Disclaimer: As with rest of this site, please treat all information as educational. Consult finance and/or legal professionals on all matters.
Finance for Consumption
The guiding principles to follow are: (in priority order)
- Matching: Recognize revenue in the period earned
- Smoothing: Recognize revenue as smoothly as possible
Billings: Greater of:
- $0
or - Cumulative usage – cumulative billings
Revenue Recognized: Greater of
- (months elapsed) * (minimum commitment)/12 – (cumul. rev. rec. at end of prior period)
- (cumul. usage) – (cumul. rev. rec. at end of prior period)
Here is an extreme example:
Imagine a customer signed a $120K minimum annual contract. It is use it or lose it and they will be billed for overage if/when they exceed $120K. Further, assumptions:
- They pay in full up-front (though payment timing is independent of revenue recognition in ordinary accrual accounting.)
- They are billed for overages in the month accrued (though there true-ups could be end of quarter or end of year).
| Month | Billings | Incremental Usage | Cumul. Usage | Revenue Recognized | Cumul. Rev. Rec. |
| 1 | $120 | 5 | 5 | 10 | 10 |
| 2 | 0 | 5 | 10 | 10 | 20 |
| 3 | 0 | 15 | 25 | 10 | 30 |
| 4 | 0 | 30 | 55 | 25 | 55 |
| 5 | 0 | 5 | 60 | 5 | 60 |
| 6 | 0 | 10 | 70 | 10 | 70 |
| 7 | 0 | 5 | 75 | 5 | 75 |
| 8 | 0 | 0 | 75 | 5 | 80 |
| 9 | 15 | 55 | 135 | 55 | 135 |
| 10 | 15 | 15 | 145 | 15 | 145 |
| 11 | 5 | 5 | 150 | 5 | 150 |
| 12 | 20 | 20 | 170 | 20 | 170 |
Accounting for Discounted Professional Services
In the context of ASC 606 and SaaS revenue recognition, it’s important to appropriately allocate the transaction price to the different performance obligations within the contract, which includes both the recurring SaaS subscription and any one-time professional services (PS). The holds true even if professional services (such as implementation fees) are heavily discounted.
By way of example, imagine you sell a new business deal for $20K of ARR and bundle professional services (PS) for free. Further assume the list price for the recurring subscription is $25K and the list price for the PS is $5K; hence the total list price for the package is $30K. For revenue recognition, the $20K should thus be split at $20K*(25/30) = $16.7K ARR and $20K*(5/30) = $3.3K PS. ARR is usually recognized linearly whereas PS is recognized when the services are delivered.
The way revenue is recognized for taxation and financial statement can be different from ARR, a non-GAAP measure. In this example, the company would likely retire $20K of rep quota, add $20K of ARR, and create a renewal opportunity for $20K (or more if a price increase is expected for the next subscription year).
CARR versus ARR
The term ARR (annual recurring revenue) is far more commonly used than CARR (contracted annual recurring revenue or committed annual recurring revenue). When I first encountered CARR, I was confused and indeed the difference is subtle.
All ARR is CARR but not all CARR is ARR. ARR represents the annualized value of all active, recurring subscription contracts. CARR is ARR plus contracts that have been signed but are not yet active or that have opt-out provisions. CARR is tied to the booking date. Neither CARR nor ARR one time fees such as those for implementation or professional services.
As C/ARR is not a GAAP measure, definitions can vary. For instance, some reduce CARR by pending churn since the intent of this measure is to provide the most accurate view of future revenue generation. Ultimately, the measures should be consistent, easy to explain, and easy to manage/administer in systems such as CRM, finance, or business intelligence tools.
C/ARR is a point-in-time measure of active and not-yet active contracts. Hence, the measures reflect what is currently ‘in force’ rather than a moment-to-moment forward projection of the next 12 months.
In general, C/ARR is unrelated to payment terms (billing).
Active Contracts & Implementation
An active contract is one where a vendor has invoiced a customer that is able to access and control the product; they need not be utilizing all seats or capabilities. While that is obvious, here are some examples of not yet active contracts that would be part of CARR but not ARR:
- Customer has signed a contract, new or expansion, with a future subscription start date. This is quite common for new deals as many vendors align start dates to the beginning of the following month. It is also common for multi-year deals with ramps at each anniversary.
- Customer is in the midst of an extended implementation during which time the vendor is not contractually allowed to bill the customer for the recurring subscription. As a rule of thumb, treat the recurring subscription amount as CARR and ARR if implementation is under 90 days. If it is over 90 days, then treat as only CARR until the customer is live.
Complex contracts often have multiple phases. For simplicity, one might trigger the recognition of 100% of CARR as ARR once Phase I is complete; by way of example, Phase I may be deemed complete with the client begins user-acceptance testing (UAT).
Usage Based Pricing (or otherwise volatile)
In the strictest treatment, CARR and ARR should only include contracted minimum commitments with no adjustment for overage invoiced or projected. Usage and/or transaction-based revenues are not ARR. There are reoccurring but not recurring revenues.
One may still want an ARR-like measure to understand the potential for the business over the next 12 months. Assuming a reasonably high month-to-month renewal rate, one may explore the following:
- Conservative: Use minimum of the last n months and multiply by 12
- Moderate: Use the average of the last n months and multiply by 12
- Aggressive: Use the moderate approach AND apply an expansion factor (this is also complicated to get right)
Here, “n” depends on how volatile monthly billings tend to be. The more volatility, the larger the number of months. I’d start with 3 mos.
Paid Trials, Pilots, or Proofs-of-Concept (PoCs)
In almost every circumstance, revenue from paid trials, pilots, or PoCs should be excluded from C/ARR.
Consider the following nuances: (I’ll use “trial” as shorthand for trials, pilots, or PoCs):
- The trial contract does not include a pre-negotiated opt-in or opt-out that triggers a 12+ month subscription: In this case, revenue is non-recurring and therefore definitely not C/ARR
- The trial contract includes a pre-negotiated opt-in or opt-out that triggers a 12+ month subscription: This case is in the grey zone. The conservative approach is to keep C/ARR at $0 until the subscription is active. The moderate approach is to include the 1st year, post-trial contract value as CARR if such trails have historically converted at very high rates (perhaps > 90%).
- The trial contract includes a pre-negotiated opt-in or opt-out that triggers a continuation for the remainder of the year. A not uncommon example would be a 1 year, $120K contract with a 3-month unconditional (termination for convenience) opt-out. Here, for the first three months, CARR = $120K and ARR = $0. After the opt-out is no longer in force, CARR = ARR = $120K.
Contracts Under 12 Months
For monthly, quarterly, or 6-month contracts, annualize as long contracts have historically renewed at high rates (perhaps > 90%). Hence, a $10K month-to-month contract would have CARR = ARR = $120K. I recommend reporting on the % of C/ARR under 12 mos, 12 mos, and over 12 mos. Healthier businesses tend to have a high percentage of multi-year deals.
Contracts Over 12 Months
If the contact does not have a built-in ramp, then simply annualize the amount as CARR and ARR. For example, a 2-year, $240K deal with $120K in each year would have CARR = ARR = $120K. Or, an 18-month, $180K deal would be CARR = ARR = $180K * (12 / 18) = $120K
When deals have ramps, there are three possible treatments, each with benefits and drawbacks. Here are the implications of a 2-year, $360K deal structured as $120K in year 1 and $240K in year 2.
For starters, ARR always equals the value of the active (portion) of the contract and will be $120K in year 1 and $240K in year 2. The variation happens with CARR.
The first and most common option is to have CARR follow the ramp. Thus, in year 1, CARR = $120K and in year 2, CARR = $240K. I recommend this especially when there is any uncertainty over the year 2 amount which would be the case, for instance, if the contract has an opt-out or opt-in provision. I also recommend this, as is true in most instances, when the quantity of service delivered, such as the number of seats, tracks the ramp.
There are drawbacks with this first option. One, we are not strictly following the annualization principle. Two, CARR does not fully reflect the return on sales effort.
The second option is to let CARR equal the average value. Thus, CARR = ($120K + $240K) * (12/14) = $180K for both year 1 and year 2. Here, we faithfully follow the annualization principle. However, CARR appears ‘inflated’ relative to ARR in year 1 and ‘deflated’ relative to ARR in year 2. Plus, we are still not fully reflecting the return on sales effort; a flat $240K renewal in year 3 would create an artificial jump in CARR. This option feels reasonable when the ramp is mainly for payment terms rather than the quantity of service delivered.
The third option is to let CARR equal the maximum annual value. Thus, CARR = $240K in both years 1 and 2. Now, we fully reflect the return on sales effort; beyond renewing the contract at the end of year 2, additional sales effort will be required to increase the deal above $240K.
Contracts With Discounts
C/ARR reflects the revenue one expects to receive over the annualized duration of the contract. So, if customer signs a 12-month contract with a list price of $120K before factoring in a 20% discount, then CARR = ARR = $120K * 0.8 = $96K.
Similarly, if a customer signs a ’14-for-12′ contract for $120K, one must annualize such that CARR = ARR = $120K * (12/14) = $102.9K. The rationale here is that the customer will mostly likely press to renew at the same effective monthly rate of $8,571.
To me, the determination of C/ARR does not depend on billing. In the 14-for-12 example, the CARR and ARR amounts are the same regardless on whether the client pays $10K monthly for the first 12 or last 12 months, pays net 30/45/whatever, quarterly, semi-annually, etc.
Contracts with Upgrades or Early Renewals
A customer signs a 12-month contract for $120K. At the start of month 4, they upgrade for another $120K ARR, co-terminus with the original contract. Prior to the upgrade, CARR = ARR = $120K. After the upgrade, CARR = ARR = $240K since this reflects the amount of revenue on can expect to recognize of the next 12- months assuming a flat renewal.
If the upgrade had not been co-terminus, the answer is the same as above for the same reason – $240K remains the amount of revenue you expect to recognize after the upgrade.
Another situation to consider is early-renewals, sometimes referred to as cancel/rewrites. Imagine a customer on a $120K contract executes an early renewal with 4 months remaining. If the renewal is flat such that is merely extends the contract, then ARR and CARR remain unchanged at $120K. If the renewal has an upgrade such that the next 12-months are now at $180K, then ARR = CARR = $180K.
Late Payment, Non-Payment, Lapsed Renewals, and Churn
A new logo signs a 12-month, $120K contract with net-30 payment terms. It is now day 60 and they have not yet paid. Ignoring implementation, CARR = ARR = $120K until the finance department determines the receivables to be uncollectable and service to the customer is terminated. After such determination, ARR and CARR must be reduced to $0. I recommend treating this as ‘cancelled’ rather than ‘churned’ contract value. Moreover, I recommend tracking the value of all such at-risk deals.
If the customer renews at a flat $120K on day 61, then CARR = ARR = $120K regardless of whether 12-month service start date was backdated to day 1 or begins on day 61. In the latter case, the customer was effectively given 2 months free. Despite the guidance on a-priori discounts, it is simpler to ignore this when computing C/ARR, especially since the measure reflects the expected revenue over the next 12 months as well as the expected contract value of a flat renewal.
An existing $120K customer is 15 days past their renewal data and still has not signed their renewal contract. CARR and ARR remain $120K until the finance department has deemed the customer as lost and terminated service. Grace periods range from 30 and 90 days based on the effectiveness of the vendor’s account management/customer success function; more effective organizations have shorter grace periods. After such determination, ARR and CARR must be reduced to $0 and accounted for as churn.
Thirty days in advance of renewal, an existing $120K customer notifies the vendor of their intent to not renew. CARR and ARR remain $120K until the contract/service end date. One might be tempted to reduce CARR as soon as the non-renewal notice is give but this introduces unnecessary administrative complexity. Similarly companies should not adjust CARR or ARR based on projected but not yet contracted net retention.
Recurring Services Contracts
Since services gross margin is almost always lower than software gross margin, report the value of recurring services contracts separately.
SaaS Tax & Finance Service Providers
- American Financial Management – AFM (commercial debt collection)
- Andersen (tax)
- Aranca (409A valuation)
- Arias Valuation Group (Joe Clement)
- Carta (409A valuation)
- Clearview Group (tax compliance; nexus)