How to calculate Annual Recurring Revenue
Gross New, Expansion, Contraction, Churn and Restart–we unpack it all.
This post is an adaptation of Chapter 2 of our book, The Ultimate Guide to ARR.
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Chris here. The guy who cleaned up all of Bobby’s messes when we worked together at Intercom. Let me start with a story he told me when I was cutting my ARR teeth. For that, I’ll quickly adopt Bobby's voice.
It was my first week at Intercom, and a report from one of our investors at Social Capital landed in my inbox. It was the first time I’d seen an ARR Build.
Ever been on a blind date? I have. It was like that—very daunting. The ARR Build didn’t make much sense to me . I didn’t have a clue what it meant to record “Gross New ARR” or how to think about “Expansion”, “Contraction”, or “Churn.” And what on earth was “NRR”? So. Many. Acronyms.
But what was scary at first quickly became clear as I asked questions and listened—the recipe for any successful date.
I quickly learned why breaking ARR into its component parts was critical to understanding the story of the business and how to influence it. Each component represented a distinct and different area of the business we could impact. With this fundamental and deep understanding of Intercom’s ARR, we oriented the company. Specific teams were assigned to own different components and their associated targets. This shift in focus played a huge role in driving the hyper-growth in the years that followed.
This “first date” with ARR marked the beginning of my journey to unravel what the hell it is, how it comes to be, and how to measure and forecast it properly. To understand ARR it should be broken into its component parts.
Isn’t Bobby a great storyteller? Alright, let’s get right into it. From the ground up.
Total ARR
Reporting on Annual Recurring Revenue is like building a house: You must start with a solid foundation. That foundation is Total ARR, which is a great place to start because it’s easy to measure and calculate. Put simply, it’s the total Annual Recurring Revenue from all customers over time.
Net New ARR
Next, you want to calculate net changes in ARR from one period to the next, which we call Net New ARR. You’ll want to set goals against Net New ARR and examine benchmarks (which we’ll discuss later) to understand how well your business is growing.
Calculating Net New ARR
From here, we need to break down Net New ARR into parts based on the type of ARR, which will expose added and lost revenue in a given period. This helps paint a clear picture of how customers’ actions impact the business.
The formula for Net New ARR looks like this:
Next we’ll cover each component in more detail, including why they are important to the health of your business, how you can influence them, and who should take ownership of that.
Gross New ARR
Gross New ARR comes from new customers who start a paid subscription to your product or service for the first time.
Why it matters
Gross New is crucial in the ARR Build for two reasons:
When a customer’s subscription starts, it determines what cohort they are part of, which impacts any cohort analyses
Gross New makes up the vast majority of Net New ARR for early-stage companies. As the business scales, the balance shifts, and a higher concentration of Net New ARR comes from Expansion ARR from existing customers. This has significant implications for your ability to forecast ARR in the early days—a pain point even the most successful tech companies have had to contend with.
In the early days at Snowflake, Brad Floering, the company’s Head of FP&A, realized the accuracy of his topline forecast largely depended on his team’s ability to predict the distribution of New vs. Existing customers and the expected usage behavior for those newly acquired customers.
Because this segment of the business was so important in getting the overall forecast right, the company eventually had to create an entire forecast model just for new customers, which they referred to as the Cold Start model.
How to optimize it
Dialing in the performance of Gross New ARR requires a deep understanding of your company’s Ideal Customer Profile (ICP). Your ICP is a generalized representation of types of people or companies you want to sell to (and hopefully are also building for). You’ll want to be clear on what pain points your product solves for them, how you differentiate your solution from the competition, and how you price your product based on that.
Operationalizing this means your sales, marketing, product, and growth teams must be aligned and in lockstep with your go-to-market strategy.
You can help them in this journey by providing clear and concise reporting on the upstream metrics that feed into Gross New ARR, such as top-of-funnel reporting and segmenting performance by firmographic attributes (e.g., geography, company size, buyer persona).
Levers to pull
Increase lead volume
Improve funnel conversion
Increase the starting price point
Expansion & Contraction ARR
Everything outside Gross New ARR is influenced by existing customers, starting with Expansion and Contraction.
These components are really two sides of the same coin: one tells you if an existing customer increased their spend (expansion) and the other if they decreased (contraction).
The main thing to keep in mind when looking at Expansion and Contraction, and other components that we’ll cover next (e.g., Churn), is that in order for a customer’s action to fall into the Expansion/ Contraction bucket, they must hold an active subscription vs. cancelling their subscription and no longer be considered a customer for the purposes of ARR reporting.
Why it matters
Understanding fluctuations in these components tells you whether customers tend to increase or decrease spend over time, in addition to the consistency in the direction of that spend.
Consider it this way: acquiring new customers is time-consuming and expensive. It often requires a large budget for demand generation, a dedicated new business Sales team, and months of engagement to get a cold lead to buy your product.
Compare that to turning your early adopters into evangelists who promote your product for you. “Word of Mouth” is a beautiful thing. It costs you (almost) nothing in terms of dollars invested, which is why almost every breakthrough startup shows signs of organic growth (with minimal spend on Sales and Marketing), and investors are so keen to track expansion dynamics.
How to optimize it
First impressions are critical to a customer’s likelihood of expanding or contracting in the future. Be diligent in tracking engagement and activation metrics as new customers are onboarded. These will be the best predictors of whether a customer will expand or contract in the future.
Work with Sales and Customer Success to roll out customer health dashboards and actively monitor response and resolution times with support. Building the right habits early on will pay dividends down the line.
Levers to pull
Expansion
Pricing that better captures the value customers derive
Launch new products and offerings
Upsell and cross-sell campaigns
Contraction
Improve onboarding and activation of feature sets most commonly
dropped
Don’t oversell in the initial sale
Churn ARR
Churn is usually defined as the point in time when a customer cancels their last remaining subscription. Similar to Gross New ARR, the exact definition depends on where you draw the line on what constitutes a “customer” for the purpose of reporting ARR. But it always involves a cancellation at some level.
Why it matters
We’ve discussed how your business's growth will eventually transition from being driven by customer acquisition (Gross New) early on to being heavier on existing business (Expansion) as the company scales.
Keeping customers active is the biggest lever to speeding up this snowball effect. Companies with a “leaky bucket”, meaning a high percentage of customers quickly churn, must work twice as hard to acquire new customers to return to growth. Doing so is resource-intensive (and expensive), which is why investors and operators alike are so focused on Churn performance.
How to optimize it
Like Expansion and Contraction, tracking engagement metrics is critical to understanding the health of your customers and their likelihood of keeping an active subscription.
Investing in teams focused on Customer Support and Success goes a long way to addressing pain points that may lead to Churn down the line. Understanding where in the customer lifecycle Churn takes place can help you infer where help is needed.
Seeing a lot of customers become inactive within the first few months? This might be an issue with onboarding. Alternatively, if you’re seeing customers leave once they hit a certain spend threshold or level of usage, that may be a sign their needs are outgrowing your product and investment in additional, usually more sophisticated, features is needed.
Don’t wait for things to reach a point of no return before engaging with customers, and make sure you have the right amount of coverage on your teams to serve their needs and be responsive. Investments in Churn-save will likely return many multiples in the future.
Levers to pull
Shore up key product gaps/issues
Improve onboarding and activation
Improve pricing and packaging
Restart (AKA Resurrection) ARR
Restarts happen when a customer who had previously churned— cancelled their subscription or downgraded to a free plan—starts a new paid subscription.
Most businesses limit the Restart window to one year. This means that if a customer churns and returns after more than one year and starts a new paid subscription, they will contribute to Gross New ARR. Landing on the right definition for your business depends on your go-to-market motion.
In enterprise companies, where customers are on annual contracts, there’s less of a need for a defined window, as the customer proactively communicates Churns in the form of an opt-out. However, self-serve or PLG businesses tend to see customers come and go more frequently and may want to consider adding a 3-6 month limit to the Restart window.
Why it matters
Restart is less important as a performance indicator and more about hygiene. Differentiating between win-back customers and those joining for the very first time helps eliminate false signals around Gross New and leads to better top-of-funnel reporting.
Having said that, understanding why customers come back can provide valuable testimonials for marketing and insights for product to prevent future Churns. It’s also a great indicator of the progress you’ve made as a team, in which you’ve potentially shored up shortcomings that customers previously felt.
How to optimize it
Because a Restart event mainly depends on the customer taking action, this component of ARR receives less proactive attention.
The obvious tactic is to target win-back campaigns at churned customers. But over the long run, what will ultimately drive restarts is your ability to fix key product issues. Resolve the reasons that customers churn, and you’ll see some customers restart.
Summary
Hopefully, you now have a deeper understanding of Annual Recurring Revenue and its components. There was a lot to digest, so we’ve created a cheat sheet for you.
May the ARR be with you.