#70- All revenues are not equal
Demystifying SaaS - Part 2
Welcome to the very sporadic Siddharth’s Newsletter. I write about my learnings and experience as an early stage investor and try to demystify key items for my founder friends. If you follow me on LinkedIn or Twitter, you may realize I am long India B2B software, and my affinity will follow to this newsletter as well.
Below you can find a bunch of my notes on B2B software here.
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This is in continuation of a multi-part series on Demystifying SaaS which will help both SaaS & non SaaS folks better understand the space. If you’d like me to cover a topic, please comment below. Thanks
In Part 1 of the series, I showed you how SaaS is 2 businesses not 1. The overall business is split into a recurring revenue business and a customer acquisition business.
What is recurring revenue?
Recurring revenue is the portion of a company's revenue that is expected to continue in the future. Unlike one-off sales, these revenues are predictable, stable and can be counted on to occur at regular intervals going forward with a relatively high degree of certainty.1
Starting annual recurring revenue (Starting ARR)
You ended the last year with some portion of recurring revenues, those become your starting revenues for this year. From the last post, we remember that the recurring revenue portion of the business was $500k.
New annual recurring revenue (New ARR)
“New recurring revenues earned from new customers” in the current year become the New ARR added in this year. Your sales and marketing efforts lead you to earn new ARR.
Expansion annual recurring revenue (Expansion ARR)
You’ve sold to one customer, and they keep buying from you for long periods of time. And, over time they may also buy more things from you. A customer who started with a $10,000 plan, is now at a $20,000 plan.
How and where do you capture that? Is it new revenue? The BD team will want to claim it. But the Customer Success team can say they helped the customer explore more and hence the sale should be attributed to them. What do you do?
So you say, let me add another line item to attribute “new business from existing customers” i.e. Expansion ARR.
Contraction annual recurring revenue (Contraction ARR)
You go set up a meeting with the customer success team. They say the customer couldn’t afford an expensive solution, so we offered them a cheaper plan with lower benefits - the customer is happy. The customer started off the year with a $5,000 plan, but by the end of the year were at the $2,000 plan. How do you measure it? Its lost revenue, but not a lost customer.
So you say, let me add another line item to attribute “lower business from existing customers” i.e. Contraction ARR.
Churn annual recurring revenue (Churn ARR)
Over the life of your business you will encounter that some customers did not like your solution, found alternatives, or were not ideal customers who require your solutions. Hence you lose them, sometimes forever. “Lost business from existing customers” is called churn ARR.
So what do you make off all this?
Enter the ARR waterfall.
ARR waterfall
For the above to make sense, we need to create the ARR waterfall which shows us the following:
This is a distinctly different picture than the one we saw in Fig 1 & 2 in the last post.
While we believed that the business added $500k of new revenue in the year, the reality was:
New ARR $700k + Expansion ARR $400k = $1.1mn in new business acquired
But we only see $500k of new business. Why? That’s because we see that the company also lost:
Contraction ARR of $350k + Churn ARR of $250k = $600k business lost
…thus we arrive at a net new business added of $500k for the year.
This is not captured in a regular P&L. And that is why every software business must capture revenue in this manner.
Recurring Revenue Definition - Investopedia