Revenue
What are ACV and ARR?
Foundership is a daunting undertaking, not least for the sheer number of terms, industry jargon, and acronyms you have to master.
Among them is the slew of revenue metrics one must memorize, understand, and distinguish, despite many of them being painfully similar.
For example, many founders of SaaS companies (perhaps like yourself) are unsure of the difference between ACV and ARR — two revenue-related metrics regularly thrown around in the boardrooms of subscription-based companies.
However, it’s important for leaders to gain a high degree of clarity when it comes to terms like these, as these SaaS metrics drive important decisions related to hiring, investment, and expansion.
In this article, we’ll outline the difference between ACV and ARR, and provide multiple examples of each calculation to illustrate. You’ll learn where each metric is most useful, and understand the important insights these calculations provide.
What is ACV?
ACV (Annual Contract Value) is a revenue metric that describes the amount of revenue you receive from a given customer each year.
ACV can be used whether you’re operating on an annual or monthly subscription model, using tiered or flat-rate pricing, as well as when you have multi-year contracts.
By averaging and normalizing the value each account brings to your SaaS business on an annual basis, you’re able to compare and contrast specific accounts, segments, and industries, to determine where your sales and marketing efforts are best directed.
So, how is Annual Contract Value calculated?
How to Calculate ACV ?
To calculate ACV, you’ll need the following information:
TCV (Total Contract Value)
Total Contract Value is the total revenue you receive for a given customer contract. It includes one-off fees and subscription revenue for the entire length of the contract.
The Total Contract Value formula is:
TCV = Monthly Recurring Revenue (MRR) x Contract Term Length + Any One-time Fees.
One-time fees
One-time fees includes onboarding, implementation, or consultation charges associated with the contract.
Contract length
Lastly, we need the length of the contract in years.
ACV Formula and Example
The Annual Contract Value formula is as follows:
ACV = (TCV - one-time fees) / total years in contract
To illustrate, let’s look at a few examples of Annual Contract Value in SaaS billing agreements.
Scenario 1:
Basecamp, who uses a flat-rate pricing model, signs a new customer on a 36 -month contract
There are no onboarding fees to consider in this example, so our figures are:
Total Contract Value - $3,564
Length of contract - 36 months
Applying our ACV formula:
ACV = ($3,564 - $0) / 3 = $1,188
As may be apparent, in simple scenarios like this, you could simply multiply the account’s monthly revenue by 12 ($99 x 12 = $1,188).
However, things get a little more complicated as we incorporate different pricing tiers, one-time fees, and discounts, such as in the following Annual Contract Value example.
Scenario 2:
GitHub, who use a tiered-pricing model, signs a deal with a new client on a four-year term.
The customer signs up for the Enterprise plan, which is charged at $252 per user, per year, but discounted to $210 for the first 12 months. The contract is for a total of 154 users and includes a one-off implementation cost of $12,500.
To calculate ACV, we need to know three things:
TCV
One-time fees
Length of contract in years
We know there are $12,500 in fees, and the contract is for four years. We need to calculate TCV.
For the first year, the cost is $210 x 154 users = $32,340.
For the next three years, the cost is $252 x 154 users = $38,808 (x3 years = $116,424)
So, our TCV is $32,340 (Year 1) + $116,424 (Years 2-4) + $12,500 (implementation fee) = $161,264.
Applying the ACV formula (ACV = (TCV - one-time fees) / total years in contract):
($161,264 - $12,500) / 4 = $37,191
What is ARR?
ARR (Annual Recurring Revenue) is a metric that describes the revenue, normalized annually, that you can expect to receive for your existing clients in a given year.
ARR is inextricably connected to growth. For the subscription business, ARR growth is revenue growth. It’s the annualized version of MRR (Monthly Recurring Revenue).
Annual Recurring Revenue is a measurement of revenue across all customers, rather than a single account.
How to Calculate ARR
The formula for calculating Annual Recurring Revenue is:
ARR = (overall subscription cost per year + recurring revenue from add-ons or upgrades) - revenue lost from cancellations
There are three components that make up the ARR calculation.
1. Overall Subscription Cost Per Year
This is the revenue you start the year with. For example, if your company uses a flat-rate pricing model with 14,000 users paying $50 a month, your total value per year would be $7m.
2. Recurring Revenue Gained from Add-ons or Upgrades.
This should only include expansion revenue that will be recurring. For example, revenue from an existing customer who also purchases a one-off consulting package from your company should not be included in the calculation.
There are three main methods for expanding revenue. The first is the purchase of add-ons, like Pipedrive’s LeadBooster add-on.
The second is a tier upgrade, such as an existing Pipedrive customer moving from the Advanced plan to the Professional plan. The third is adding additional users, if you’re operating on a pay-per-user model.
3. Revenue Lost from Cancellations or Downgrades.
This includes any reduction in the number of users, downgrade to a lower tier and removal of add-ons.
Let’s look at an example of ARR to illustrate how the formula works in practice.
ARR Calculation:
Let's say the company Copper, has 800 users across three plans:
Basic - 250 users
Professional - 450 users
Business - 100 users
During the year, the following events take place:
5 Professional users downgrade to Basic - Revenue loss of $2,400
2 Business accounts add 10 more users each - Expansion revenue of $30,960
10 Basic users upgrade to Professional - Expansion revenue of $4,800
3 Professional accounts remove 3 users each - Revenue loss of $7,452
2 Professional users upgrade to Business - Expansion revenue of $1,440
4 Basic accounts add 2 more users each - Expansion revenue of $2,784
The figures we require to calculate ARR are as follows:
Overall subscription cost per year = $614,400
Recurring revenue from add-ons or upgrades = $39,984
Revenue lost from cancellations = $9,852
Applying the ARR formula:
$614,400 + $39,984 - $9,852 = $644,532
Annual Contract Value vs ARR: Understanding the Difference
Though ACV and ARR both measure revenue on an annual basis, there is one crucial difference between these two revenue metrics:
ACV measures a single account; ARR measures all accounts at the same time.
For instance, let’s say you have 150 accounts, each with a different number of users, spread across your four pricing tiers.
Each account has an ACV, and it’s calculated individually for that account.
ARR, however, is the total amount of your annual revenue across all accounts.
When to Use ACV and ARR?
ARR is a powerful metric for measuring year-on-year revenue growth in subscription businesses.
Startups and organizations focused on monthly subscriptions (over annual contracts) might prefer to use MRR, though the two are fairly interchangeable.
ARR is most helpful for C-suite executives, founders, and revenue leaders as a measurement of overall revenue growth, as a means of comparing against the competition, and for demonstrating growth to investors.
ACV is a more useful metric for sales and marketing to track.
It can be used to understand sales team performance (how are our cross-sell/upsell initiatives aimed at increasingly ACV performing?), and to determine where marketing efforts should be aimed (segmenting users by industry and then analyzing ACV can tell you which markets generate the most revenue).
Whereas with ARR, we always want to see growth, there is less need for ACV to continue growing (though it’s often a good sign), and companies can still win even with a fairly low ACV.
Consider the pricing structure for HubSpot’s CMS product:
Revenue growth can come from any segment. Enterprise clients will obviously have a higher ACV than Starter clients — $14,000 a year vs $270 a year.
However, it may be easier and more cost-effective for HubSpot to attract 50 Starter customers than it is to close a single Enterprise contract. Though their ACV would stay low ($270), their ARR would grow just as much as if they signed one Enterprise customer.
ACV and ARR Calculation with Examples
To understand how ACV and ARR differ in practice, let’s look at a theoretical example using Pipedrive’s pricing model.
Let’s say Pipedrive has four customers (for the sake of simple calculations):
Customer 1 - 5 users on the Essential plan, 3-year contract, no one-time fees
Customer 2 - 3 users on the Professional plan, 1-year contract, $2,000 in one-time fees
Customer 3 - 10 users on the Advanced plan plus Smart Docs add-on, 2-year contract, no one-time fees
Customer 4 - 7 users on the Professional plan, 2-year contract, $5,000 in one-time fees
We calculate ACV on a per-customer level, using the following formula:
ACV = (TCV - one-time fees) / total years in contract
Customer 1 ACV = $3,240 / 3 = $1,080
Customer 2 ACV = $4,124 - $2,000) / 1 = $2,124
Customer 3 ACV = $8,700 / 2 = $4,350
Customer 4 ACV = ($14,912 - $5,000) / 2 = $4,956
ARR, on the other hand, is calculated at the level of the organization, using the formula:
ARR = (overall subscription cost per year + recurring revenue from add-ons or upgrades) - revenue lost from cancellations
To calculate ARR, then, we need to know the changes that occurred during the year:
Customer 1 - added two users
Customer 2 - downgraded to advanced plan
Customer 3 - added five users but removed the Smart Docs add-on
Customer 4 - no change
Calculating the required figures:
Overall subscription cost per year: $1,080 + $2,124 + $4,350 + $4,956 = $12,510
Recurring revenue from add-ons or upgrades: $432 + $1,980 = $2,412
Revenue lost from cancellations: $936 + $390 = $1,325
And applying the ARR formula:
$12,510 + $2412 - $1325 = $13,597
Having a strong understanding of metrics like ACV and ARR is crucial for today’s SaaS revenue leaders, but it’s only part of the picture.
To put your knowledge into practice, you’ll need a robust method for tracking and reporting on these revenue metrics.
Book a demo with Chargebee today and find out how our subscription billing solution can help you grow, measure, and report on ACV and ARR.