Spot ARR…What’s the Big Deal?

Early-stage founders often ask: “what metric will investors use to value my business in calculating my multiple? Enterprise Value as the numerator but what will be used as the denominator?”

The answer is usually “Spot Annual Recurring Revenue” or “Spot ARR” for short. Spot ARR tends to be the most common metric that investors use because a) most early-stage SaaS businesses are optimizing for growth vs. cash flow generation and so a topline metric makes more sense vs. a profitability metric, b) especially at the early-stage of a SaaS company’s growth curve ARR will materially outpace GAAP revenue (and so provides a leading indicator for what GAAP revenue will be), and c) ASC 606 has made it harder to compare “apples-to-applies” revenue between companies. It’s vital to get Spot ARR right in the eyes of investors to maximize process efficiency and avoid a potential re-trade as they perform their accounting diligence.

Is it Really That Complicated?

Everyone knows what Spot ARR is, right? It’s just your annualized subscription revenue at the point in time that investors are valuing your business. Sounds easy enough…well, kind of. It’s not a GAAP term and so it’s subject to all kinds of manipulation and cloudy definitions…founders often ask questions like…should ongoing services be included? What about episodic, usage-based revenue? What about the license-maintenance revenue from my customers that are transitioning to our new cloud platform? Depending on the answer Spot ARR can take on a bunch of different definitions. Further complicating spot ARR is the evolution of SaaS pricing models the past few years away from simple, seat-based subscriptions towards a myriad of options (e.g. usage-based, outcome-based, consumption-based, hybrid). So yes, it can get fairly complicated…to help clear up the confusion it might be helpful to examine how various public companies calculate it…

So How Does Public SaaS Define It?

Let’s take a look at a handful of recent software IPOs to get a sense for the various flavors of ARR…

Source: S-1s

Overall Observations: What do we notice? We see one commonality - each company annualizes its software revenue and only its software revenue. Beyond that, there’s all kinds of different flavors. OneStream is arguably the most aggressive as they take the final month’s subscription revenue from each contract and annualize it. This is very beneficial to ARR for a business like OneStream whose contracts tend to scale over time with each customer starting with a certain number of seats and committing to an increasing number of seats as the contract proceeds. There’s an argument to be made this makes sense though - after all this is contracted revenue from live customers and so if you calculated ARR using that months’ subscription revenue you’d penalize a business like OneStream that takes a scaling approach to implementing their software which can be common for companies selling to large enterprise. Perhaps partly because Klayvio skews towards SMEs they take the simplest approach - just take that months’ subscription revenue and multiple times 12. Because Toast’s payments revenue can be volatile they take the trailing three months of payments revenue and annualize it when adding to the annualized monthly subscription fees.

Services Revenue: Importantly services revenue is not included by any of these companies nor any other public SaaS in ARR calculations. “But it’s recurring professional services revenue contracted annually!!”. Doesn’t matter. It’s not cloud subscription. Period. Toss it out. Importantly if your business skews towards services vs. software investors will then tend to value your business based upon gross profit or revenue vs. ARR. Or perhaps they’ll take a sum-of-the-parts approach (software valued based upon ARR and services based upon EBITDA).

License-Maintenance Revenue: This depends. If it’s a legacy, on-premise product you’re winding down then probably not. What is certainly more justifiable is license-maintenance revenue that is being transitioned to cloud (see OneStream above). Investors know it’s not going to zero at contract expiration. Keep in mind, however, that your cloud revenue growth rate will come under greater scrutiny in this scenario as some of the growth will be discounted - after all transitioning current customers to a new product isn’t as difficult as adding new logos.

Variable, Usage-Based Revenue: This probably requires the most company-specific approach. As mentioned, Toast takes the trailing three months and annualizes it. If your usage revenue is scaling quickly, you might be able to credibly annualize the latest month instead but will need to justify this by perhaps pointing to strong usage revenue retention such that investors can take comfort in the visibility of this revenue despite being non-contractual.

Last thing…and one of the more common mistakes we see founders make…Contracted Annual Recurring Revenue (“CARR”)? No. It’s forward looking ARR that is not yet implemented…not spot ARR. Notice none of these companies include contracted but not yet implemented customers in ARR. Neither should you. Sure, CARR is a helpful metric in illustrating to investors the visibility of your projected ARR but do not conflate the two.

So yes, spot ARR takes on a variety of flavors but there’s definitely a box that you shouldn’t think too far outside of or else you’ll get into trouble with investors.

Conclusion

Hopefully this was helpful in shedding some light on Spot ARR considerations. We encourage founders to strike a balance between a definition that will be palatable to the greatest number of investors while optimizing for the highest possible figure. This can be a difficult balancing act - we’re more than happy to help you think through it based upon your specific data.