GTM Navigator: Properly Defining ARR for Your Startup 

GTM Navigator is our ongoing series where we break down the essential components of nailing the right go-to-market strategy. 

In this episode, Matthew Mann, Managing Director of Corporate Development, is joined by Gregory Capitolo, Partner & Co-Founder of Attivo Partners. Greg currently serves as a CFO for Attivo clients, where he is actively engaged in helping companies raise venture funding from Series Seed to Series C. Over the course of $500+ million in transactions, Greg has advised high-growth companies from formation through funding and liquidity events. 

We hope in this edition you’ll gain insights into how to calculate ARR, the advantages and disadvantages of different pricing models, and other financial metrics that are vital as your startup grows. 

Key Questions Discussed: 

• What is Annual Recurring Revenue (ARR)? 
• How do different pricing models affect ARR? 
• What are best practices when calculating ARR? 
• Why is ARR important to fast-growing startups? 
• How do you calculate Contracted Annual Recuring Revenue (CAAR)? 
• What’s the difference between CAAR & ARR? 
• As companies scale, how should they be thinking about GAAP metrics?  

Transcription (edited for clarity): 

Matthew (00:37): Greg, welcome to our program. I would love it if our viewers could hear a little bit of your background before we really kick off the conversation in earnest. 

Greg (00:46): That’d be great, thank you for having me, Matthew. I’m excited to be here. So, a little bit about myself and Attivo. I’ve been in the venture backed space for about 30 years now. I spent my first 15 years as a VP of finance and CFO at several public and private companies. Then for the last 17.5 years, I’ve spent time as a fractional CFO – the last 7.5 leading the team at Attivo that I co-founded with Rebecca Lee. At Attivo, we focus on a full stack of finance and accounting services provided to almost exclusively venture backed companies. About 98% of our clients are venture backed. We enjoy working in that space and have a significant amount of experience helping our clients scale. As we get into this conversation about ARR, it’s important to note that we help our clients understand the importance of metrics, how you calculate those metrics, how you present those metrics, how you tell the story around those metrics, and then how you use them for forecasting. Our business is typically with clients that are at zero to 30 million in revenue. We have several that are up to 70 or 80 million in revenue. And so, as I think we’ll get into later in the conversation, we’ll be talking a little bit about how metrics might change as you scale your business. 

Matthew (02:24): Makes sense. I really appreciate you sharing that with all of us. We’ve obviously worked with Attivo very closely, and you all with some of our portfolio companies to great effect. I think financial metrics in general are really just a report card effectively, a way to measure what you’re expecting, and the day-to-day activities of the business. To that end, I would love to hear, for those who may not know, what is annual recurring revenue? 

Greg (02:54): Annual recurring revenue represents the committed revenue, or I’ll say the contractual revenue that you have with your customers that might extend over a period of time. In this particular case, we’re talking about annual recurring revenue. So, if I sign a contract with a customer that says they’ll pay us $10,000 a month for 12 months, we would say that that annual recurring revenue is 120,000 for that particular customer.  

Typically, annual recurring revenue is based on a subscription model. What we see from our clients is that a subscription model is, let’s say for a platform that is operating in the cloud, so we’re providing some tools or reporting or data analytics software for our customers, for which they pay some fixed fee on a monthly basis. That’s annual occurring revenue. As I think we’ll talk about later, we might begin talking about reoccurring revenue related to usage. If we go back a little bit on history, maybe 20 years ago, people began looking at subscription revenue as a tool to bring visibility into the business to engage directly with the customer over a longer period of time – as opposed to a one-time installation implementation. What we’re seeing today is that it is moving more to a usage or a platform and usage-based model in which there’s a basic fee and then there’s a usage fee, or I’ll call it a usage/value fee on top of, which we call reoccurring revenue. 

Matthew (04:50): We here at Fin certainly invest in those types of businesses. I think the subscription-based model and also that historical software pricing because it’s very predictable. It’s valued quite highly in the market, which is great. As you grow and scale and as customers use more and more of your product, it also makes sense to effectively get a toll fee, flow fee, spread fee interchange, or whatever it may be in the financial services world to grow alongside your customers.  

We’ve certainly seen both pricing models; I think what would be great is hearing some of your takes on both, and then we should get into whether reoccurring revenue is included in ARR and how you go about calculating. But let’s back up just on those two different pricing models. What are some of the advantages and disadvantages of pricing that way? 

Greg (05:54): Sure! Typically, when we begin with our earlier stage companies and they’ve built a business model around enterprise software businesses; they’ve built a model around a subscription platform. For example, they’ve found a customer or a marketplace that is looking for their services and said, “we’re going to just provide a platform and that customer will pay us $10,000 a month over the course of a year, or we’ll charge them $120,000 over the course of a year and set up a payment plan for them”, whatever that might be. What we’ll then do is see how their customer is using that platform and add features and functionality.  

Then as you see them diving in a little bit more in different places, we can add features and functionality for which we’re going to charge you a usage fee. For example, if you’re doing API calls, or if you are running certain reports over a period of time, we’ll give you 10 per month, if you go over 10 per month, we might take you to a different tier.  

We might charge you on a report-by-report basis, and that becomes a usage / reoccurring fee. I think when people, let’s say investors and management teams, are looking at those two types of revenue, there should be a delineation between the two because that usage revenue can fluctuate up and down month to month, and the annual recurring revenue or the recurring revenue tends to be steady and provides straight visibility over a selected period of time. 

Matthew Mann (08:16): I think from a valuation standpoint, it is the volatility of cash flows type situation too, right? Where you have very low volatility, highly predictable cash flows from the subscription base, thus higher valuation multiples attributed to it as opposed to transaction revenue, which is a little bit tougher to forecast, which has higher volatility around those cash flows. So, it certainly makes sense. I mean, I think from where we sit, the software piece is critical component, but if you think about your customers and you think about how every company is trying to get operating leverage, and most of your customers are likely not going to be human scaling type businesses. Depending on how you charge, whether on the software side, by license, etc., the business, your customer might be growing much faster than the seats or your pricing model. The usage base allows you to effectively capture some of that upside as your customer gets more and more value from what you’re providing. Then you’re able to capture more economics on the upside there – there’s value on both sides. How do you think about that? Two questions here. How do you think about that in ARR? What are the best practices there?  Secondly, why is ARR so important with fast growing startups as opposed to LTM or looking at recent financial history. 

Greg (09:47): In terms of capturing ARR, what we typically do when we work with our clients to build waterfalls in terms of what your ARR is today, and based on the length of your customer contracts, here’s what your ARR will be in the future, given where you are today. The importance of that is that we can have visibility into what’s going to happen in the future, so we know that we’ll have revenue, because we recognize that revenue on a rate over a period of time, and we will have a predictable amount of revenue in the future.  

When we match that up with our pipeline, we essentially have better visibility into our forecast in the future. When we talk about that annual recurring revenue and check daily between the two because that reoccurring revenue can fluctuate month to month. What we do with our clients is, we’ll take an average over the past period, three six months, look at the growth rate that recurring revenue is occurring and project that into the future. When we’re forecasting or we’ll take that fixed number at a point in time, so when we come to the end of the month, we look back three months, we have our known contractual ARR – we have historical reoccurring revenue for the last three months. 

We’ll take an average of that and then add that to the annual recurring revenue and present that as we call it a monthly or monthly adjusted annual recurring revenue to reflect that additional usage that comes into play. 

Matthew (12:03): Yeah, it makes sense. I think that speaks a little bit too of why ARR is a really valuable metric, though it’s non-GAAP, it’s a very good metric to assess where the company is, what their current financial profile in this snapshot at time is, and annualizing it effectively in one of the methods you mentioned. Especially for fast growing startups, if you’re growing 10% month over month, the amount of GAAP revenue you achieved in the last 12 months is changing dramatically at a very solid rate of change. That snapshot in time is really important because as time moves on, the business profile is changing rapidly – so certainly a helpful indicator. 

Greg (12:54): One of the things that comes up quite often as we’re talking to our customers is how should I calculate annual recurring revenue? There are many ways to do that, and we might, as we go through the course of this conversation, talk about a couple of them. However, what we find important as we’re working with our clients, and their management teams and investors, is that there is transparency around how annual recurring revenue and reoccurring revenue is calculated. 

Then that trended consistently, both for today and historically to say, I’ve achieved X amount of growth over the last month, last quarter, last year. As well as, how am I going to use that to project my growth in the future? What we find is that many times there is a misunderstanding between certain parties of how the metric was formulated. I will point out one important difference is there’s a term called contractual annual recurring revenue and annual recurring revenue. 

Matthew (14:17): Yeah, let’s talk about that. 

Greg (14:19): What annual recurring revenue represents is services that you’re providing as of a point in time and how those services will be provided in the future. For example, when I come to the end of a month, I close several deals and implement and allow access to my software to those customers in the last week of a month. We’re now providing a service, and we’re now recognizing revenue against the services we’re providing to those customers. That’s annual recurring revenue. 

Contractual, annual recurring revenue or CAAR is a metric where “I’ve closed a deal with the customer, but I do not begin providing the service, let’s say for 60 days or 90 days.” The question becomes, should I include that deal that’s closed at the end of the month for which I do not begin providing services for 60 days in my ARR that I’m presenting to my management team and my investors? What we’ve found in our experience is that most of the time our clients are presenting contractual annual recurring revenue. So, if I close a deal in the last week of a quarter, I count that towards my ARR and it becomes CAAR. Even if I’m going to begin that 15 days later, 30 days later, 45 days later. 

We typically put a limit in terms of what we do there. For example, if it’s 120 days out, maybe we don’t include it. If it’s 10 days out, we’re definitely including it. I think that it’s important to make sure that that’s conveyed with the people who are looking at the metrics, especially for those early-stage companies.  

Bookings, at least I’ll say as we define it within Attivo, as a closed contract, so you’ve signed a contract with signatures from both parties, dates of those signatures, and that becomes a booking that then we take a look at that contract, the company takes a look at the contract and says, how am I going to recognize that revenue over time? Is it annual recurring revenue? Are there implementation fees that are associated with that? Is it just a point in time type of revenue where I’m delivering something and then I’m no longer involved in that process? Revenue recognition can be very complex as it relates to contracts, as I hope most people who watch this know, but we tend to go through that with the client and make sure that they understand as they’re closing a contract what the revenue impact is. It’s important for the company to know what the revenue recognition impact is when you close a deal. 

Matthew (17:43): Yeah, definitely. Super enlightening on this point, and we haven’t gotten anywhere below revenue on the income statement in this discussion, which is the intent. I think one of the things that I wanted to bring into the conversation, especially in the seat that I’m in here at Fin Capital, which is really helping our companies go through subsequent equity rounds and help them navigate those discussions and on M&A – which is where our team spends the bulk of our time. Also on IP readiness, if you think about those three different use cases in financing, a lot of a net new equity round is going to be based and focused on traction around the metrics you just discussed, specifically ARR. So, understanding that, being able to communicate that effectively, track it and forecast it is really important.  

I think the forecasting piece, if we could just dovetail a little bit here, the forecasting of the reoccurring revenue is difficult depending on how the business fluctuates. How much are your customers going to use that product? How many API calls, interchange usage? Whatever it may be on the usage base component is tough to do. Can you talk a little bit about that? I think this is where, when investors or buyers are looking at the forward momentum of a business and want to pressure test, they really focus on how well a management company can forecast that – and if they can’t forecast it well, where’s conservatism effectively, right? So yeah, maybe just talk about that for a couple of minutes. 

Greg (19:30): I talked about that a little bit earlier in terms of taking a look at historical activity, finding averages that make sense, and based on those average growth rates, having growth rates applied to those. A lot depends on how we’re forecasting; we’re using statistics or data to do that. However, a lot depends on the management team’s outlook in terms of their ability to acquire customers and to build features for which those customers will be acquired.  

Like you used the word conserve, being conservative. Our experience is that when we have clients that are out looking at fundraising, doing M&A, we’ll discount the numbers that we put out there because of the risk associated with those and the uncertainty that occurs as you see fluctuations in the monthly numbers. Now on the positive side, if there is continued growth in that usage, then there’s more assurance that things are going to be heading in the same direction as we’re forecasting. And so, we’ll put numbers together and do an analysis that shows what we believe is going to happen. 

I think also with forecasting, something that’s important is that we look at history as well as rolling forward. We see investors looking at companies as we prepare for what we call “a roll forward” for annual recurring revenue, roll forward for reoccurring revenue, and roll forward for customers. Essentially because we’re trying to create visibility in the company or show visibility with our forecasting, we look at where we are today, let’s say the customer’s ARR or reoccurring revenue that we anticipate closing those new customers that will drive revenue. We look at existing customers that we hope to expand, and we look at customers that we may lose. We go through a process where we take that out over a period of two or three years, and these terms are probably familiar to most viewers.  

We take a look at expansion churn and come to an ending balance at given points in time. I do believe that when you’re thinking about that next step in funding or the next step in M&A, expansion rates and churn rates become very important, and that investors look at those. There are other important metrics that are outside of just ARR growth or reoccurring revenue growth, like net revenue retention.  

Matthew (22:55): It speaks to, again, the volatility of cash flow and the predictability and certainty around it. I think just two points on the forecasting reoccurring. I think when we look at a company’s ability to do that cohort analysis, so looking to the past, how various customers have ramped and how long that took and at what level they sort of reached maturity, et cetera, or what rate the growth rate slowed is a nice way to do that and use history to inform the future a bit on forecasting the reoccurring. In addition, how do new products and new services drive additional top line growth there. The other thing I would say is the customer type is interesting. If you have a fast growing startup that is serving a lot of fast growing startups, and the way that they’re ingesting and building their forecast is to take the customer’s word for it, of what they’re going to use, sometimes you’re taking a lot of bullishness and compounding it, right? 

You’re saying a lot of optimism here from my customers on what they’re going to do. I myself might be an optimistic startup and might fall a little bit short on my forecast. Now, you’re compounding that effect. I think that’s where using history to inform the future is important. Now, if you don’t have that history, you can build it quite quickly with your customers and continue to refine as you move forward. The last piece I wanted to take this conversation, Greg, is really around the M&A aspect on acquirers and how they look at ARR. 

I want to hear your experience, and I’ll share mine quickly here, which is most of the time if we’re selling a company to a large public strategic; they are trading on GAAP, right? Their stock is moving on GAAP metrics. ARR is a non-GAAP metric. I think your point earlier was a really important one about that walk – that walk from ARR down to GAAP revenue or understanding the components very intimately of what goes into ARR and making sure that’s been very consistently reflected over time, because an acquirer is going to need to effectively say, “I trade on GAAP and I’m valued by my investors on GAAP.” What does this mean for me and how do I get there? I also think as a company continues to grow and scale, ARR will always be important, but GAAP becomes more and more important. 

The larger a company grows and starts looking toward exit paths, that might be M&A, which is generally GAAP focused in a strategic acquisition or in an IPO world, certainly, we need to see GAAP financials in an S-1, right? I think as we move forward, that center of gravity around GAAP pulls harder than just for companies that are engaging in those discussions. Know that your acquirer is going to be focused on translating your metrics to a metric that really matters to them, whether that be EBITA, whether that be top line revenue, GAAP revenue, gross profit, or something that makes real good sense in terms of the way their investors value them. We’d love to hear about your experiences and your reactions to that, Greg. 

Greg (26:43): We talked earlier about how each company might have a unique way of talking about annual recurring revenue or reoccurring revenue. As you become larger, your revenue goes from 10, 30, 80 million; you do need to begin to be really transparent and move towards more GAAP accounting. Which can still lend itself to annual recurring revenue, but maybe the uniqueness of your metrics that you’re reporting to your investors needs to be much more in line with GAAP. What we’ve typically seen is that the multiples on annual recurring revenue, or ultimately as we’re getting larger, TTM trailing 12 months become tighter or smaller as you get closer to an exit point or as you grow larger. 

I’d say if you’re starting early, in terms of disciplined reporting, disciplined tracking against metrics, and being honest with yourself about how you’re hitting your revenue numbers as a private company, how you’re hitting your ARR numbers, both in dollar amount and in customers, that that transition should be very straightforward. The less unique you are, the more comparable you’ll be to other companies that investors are looking at. Then, the easier things can get done as you move forward, for example, to your next round of funding. 

Matthew (28:39): Definitely. The last comment on this point or just my reaction, is that you’re running a business as a founder, you’re in front of customers, you’re generally the best salesperson for your company. The finance function can be an afterthought at the onset, but as you grow and scale, it just becomes more and more crucial. One for measuring success. Two for scenario analysis. If we do this, this is what that looks like. If we do this, this is what that looks like.  

Fundraising, which of course, is the lifeblood to allow you to reach those big dreams of building an incredible company. Then on two sides, when things get really tough and you need to either do that scenario analysis or cash is tight, and you’re really starting to hone in on the numbers and figure out what options are, that’s absolutely crucial. 

On the other hand, when things start going really well and buyers start coming around, knocking on your door and want to go through financial diligence, I have seen this in past lives where the company will fall short on that front and valuation follows. It is something where the good hygiene of financial reporting will help you run your business in a way that you just feel like you have a windshield that’s completely clear, and at least accurate, in terms of what you’re seeing and how that’s translating to metrics.  

However, when it comes time to get on and off ramp, whether that’s good or bad off ramp, it becomes absolutely critical and crucial. It is one of those things that when things are going well and there’s a million problems to solve as a founder, it can be overlooked, and sometimes slowing down to go fast makes a ton of sense in the finance function, so that you’re really set up for success no matter what the journey of your company may look like. 

Greg (30:45): Well, I think that’s a good sales pitch for the services that we provide. I’m not going to add much to that except that we get a lot of “thank yous: from clients as they maybe have transitioned to Attivo in the near past, and they’re getting ready to go through a fundraising process that goes smoothly. It’s nice to hear that. Thank you for not having any hiccups related to the finance side and no delays related to the finance side. 

Matthew (31:26): Yeah, absolutely. Well, Greg, I’ve certainly appreciated the time and the conversation, and hopefully our viewers and listeners found it helpful. Where can folks find you to the extent, they want to learn more? 

Greg (31:38): Yeah, they can go to attivopartners.com and my email is [email protected] – I’d be happy to answer any questions or have one of my colleagues meet with you and answer questions. 

Matthew (31:57): Great, and I’m at [email protected]. This concludes our session. Thanks again, Greg, for the time and hopefully everyone found it really helpful. 

Greg (31:07): Thank you, Matthew. I appreciate it.