VCs love SaaS businesses because they are incredibly capital efficient. Most public SaaS companies need less than $1 of capital to acquire $1 of ARR.
What is ARR?
ARR is an acronym for Annual Recurring Revenue and a key metric used by SaaS or subscription businesses that have Term subscription agreements, meaning there is a defined contract length. ARR is the value of the contracted recurring revenue components of your term subscriptions normalized to a one-year period.
For example, Smartsheet burned $55M of cash prior to IPO and grew to ~$130M of ARR, so it only cost ~$0.40 for Smartsheet to acquire $1 of ARR.
This post has charts where you can see how companies “below the line” (i.e., need more than $1 of capital to get $1 of ARR) like Domo have had a harder time finding efficient growth, while Zoom (far left, middle of the way up) was actually able to grow to $423M of ARR with negative cash burn (i.e., they had more cash at time of IPO than they raised). Pretty incredible!
Tip: B2B SaaS is a home run if you can find product market fit.
Non-software companies, however, look quite different. With the exception of WeWork, many of the recent non-software IPOs companies can actually get quite close to or above the $1 for $1 line (charts here). However, a few things to note:
- ARR ≠ revenue. SaaS companies have higher “quality” revenue that grows every year. $1,000 of ARR will grow to $1,200 of ARR next year, but $1,000 of mattress probably means $0 of mattress next year
- Margins. Uber, Lyft, Casper, Peloton, and Sonos have 40–50% gross margins (vs. 80%+ SaaS gross margins), so they need 2x as much revenue to earn the same number of gross margin dollars
- Growth and scale. Many of the non-SaaS companies can grow much larger than SaaS companies more quickly, and they are targeting significantly larger markets (e.g., transportation vs. data visualization)
ARR formula
The formula for ARR is:
ARR = average annual profit / average investment
So what does this all mean?
VCs are looking to earn the best return for their money. If they invest in SaaS startups, there is the opportunity to invest $100M in a company and reach $100M+ of high margin ARR.
To earn the same returns with a non-SaaS company, investors need to (1) see significantly faster growth with the same $100M investment and/or (2) invest at valuation multiples that take into account lower margins and revenue quality.
This hasn’t really been happening over the last few years, so these companies get negative surprises when they go public, but hopefully we will see more rational valuations for non-SaaS startups over the coming years.
ARR — Example 1
XYZ Company is looking to invest in some new machinery to replace its current malfunctioning one. The new machine, which costs $420,000, would increase annual revenue by $200,000 and annual expenses by $50,000. The machine is estimated to have a useful life of 12 years and zero salvage value.
- Calculate the depreciation expense per year: $420,000 / 12 = $35,000
- Calculate the average annual profit: $200,000 — ($50,000 + $35,000) = $115,000
- Use the formula: ARR = $115,000 / $420,000 = 27.4%
Therefore, this means that for every dollar invested, the investment will return a profit of about 27 cents.
ARR — Example 2
XYZ Company is considering investing in a project that requires an initial investment of $100,000 for some machinery. There will be net inflows of $20,000 for the first two years, $10,000 in years three and four, and $30,000 in year five. Finally, the machine has a salvage value of $25,000.
