The ARR formula, the six adjustments a growth investor makes to management ARR, and the revenue test that catches what does not belong.
ARR is the contracted recurring subscription revenue of customers who are live at the measurement date, at the price they pay today, multiplied by twelve if you start from monthly figures. It excludes one-off fees, contracts not yet live, future ramp steps, uncommitted usage and customers who have served notice. On an illustrative company reporting 50.0 million, those exclusions bring diligence ARR to 38.5 million, 23.0 per cent lower, and a 10x valuation from 500 to 385 million.
Worked in full in The Growth Equity Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
ARR is not an accounting measure. No accounting standard defines it, it is not audited the way revenue is, and two companies with the same revenue can report very different numbers. That is why growth investors rebuild it from the contract list in every diligence, and why the reconciliation from management ARR to diligence ARR is often the most valuable page in the quality of earnings report.
ARR = Σ (current monthly recurring subscription fee of each live customer) × 12
Or, from annual contracts, the sum of the current annual subscription value of each live contract. In Excel, on a contract list with the monthly fee in column D, status in E and fee type in F: =12*SUMIFS(D:D, E:E, "Live", F:F, "Subscription"). Everything that follows is about which rows belong in that sum.
An illustrative B2B SaaS company in a growth round. Management reports ARR of 50.0 million, up from 34.0 million a year ago. The data room holds the contract list, billing data and the last twelve months of revenue. Subscription revenue recognised over those twelve months was 33.0 million.
| Item | Amount |
|---|---|
| ARR as reported by management | 50.0 |
| Less implementation and training fees, annualised | −2.5 |
| Less contracts signed but not yet live | −3.0 |
| Less ramped contracts counted at the final-year price | −1.8 |
| Less usage above committed minimums, peak month × 12 | −2.2 |
| Less list price shown instead of the discounted contract price | −0.8 |
| Less customers who have served notice to leave | −1.2 |
| Diligence ARR | 38.5 |
Monthly, that is 3.208 million of recurring revenue, times 12. Each adjustment has a reason.
ARR has to reconcile with recognised revenue. For a company growing steadily through the year, last twelve months' subscription revenue should sit close to the average of opening and closing ARR. Clean ARR passes: the average of 28.0 and 38.5 is 33.25, against 33.0 recognised, and clean ARR is 1.17 times LTM revenue. Management's figures fail: the average of 34.0 and 50.0 is 42.0, 9.0 million more than the revenue the company actually recognised, and management ARR is 1.52 times LTM revenue. A ratio that high for a company growing below 50 per cent means the ARR contains things that never become revenue.
Rebuilt on the same basis a year ago, ARR was 28.0 million rather than 34.0. Growth is 37.5 per cent, not 47.1. At 10x ARR, the gap in enterprise value is 115 million: a price of 500 million is 13.0x clean ARR. A growth investor buying 20 per cent for 100 million overpays by 23 million before any other diligence point.
| ARR multiple | On 50.0 | On 38.5 | Gap |
|---|---|---|---|
| 6x | 300 | 231 | 69 |
| 8x | 400 | 308 | 92 |
| 10x | 500 | 385 | 115 |
| 12x | 600 | 462 | 138 |
The higher the multiple, the more each million of soft ARR is worth to the seller, which is exactly when definitions drift. The growth rate matters even more than the level: the multiple a buyer will pay is itself a function of growth, so an inflated growth rate is applied to an inflated base.
Annualising revenue instead of contracts. Multiplying last month's total revenue by 12 drags in services, overage spikes and catch-up billing: here that is the one-off fees and the usage peak, 4.7 of the 11.5 million of adjustments. The rest, unlive contracts, ramp prices, list prices and notified churn, come from reading the contract list too generously. The other mistake is consistency: diligence ARR must be rebuilt for prior periods on the same definition, or the growth rate compares a clean present with an inflated past. Net revenue retention, the NRR calculation, and the payback metrics all inherit whatever went into ARR. The cost of growing into a valuation built on the wrong base is worked in how much ARR growth offsets multiple compression.
State the definition in the investment memo: live customers only, current contracted price, subscription fees only, usage at committed minimums, notified churn removed. Then show CARR and trailing usage on separate lines. Nothing is hidden, and nothing is double counted.
ARR is a sum over live contracts at today's price, and every exclusion has a reason: here 50.0 million becomes 38.5, growth falls from 47.1 to 37.5 per cent, and 115 million of enterprise value disappears at 10x. Rebuild it from the contract list and reconcile it to revenue before you price the round. The Growth Equity Investor covers underwriting a growth company end to end, and the free workbook for the book works the pro rata decision that follows.
ARR counts only customers live at the measurement date; contracted ARR (CARR) adds contracts that are signed but not yet live. In the illustrative case ARR is 38.5 million and CARR 41.5 million, with 3.0 million of signed contracts awaiting go-live. Report both, but never inside one number.
Committed minimums, yes; usage above them only with care and on a separate line. In the example the committed minimums are 1.5 million, the trailing three-month average annualised is 2.6 million and the peak month annualised is 3.7 million. Annualising a single peak month overstated ARR by 2.2 million.
Compare it with recognised subscription revenue. For steady growth, last twelve months' revenue should be close to the average of opening and closing ARR. Clean ARR of 28.0 and 38.5 averages 33.25 against 33.0 recognised; management's 34.0 and 50.0 average 42.0, 9.0 million more than the revenue booked.
This article is one calculation from The Growth Equity Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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