Not all ARR is created equal. You must determine how recurring & "sticky" a revenue base truly is to forecast accurately, especially in early days. Here are the four main criteria I use to assess Quality of ARR:
1) HISTORICAL RETENTION & NPS
The most useful indicator of future customer behavior is past customer behavior, so I look at retention metrics (logo, gross dollar, net dollar, etc.) as the leading indicator for Quality of ARR. Customer satisfaction (NPS/CSAT) is a good secondary indicator.
Note that these metrics are more trustworthy for businesses with larger sample sizes + established PMF, but should be heavily discounted for earlier-stage companies. Retention metrics aren't very reliable or predictive until you've shown that they hold up with a large sample of customers over a long time horizon, so use common sense (and the indicators below!) to decide whether promising early results are sustainable.
2) CONTRACT TERMS & BILLING CADENCE
Contracts with longer durations, upfront payments, auto-renewals, price escalators, and cancellation penalties are fairly bankable. On the other hand, month-to-month agreements are more flimsy. Look at contracts to determine whether customers are investing for the long haul or softly committing to a tool they can abandon at will.
This indicator is more valuable in the short-run than the long-run, so I tend to prioritize it behind some others on this list. Strong contracts can prevent early cancellations, but renewals only come from customer obsession and/or mission-critical functionality that is painful to replace.
3) CUSTOMER SIZE
When it comes to retention, larger customers are generally better than smaller ones. On average, enterprise SaaS has longer lifecycles than SMB SaaS, which has longer lifecycles than consumer SaaS. Larger customers have more stable budgets, are less likely to dissolve or pivot, and take a longer time making decisions and changing their minds.
4) BONE, MUSCLE, or FAT?
I'm borrowing this terminology from Permanent Equity, who used it in an excellent guide on corporate expense cuts. Their thesis is simple: if you have to trim your budget, start by cutting fat ("nice-to-have" subscriptions, non-essential travel, gifts/perks, etc.), then cut muscle (sales/growth spend), and only cut bone (people, software, and assets that critical to sustaining the business) if absolutely necessary. To determine the long-term stickiness of a solution, consider whether customers view it as fat, muscle, or bone.
Hopefully this framework helps investors make smarter evaluations and founders budget more accurately. Chime in below if you think I missed anything important!
#startups #venturecapital #SaaS #ARR #diligence #budgeting
