How to calculate recurring revenue
Recurring revenue—like any kind of revenue—is a number. But just as there are multiple types of recurring revenue, there are multiple ways of calculating it mathematically. There are component parts to the equation and some of these are more useful to certain businesses and less useful to others. We're going to take a look at all the various revenue metrics in the subscription world and understand how to calculate them in this chapter. We'll also talk a bit about what they mean for your business.
Annual Recurring Revenue (ARR)
How much money do you make in a year? This is a simple number: it's the total dollar value of revenue earned from a customer in a year. You can also use it to refer to the total dollar value of revenue from ALL customers in a year. The one wrinkle is the contract value. If you have a two-year contract with a customer worth $10 million, that customer's ARR is $5 million.
Monthly Recurring Revenue (MRR)
Some companies renew monthly rather than yearly. You see this more often in smaller, self-serve models as opposed to big B2B enterprises. It's the same as ARR, except instead of a year, it's a month.
Gross retention, sometimes styled as Gross Retention Rate (GRR), is the percentage of renewed dollars over a defined period of time. The maximum is 100% if you renew every dollar of recurring revenue during that period. This number doesn't include cross-sell or upsell. You can calculate this by dividing the number of dollars renewed during the given time period by the total number of dollars able to be renewed.
Renewed dollars / Renewable dollars
So if you renew contracts worth $4 million out of a possible $5 million, your GRR is 80%.
This is the same as gross retention (it can even be referred to as Net Retention Rate (NRR)), except it does include the number of expanded dollars, whether through upsell or cross-sell, so the maximum can be over 100%. You can calculate this number by adding the dollars of renewed and expanded revenue together, then dividing by the number of dollars up for renewal.
(Renewed dollars + Expansion dollars) / Renewable dollars
Let's say you renew $4 million out of a possible $5 million, but you also sold $2 million in upsell and cross-sell. Your NRR is 120%.
Which metric should I optimize for—NRR or GRR?
An excerpt from The Right Financial Metric for Customer Success: Gross Retention or Net Retention? by Nick Mehta
At first glance, it's tempting to automatically assume NRR is the better indicator because it synthesizes two revenue streams—the renewal and the upsell. In a nutshell, it includes more information. But that's not necessarily the case.
On one hand, GRR has an advantage over NRR in that it truly measures the long-term health of the business because gross churn erodes expansion opportunity over time. In other words, you can’t upsell clients that you lose!
On the other hand, an over-focus on gross retention and churn can lead to a point of diminishing returns.
And this focus has practical effects every day. Do I focus on the nth at-risk client and trying to save them (sometimes in futility) or take that energy and spend it on a healthy client ripe for expansion?
3 Dimensions to the GRR vs. NRR Problem
There are a few core dimensions to consider in this problem:
- Financing: Are you private and needing to raise additional capital? In that case, investors may scrutinize your GRR. Alternatively, are you public or do you plan to go public? In that case, you likely will be reporting NRR.
- Growth Rate: If you are growing fast and valued on growth, NRR may have a larger economic impact near-term. On the other hand, slow-growth companies can receive great ROI from optimizing GRR (and therefore churn).
- Current Gross Retention: In general, there is a bright line for GRR and you don’t want to go below it. Depending on your target customer segment and Customer Acquisition Cost (CAC), that rate could be below 60% (for SMB) or below 70% (for Enterprise). Below a certain point, investors look at a business as being not viable, and the churn rate indicates more fundamental, systemic challenges.
It all comes down to how optimized you are around Gross Retention—or to put it another way, how optimized your renewal mechanism is. If that mechanism fully optimized or very efficient, the higher-ROI focus might be around Net Retention. My recommended GRR ranges are:
So Do I Optimize for GRR or NRR?
If you’re a private company needing more capital, I would work hard to get your GRR to the Fully Optimized level, since investors will notice. If you’re public and reporting NRR, you can probably live in the zone of “Room for Optimization” for GRR and focus on improving net retention. Similarly, the higher your growth, the more you should focus on Net Retention versus Gross Retention.
It’s certainly a continuum, but if you’re a high growth public company with a 97% GRR, you might take those incremental hours spent chasing the pesky few RED customers and instead double down on your successful ones to help them grow and expand.
Customer Lifetime Value (LTV)
Customer LTV or CLTV is really the "holy grail" of financial metrics. It's the ultimate goal of the recurring revenue business model, even though it's not something you'll look at very often from an operational perspective. That's because it's the quintessential lagging indicator. You want to maximize it, but tracking it won't give you any insight into what you need to do to achieve it. That being said, it's helpful to look at for a sense of how your recurring revenue compounds over time to validate your investment and understand your most successful customers. Calculating LTV is simple.
Average Transaction Value X Average Retention Time X Number of Transactions
So a customer who spends an average of $100 per renewal every one month (on average) for four years (48 months) has a CLTV of $4800.
Cost of Acquiring a Customer (CAC)
We'll talk more about these next two in the next chapter, but let's quickly understand what they mean and how to calculate them. CAC is simply the total amount of sales & marketing spend divided by the number of new customers during a given period of time.
Sales & marketing / Number of new customers
If you spend $1 million a year on sales & marketing staffing, programs, and operations, and you book 100 new logos during that year, your CAC is $10,000.
Cost of Retaining a Customer (CRC)
It's the same idea here, except instead of sales & marketing, you need to combine the spend for all your retention-related operations, programs, and staff. This could include Customer Success Managers and technology, Account Management, Onboarding, and more. Divide all that by the number of renewed customers and you have your CRC.
Retention costs / Number of retained customers
We'll use the same example above. $1 million on all costs budgeted for retention results in 100 renewed logos equals a CRC of $10,000.
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