ACV vs. ARR: SaaS metrics defined + How to calculate

Understanding the financial health and growth trajectory of a subscription business hinges on key metrics. Among these, ACV and ARR stand out as vital indicators. They offer distinct yet complementary perspectives on revenue, helping firms gauge performance and plan ahead.

This post explains all you need to know about ACV and ARR in the SaaS world, clarifying their definitions, calculations, and strategic importance.

Read on to learn:

• The fundamental definition and components of ACV
• How ARR provides a view of annual recurring revenue
• The core differences and unique use cases of ACV vs. ARR
• Practical formulas and examples for calculating both metrics
• Common pitfalls to avoid when reporting ACV and ARR
• How pricing strategies impact these crucial figures.
• The role of tools in effectively tracking ACV and ARR
• Why investors pay close attention to both ACV and ARR

Let’s start by explaining what ACV means.

What is ACV (annual contract value)?

Annual Contract Value, or ACV, represents the average yearly revenue generated from a single customer contract. It's a key metric, especially for B2B SaaS companies that operate with subscription models and contracts.

ACV looks at the value of these agreements, often spanning one or more years.

ACV is particularly useful in understanding the worth of individual customer accounts. For instance, if a client signs a three-year deal totaling $30,000, the ACV for that customer would be $10,000 per year. This normalization over the contract term provides a clear view of the ACV revenue expected annually from that specific agreement.

When discussing contracts, it's important to understand what contributes to the ACV. Generally, the ACV calculation includes the recurring charges, along with any upgrades or add-ons within the contract.

However, ACV fees typically exclude one-time charges such as setup or training fees, focusing purely on the annualized recurring value of the service. Different ACV software and businesses might have slightly different approaches to including these one-time fees in their calculations.

Is ACV the same as annual revenue?

No, ACV is not the same as total annual revenue. ACV focuses on the revenue per contract per year, while annual revenue is the total income a company generates in a year from all sources, including all customers and any non-recurring revenue.

ACV helps in assessing the value of individual customer relationships, whereas annual revenue provides an overall picture of the company's financial performance.

Gross ACV vs. net ACV

For a clearer understanding of ACV in business, it's also helpful to distinguish between gross ACV and net ACV. Let’s look at both closer:

• Gross ACV typically refers to the total value of all new contracts signed in a specific period, plus the value of any upsells or expansions within existing contracts during that same period. It represents the total added ACV before accounting for any losses.
  
  
• Net ACV, on the other hand, takes into account the gross ACV and subtracts any ACV lost due to downgrades or cancellations (churn) of existing contracts within that period. net ACV provides a clearer picture of the actual growth of recurring revenue by factoring in customer attrition.

What is ARR (annual recurring revenue)?

ARR is a crucial metric that measures the total yearly revenue a business expects from its recurring subscriptions. It focuses purely on the income that is anticipated to continue, year after year, from existing customers. ARR is a vital indicator of a subscription business's health and growth momentum.

Unlike ACV, ARR looks at the overall recurring revenue of the entire company, not individual contracts. It typically includes revenue from annual subscriptions, as well as the annualized value of monthly subscriptions.

The link between ARR, retention, and churn

A key aspect of ARR is its close relationship with customer retention and churn. A growing ARR often signifies strong customer retention, as the recurring revenue base is maintained and expanded.

Conversely, high churn rates can negatively impact ARR, as lost subscriptions reduce the recurring income. Many businesses use ARR software to automate the tracking and calculation of this important metric, providing real-time insights into their recurring revenue trends.

By monitoring ARR, companies can forecast future revenue, assess the success of their customer acquisition and retention efforts, and track progress toward their growth goals. ARR offers a clear view of the predictable revenue stream that underpins the subscription business model. However, ARR is only truly powerful when it’s calculated correctly and not oversimplified.

Note: To gain a deeper understanding of ARR, other vital SaaS metrics, and best practices for SaaS revenue recognition, we encourage you to explore our blog.

ACV vs. ARR: What’s the difference?

Understanding how ACV and ARR differ is key to gaining a holistic view of your business performance. Sometimes it’s more important to consider the ACV when evaluating each customer contract rather than always focusing on your total company profits in the ARR.

See a side-by-side comparison of ACV vs. ARR in the following chart:

Takeaway: The biggest difference between ARR and ACV is that ACV zooms in on individual deals, while the ARR provides a broader financial overview for your business.

Dispelling common confusions

One common point of confusion is thinking ACV and ARR track the same thing. Remember, ACV answers: "What is the average yearly value of each of my contracts?"

ARR, on the other hand, answers: "What is the total recurring revenue I expect to make in a year?"

Another misconception can arise with multi-year deals. ACV normalizes the total value of these deals over their entire length to give an annual figure per contract.

ARR simply counts the total recurring revenue expected in the current year, regardless of when the contracts were signed or their duration. So, while a five-year, $50,000 contract would have an ACV of $10,000, its full $10,000 would contribute to the ARR in each of those five years (assuming no changes). Understanding this distinction is crucial for the accurate interpretation of both metrics.

Calculating ACV: Formula and examples

The basic formula for calculating ACV is quite straightforward. It helps normalize contract values over a year. The formula is:

ACV = Total Contract Value (excluding one-time fees) / Total Years in Contract

When dealing with different ACV pricing models, it's important to correctly identify the recurring revenue and separate it from any one-time fees. ACV focuses solely on the annualized recurring portion.

Here are some hypothetical examples:

• Enterprise deal (multi-year): An enterprise client signs a three-year contract for a total of $150,000. This contract includes a $10,000 implementation fee (one-time).
  
  • Total contract value (excluding one-time fee) = $150,000 - $10,000 = $140,000
  • ACV = $140,000 / 3 years = $46,667
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• Small and medium-sized businesses deal (annual): A small business subscribes to an annual plan for $5,000 per year. There are no one-time fees.
  
  • Total contract value (excluding one-time fee) = $5,000
  • ACV = $5,000 / 1 year = $5,000
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• Multi-year deal with upgrades: A customer signs a two-year contract for $10,000 per year. In the second year, they upgrade, increasing the annual recurring revenue to $12,000.
  
  To calculate ACV at the time of signing, we use the initial contract value. For looking back at ACV after the upgrade, you might calculate it based on the average annual value over the contract's remaining life.
• ACV at signing = ($10,000 * 2) / 2 = $10,000
• ACV after upgrade (looking back) = ($10,000 + $12,000) / 2 = $11,000

These examples illustrate how ACV helps in comparing the annual value of different types of customer agreements, regardless of their total length or initial fees.

What is a good ACV for a SaaS company?

A good ACV depends heavily on the target market, business model, and overall strategy. Companies targeting large enterprises will naturally have a much higher ACV than those focused on individual users.

A high ACV often means a longer sales cycle, but it can also lead to significant revenue with fewer customers.

A lower ACV typically requires a larger customer base to achieve the same revenue levels. It’s more important to track your ACV trends over time and compare them to industry benchmarks for similar SaaS businesses.

An increasing ACV can indicate success in moving upmarket or providing more value to customers. Ultimately, a "good" ACV is one that supports your company's growth targets and profitability goals.

Note: Building upon your understanding of ACV and ARR, you might also be interested in learning how to calculate net revenue retention (NRR), SaaS bookings, and revenue efficiency. We have dedicated posts that dive into these crucial SaaS metrics.

When to use ACV vs. ARR in business

Knowing when to apply ACV and ARR is essential for SaaS businesses. Each metric serves a distinct purpose and provides valuable insights in different contexts. Here are several situations where you would specifically use one over the other:

• Sales planning: Use ACV to set targets for individual sales representatives or teams. It helps define the average deal size needed to reach overall revenue goals. ARR is useful for understanding the total recurring revenue the sales team needs to generate collectively to achieve company-wide targets.
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• Financial modeling: Employ ARR for forecasting future recurring revenue streams and long-term financial projections. ACV can inform assumptions about average deal sizes for new customer acquisition within these models.
  
• Board reporting: Highlight ARR to showcase the company's overall growth trajectory and the health of its recurring revenue base to investors and the board of directors. ACV can be used to provide context on the average value of new customers being acquired.
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• Compensation structures: Utilize ACV to design commission plans for sales teams, rewarding them based on the annual value of the contracts they secure. ARR growth can be a component of broader company performance bonuses.
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• Marketing performance analysis: Leverage ACV to evaluate the quality of leads generated by different marketing campaigns by looking at the average annual value of the customers acquired through each channel. ARR growth reflects the overall success of marketing efforts in driving revenue.

Common mistakes in ACV vs. ARR reporting

Accurate reporting of ACV and ARR is crucial for informed decision-making. However, several common mistakes can skew these metrics, leading to a misleading understanding of business performance. Let’s zoom in on those mistakes:

Oversimplifying ARR in usage-based pricing

Many SaaS companies make the error of simply calculating ARR by multiplying monthly recurring revenue (MRR) by 12. While straightforward, this calculation can significantly obscure usage variability and customer churn, particularly in usage-based pricing models.

For instance, customers may drastically reduce their usage or churn completely after one or two months, resulting in inflated ARR estimates. To avoid this, ARR calculations should factor in historical usage data, account for churn trends, and reflect realistic recurring revenue rather than a simplified projection.

Counting one-time revenue in ARR

A frequent error is including non-recurring revenue, such as setup fees, training costs, or one-time purchases, in the ARR calculation. ARR, by definition, focuses solely on predictable, recurring income. Including one-time payments inflates the ARR figure and doesn't accurately represent the sustainable revenue stream.

This mistake can therefore lead to much higher future earnings projections than you can realistically expect to receive.

It's important to isolate these non-recurring items when calculating ARR to keep its integrity as a measure of recurring business.

Misrepresenting multi-year deals

Another common mistake involves how multi-year deals are represented. Sometimes, the entire value of a multi-year contract might be incorrectly attributed to the ARR of the initial year. ARR should only reflect the annualized value of the recurring revenue for the current year.

Similarly, when calculating ACV, the total contract value needs to be correctly divided by the total number of years in the contract to get an accurate annual representation. Misrepresenting these deals can distort both ACV vs. ARR comparisons and individual metric interpretations.

Double-counting revenue across metrics

It's also possible to inadvertently double-count revenue when analyzing different metrics. For instance, if upgrades are already factored into the ARR calculation, they shouldn't be counted again as separate "expansion revenue" in a way that skews the overall picture.

Make sure that your reporting framework clearly defines what revenue components are included in each metric to avoid such overlaps. Consistent and well-defined calculations are key to preventing this issue and ensuring an accurate understanding of your SaaS revenue landscape.

ACV vs. ARR in pricing models

How you price your SaaS offerings has a direct impact on both your ACV and ARR. The structure of your plans shapes the annual value you get from each customer and your total recurring revenue. Let's explore this with a few common pricing approaches:

Fixed pricing

• Customers pay a consistent fee, whether monthly or annually, for a defined set of features or usage.
• ACV calculation: For annual contracts, ACV is the yearly price. For multi-year deals, the total contract value (excluding one-time fees) is divided by the contract's length in years.
• ARR calculation: ARR is the total of the annualized value of all these fixed-price subscriptions.

Usage-based pricing

• Customers are charged based on their consumption of the service (e.g., API calls, data usage).
• ACV: Can be variable, depending on how much each customer uses the service annually. Projections can be made, but actual ACV will fluctuate.
• ARR: The sum of the annualized revenue from all customers, which can also vary monthly based on usage. Predicting ARR with this model can be less precise.

Remember: Because customer usage in these pricing models fluctuates, ARR calculated by MRR by 12 can yield inaccurate predictions. Companies with usage-based models should instead focus on documented data to anticipate revenue and manage the uncertainty effectively.

SaaS models with variable ACV

• It’s common with tiered pricing or when customers can add features or upgrade plans.
• ACV: Higher-tier plans or more extensive usage lead to a higher ACV per customer. Upselling and cross-selling also increase individual ACVs.
• ARR: The total annualized value of all current subscriptions, reflecting the mix of different ACVs across your customer base. A key growth tactic is often to move customers to higher-value plans to boost both ACV and overall ARR.

Tools for tracking ACV and ARR

Accurately tracking ACV vs. ARR is fundamental for any SaaS business. The methods you choose can significantly impact the insights you gain and the effort required. Let’s compare spreadsheets to dedicated platforms:

• Spreadsheets: For early-stage startups with a limited number of customers, spreadsheets (like Google Sheets or Microsoft Excel) can be a starting point. They offer flexibility for manual data entry and basic calculations of ACV vs. ARR.
  
  However, as your customer base grows, spreadsheets can become cumbersome, error-prone, and lack automation for handling upgrades, downgrades, and churn.
• Platforms: As your business scales, dedicated subscription management and billing platforms become essential. Some billing solutions are even designed specifically for managing recurring revenue.
  
  These platforms automate the calculation of ARR and often provide features for tracking ACV, churn, and other vital SaaS metrics. They offer better accuracy, scalability, and integration with other business systems.

Revenue recognition implications

Tracking ACV and ARR accurately is closely tied to revenue recognition principles. Accounting standards require that revenue is recognized over the period when the service is delivered.

Your tracking tools should allow you to align your ACV and ARR data with these requirements, especially for multi-year contracts. Platforms often have built-in features to help with proper revenue recognition.

Connecting billing and finance

Integrating your billing system with your finance and accounting software is crucial for easier ACV and ARR reporting. When your billing platform is connected to your accounting system, it ensures that revenue data flows accurately and efficiently.

This integration reduces manual data entry, minimizes errors, and provides a unified view of your financial performance. A robust billing platform also aids in managing dunning management processes, which directly impacts retained ARR.

Takeaway: While spreadsheets can suffice in the very early days, dedicated platforms offer the automation and integration needed for accurate and scalable tracking of your ACV vs. ARR, while also supporting proper revenue recognition and a connected financial ecosystem.

How do ACV and ARR impact investor valuations?

ARR often takes center stage for top-line focus. ARR provides a clear, recurring revenue figure that indicates the scale and predictability of future income, making it a key metric for valuation.

A higher ARR generally translates to a higher valuation multiple, especially when coupled with strong growth rates. Investors like the stability and visibility that a significant ARR number provides.

A healthy ACV suggests that the sales team is acquiring valuable customers. It directly informs metrics like customer acquisition cost (CAC) payback period. A higher ACV means that the revenue generated from each new customer is greater.

While ARR gives investors a snapshot of the recurring revenue size and momentum, ACV provides crucial context about the unit economics of customer acquisition and the health of the sales process.

The key point: A strong ARR coupled with a healthy and growing ACV paints a compelling picture for potential investors.

Improve your billing and revenue reporting with Orb

Understanding your ACV and ARR is paramount for sustainable growth. Orb is a done-for-you billing platform that helps SaaS companies move beyond rigid billing systems and gain a clear, data-driven understanding of these key metrics, fueling flexible pricing, billing, and faster expansion.

Here’s how Orb plays a pivotal role in managing your ACV and ARR:

• Agile pricing for higher ACV: Experiment with pricing models rapidly using Orb's RevGraph and SQL Editor. Test tiers and add-ons to boost your average deal size. Simulate the impact of changes on ACV with real data using Orb Simulations.
  
  
• Accurate billing and reliable ARR: Guarantee precise, error-free billing based on raw usage data. This builds trust and prevents revenue leakage, securing your predictable recurring payments and ARR.
  
  
• Extensible platform for ARR insights: Integrate Orb directly for a unified view of your usage data and revenue. Built-in analytics provide clear insights into your current ARR and its drivers.
  
  
• Proactive retention for ARR growth: Identify at-risk customers early with Orb’s usage tracking. Implement targeted customer retention strategies to protect and grow your ARR.
  
  
• Automated billing and consistent ARR: Automate recurring billing and invoicing, reducing manual work and ensuring timely recurring payments, a key component of a healthy ARR.

Ready to transform how you understand and manage your SaaS company's ACV and ARR? Explore Orb's flexible pricing options and find one that fits your business.