting specifics, we can break down Profit into
Revenue - Expenses.
Revenue can be split into New sales and Recurring revenue.
Expenses can be split into Customer Acquisition Cost and Cost to serve.
What is a good ARR for SaaS?
Benchmarks can be useful as long as they're understood in context. When asking what a good conversion rate is or good funnel metrics are, you have to remember that metrics like that depend on time, place, industry, and a whole host of other factors.
That said, there is a benchmark you can try to compare yourself against. Salesforce may be the most popular example of this.
You may have heard the term T2D3 before. T2D3 refers to the growth trajectory that the most successful tech startups follow. They all Triple their ARR two years in a row then Double their ARR three more years in a row, resulting in $100M ARR and landing them at the $1B valuations coveted by investors everywhere. But hitting that hockey-stick growth figure is hard, which may be why you're here reading this. So let's dive in!
B2B SaaS company maturity stages
A viable SaaS enterprise goes through four distinct growth stages. Each stage focuses on specific KPIs that are most important to the company's growth at that particular point in time.
Start stage: MVP to PMF
First step is getting a working MVP that's usable and useful. Get people to test it, like it, and hopefully talk about it. At this stage, you want as many users as you can get to help validate your business idea and reach Product-Market Fit.
This stage ends once you hit PMF.
Before you can really starting spending on marketing, you have to confirm you've reached product-market fit. This checklist is a good place to start. The idea is to validate your GTM hypotheses by getting raving early adopters that pay and stay, who vote not only with their time but also with their wallets, and who ultimately close out the last step in the flywheel by bringing in more people themselves.
Scale stage: PMF to T2D3
This is where we start really caring about ARR!
Once you've hit PMF, your next priorities are about scaling up and growing. Enter ARR growth.
A lot of tech companies ignore profitability early on in order to build an important user base. A lot of them may have churned, most of them had a CAC that was higher than their LTV, etc.
- LVR: Lead velocity rate measures the growth rate in the number of MQLs your pipeline generates.
- Reduce Churn: Nurture and retention programs to increase LTV and keep customers longer
- Improve ARPU: Upsell discipline on the sales side, supported by strong automation to increase each unit's/user's revenue
Profit stage: T2D3 to 40%
Once you've hit PMF, the timer starts ticking. The most successful companies hit $100M in ~5 years from confirming PMF. After years of growth-focused scaling, it's time to start cashing in. Profitability growth sounds a lot like ARR growth, but the big distinction is that we're moving from increasing positive metrics to decreasing negative ones.
B2B SaaS companies are selling an ongoing service after all. Growth will eventually start to plateau. The law of diminishing marginal returns dictates that past a certain point, efforts in a new area will yield greater results than equal efforts in the area you've already been focusing on. After years of improving customer retention, demand, and growing ARPU, the next best things will be to optimize CTS, CAC, and eventually go back to your first positioning and Ansoff exercises, revisit your SOM, and finally expand your ICP.
Lastly, once ARR and user-acquisition growth start to slow down, make sure that profitability keeps up. As long as profit and growth continue adding up to 40% or more, you'll be in the clear.
- CAC < LTV: optimize demand channels to lower CAC.
- CTS: Get your Cost-to-service as low as possible.
- Rule of 40%: Investors expect growth rate and profitability to add up to 40%.
- LTV: Eventually, once your growth has plateaued and you've reduced your CAC and CTS, the only remaining meaningful area to increase profitability will be upselling current customers. Keep that churn down and ARPU up.
Actionable ways to improve ARR growth
If you've skipped straight to this section, just remember the main takeaway: ARR growth must be approached holistically by focusing on different factors at different times of your growth journey.
- While not mathematically accurate, this thematically correct formula shows the different areas you can optimize and the effect each of them has on your bottom line.
This formula is taken directly from co-founder Stijn Hendrikse's book of the same name, T2D3. Check it out for a whole ecosystem of articles and resources, including a masterclass.
- You want CAC and churn to go down while increasing MQL and ARPU growth and optimizing conversion rates.
- You can hit $1M ARR by making 10 sales at $100k each, or by making 10,000 sales at $100 each. The lower the ACV, the more low-touch and zero-touch acquisition methods can work.
- Self-service freemium and free trials and drive your funnel without much sales or even marketing interaction. On the other hand, if your customers are big enterprises or government contracts with longer sales cycles and more relationship-building and analyst
ARR growth tip #3: Improve the quality and quantity of your MQLs
No two ways about it. No MQLs, no sales, no revenue. You hit PMF, you confirmed your ICP; you have permission to spend marketing dollars. The question is where and how. You have so many options!
- We talk a lot about balancing long-term setup (organic) with quick wins (paid). We talk about lead scoring, nurture, paid media, ABM, etc. On your way to PMF you may have used a few of these and figured out which ones you'd like to double down on, try next, or stop using.
- Friction reduction is paramount for improved conversion rates. Aside from improving raw generation numbers (page visits, lead magnet downloads), a single % improvement between one step and another (e.g. MQL to SQL or subscriber to lead) can have a much bigger effect on the later stages of the funnel than strict improvements at any one stage.
- Revisit your ICP criteria at least once a year if not every 6 months, and compare your funnel, as well as your closed, won vs lost to your ICP, and talk about any findings or patterns.
- Align sales and marketing. Make sure sales follow up on MQLs handed off by marketing while they're still hot. Make sure marketing isn't wasting the time of sales with low-quality MQLs.
ARR growth tip #4: Optimize your CAC
- Early on, a lot of tech companies can justify exorbitant CACs because users are worth more than their LTV when trying to cross the chasm. But that's temporary.
- In your effort to lower your CAC, you'll inevitably strengthen your demand generation standards, resulting in a cleaner funnel with higher ARR potential in the form of better conversion rates, increased ARPU, and increased LTV.
- Notice the use of the word "optimize" instead of "decrease". Sometimes, the optimal CAC is not the lowest CAC. Find the sweet spot.
- You should implement solid NPS (net promoter score) feedback loops and referral programs and incentives to get that SaaS inbound flywheel in full swing.
ARR growth tip #5: Get churn under control
- The whole premise of subscription-based pricing is the recurring element of it. Churn is your biggest enemy in the long run. Start thinking about how to optimize it earlier rather than later.
- Two go-to ways are nurture campaigns and retention programs.
- Nurture campaigns can be aimed at leads and MQLs, recent app signup users, and of course customers as well. From simple marketing emails to more involved onboarding emails, nurturing content can keep the target audience engaged.
- More importantly when it comes to churning, retention should be baked into the software and service components of the offering. Marketing's job often ends when the MQL is handed off to sales after all.
- The HEART framework helps break down how UX can be impacted inside and outside of the software. This is most important to help identify at-risk customers.
- The best place to start with churn reduction is by targeting at-risk customers. Threats and signs can depend on your SaaS and industry, but a universal signal is an engagement. App usage metrics are paramount to tracking which customers are decreasing their usage of your app, allowing sales and customer success to jump in before it's too late.
ARR growth tip #6: Increase ARPU and LTV
- Sales may have gotten used to offering discounts and focusing on new business at the expense of driving upsells and potentially renewals.
- A great first step when growth starts slowing down is ensuring that the ACV is as high as can be.
- To do so, the sales team can stop using discounts to get people in the door and sell at full price.
- On top of selling bigger accounts, the sales team can look to bake into its sales process upselling and cross-selling points. A bigger emphasis on account management will yield equal and eventually greater returns than a focus on new business, so start laying the foundation for that as you go.
- Cracking down on discounting will not only increase your average LTV (the holy grail metric in the SaaS world), but it will also indirectly reduce your churn by keeping at bay lower-quality prospects.
- Depending on your ACV and user numbers, an incorrectly-timed trial period can really add up in lost revenue. Make sure that your 7-, 14-, or 30-day trial is of the appropriate length. You really want to go through the onboarding process as early as possible to reinforce the feeling of commitment.
- Speaking of which, once the trial is over, sales should really drive year-long commitments. Month-to-month or sub-year contracts should be exceptions.
- You can raise your prices every year or two with no impact on sales volume.
- But more importantly, you have to make sure that your pricing structure is optimal to being with. Just like your ICP, you're expected to keep coming back to your pricing framework.
- That said, a good place to start is making sure you're not offering too many or too little options.
- You should also strive towards value-based pricing.
- This is done by focusing on your ICP, diving deep into your sales data and identifying any patterns, use cases, or verticals that you really resonate with.
- The result is an increased likelihood to survive midway through your 5-year T2D3 journey when competition is at its peak and the only companies to survive are the biggest players with the most lighthouse logos, strongest word-of-mouth, and traction, or most robust niches.
ARR growth tip #9: Work on your analyst relations
- As your product category matures and more and more people cross the chasm, you might find yourself or at least your market featured as a software category by leading analysts.
- Aside from PPL (pay-per-lead) offered by third-party review sites like Capterra and the like, having your very own Garnet and other contacts will ensure that you don't fall behind.
ARR growth tip #10: Upgrade your team
- During our marketing audits, one of our most common findings is that most young B2B SaaS companies don't know what to hire for. At least in terms of marketing.
- Leaving important skill groups unfilled, or only partially filled by under-qualified members has a direct effect on your yearly ARR growth.
ARR growth tip #11: Explore channel sales and partnerships
- Hand in hand with the tip above, as you invest in your people, think also of investing in partnerships and resellers.
- Don't do this too early. Once the market is mature enough and you're established as a primary player, it can be worth it to explore this particular demand gen avenue. But make sure this comes after the optimization of your primary demand generation channels.
ARR growth tip #12: Expand your ICP
- First, make sure there is no more room for improvement in any of the following areas:
- Funnel growth: MQL quantity and quality
- CAC optimization
- Conversion rates and friction optimization
- ARPU and LTV expansion
- Once you've exhausted your SOM in terms of both acquisitions, but also cross- and up-selling as well as costs optimization, it may be time to revisit your initial ICP filters and relax some of the criteria limitations. That could mean moving upmarket, to different geographic markets, or targeting new verticals.
- ARR is a useful metric for valuation, financial reporting and projections, as well as sales and marketing management and decision-making.
- ARR growth is a multi-variable function with lots of moving pieces that can all be improved upon in tandem.
- Some measures have a higher priority and should be focused on first before moving to other levers to pull.