ARRgh!! Avoid this investing trap

Sometimes startups stretch the numbers.

There’s more than one way to calculate common startup metrics - but after this article, you’re going to know how to see past the bullsh*t.

ARRgh!!

How to see past the bullsh*t…

With so many businesses operating on a subscription model, Annual Recurring Revenue (ARR) has become an incredibly important metric to investors.

Recurring revenue does not include one-time fees, only revenue which is recurring (like a renewable subscription). Recurring revenue is a fairly dependable income stream that helps reduce the perceived risk in a startup.

The dirty secret behind ARR is that there are multiple ways to calculate it.

And with some methods, startups can manipulate the numbers to give a rosier picture than reality. Let's jump into each method:

Simple Math

This is the most straightforward way - simply tally the recurring revenue your startup has from Jan 1- Dec 31. If you made $10k in every month your ARR would be $120k ($10k + $10k + $10k… for 12 months).

It's pretty difficult to manipulate these figures, so this is the least concerning method.

Extrapolation

Let's say that when starting your business you didn't begin selling product until month 9. After that you averaged $10k in monthly subscription revenue for the remaining 3 months.

It wouldn't really be fair to say your ARR is $30k, because one would assume that revenue will be generated for the full year moving forward.

To address this, a founder may take the revenue from their most recent month and multiply that by 12. So even though the company made $30k this year, they expect their ARR to be $120k.

In some instances this makes sense - in others, it can be totally misleading.

For example, let's say I own a Christmas Cookie subscription business - something that is super seasonal. I may sell a total of $500k in the months of January through November, but see sales explode to $5M in December.

It would be misleading to extrapolate December (my best month) to the rest of the year and claim that as my ARR. Doing so would make it appear as if I have a $60M ARR (12 months x $5M). When in reality, we know that my ARR is $5.5M ($500K + $5M).

Okay one more example of how founders can manipulate the data. Let's say I have a subscription business that charges $2,000 annually. In December, 100 people renew their subscription, collectively generating $200,000 in revenue.

If I were to extrapolate the $200k across 12 months, that would again be misleading because it's an annual subscription. You'd be double counting here - naughty, naughty.

Good founders would take the $2,000 annual fee and spread it across the 12 months ($168 per month) when tallying up their ARR.

What comes down to it is the founder - a good, strong founder will calculate ARR in a proper manner that reflects the actual health of the business. A bad founder may manipulate the numbers to make it seem better than it actually is.

My tip - always ask the founder exactly how they calculated ARR. 

If they extrapolated out a single month's data, then ask if there are any factors that might've contributed to an artificial boost in that specific month.