The Rise of ARR

$ value of yearly subscriptions + $ from expansion revenue - $ lost from churn = ARR

It isn't a complex formula, but it is a very important one - for subscription businesses, and it is even more important in what it means for the changing business landscape. For those that don't know what ARR stands for, it means the Annual Recurring Revue and for simplicity, all it means is the amount of money a subscription business has "guaranteed" to come in within a given year.

This is important, because in recent years, the focus of value of a business has been on the current share price, where for example a "unicorn company" is defined by an evaluation of over a billion dollars. However, this is driven by share price evaluation, not business activity.

ARR however has a very direct relationship to business activity, as it is simply tracking how much money is committed by customers under contract. Depending on the business, this is a far more reliable indicator of company value than share price, as it doesn't depend on market hype, it reflects customer usage.

While unicorn company has the magical billion dollar market evaluation, ARR companies use a different name, which is a "Centaur company", a company with an ARR of 100M or more. This means that in a ten year period, the company will generate in excess of at least 1 billion dollars in revenue.

Why is this important? Well, because of market stability. While many companies might have had meteoric share price evaluations, over the last year and a bit, that hype has cooled with many shedding up to 90% of their evaluation. This is very important, especially for startups, because this evaluation has been used to secure capital inputs and when it drops significantly, it can be a death knell for investment inflows.

However, an ARR-based company can ride the economic storms far better, especially if their product returns value to the subscriber or is heavily integrated into core infrastructure, reducing the chance and therefore effects of churn. "Nice to have" business models will be more heavily affected, as they are also easier to let go and don't tend to be leaned on strategically - companies like Netflix.

They can ride the storm so effectively because, the customer has agreed to use the service at a specific price for a designated amount of time and, this is going to be an incoming revenue stream regardless of what the market is doing. Essentially, a business would be able to not sell anything and still make that total ARR, provided there is no churn along the way.

While this sounds like a good deal for the business, it also means that there is a fair amount of responsibility involved as in order to reduce churn, the company has to keep providing services that their customers will keep opting into year after year. This generally means improving what they offer over time to keep meeting the needs and demands of their customer base, so there is a direct relationship between what is offered and what value is generated. Fail to meet customer needs and that ARR will quickly drop away to nothing. This incentivizes the business to truly keep their customer base happy, especially in high-competition fields.

This is interesting to me as I work for a SaaS (Software as a Service) B2B company that works using the ARR model to track growth. It is also likely to cross into Centaur status next year, making it quite an attractive business model, especially considering it is still not public. When it does finally go public (or gets sold), it will be the ARR and churn that they will look at to evaluate the share price, not just the potential to earn more in the future. This means that the evaluation is more realistic from the start and is there fore less likely to burn investors who are buying in on the market hype.

It is also interesting to me as I see that this is far closer to the crypto model, where there is a more direct relationship between business and customer and when businesses are no longer deemed "worth it" they will get dropped by the market very quickly. This means that crypto businesses will have to consistently meet the demands of their user base, but it can't just be through schemes to get more buyers in. What they will have to do is be able to generate value for the userbase through mechanisms that find a balance of investor return and user return.

This is not an easy equilibrium to find, but it is an important one for the long-term health and viability of crypto as an industry, as while it offers less to investors, it also offers* something* to consumers. This is important to note, because in crypto, they are often the same people, effectively double dipping on both sides of the value equation.

The more this happens with second-layer business applications, the more stable and therefore viable as an investment standard crypto becomes, as the market evaluation is tied to real-world usage. The hype starts to disappear on tokens going to the moon and is instead replaced by the demand on business products and services. The investment potential is still there, but the business is pushed to actually perform and build a customer base consistently.

So far, this is not where most of the money in crypto "projects" has been generated and likely, most of the revenue from a customer base has been made by the exchanges themselves, whose business model prays on the hype on tokens, much like any traditional exchange. The few business models like Splinterlands out there, are constantly struggling to find a way to secure that equilibrium where the value they offer their user base is adequate, as too the value they offer their investors. And of course, they have to cover their costs and make a profit also, which throws in more complexity.

In time, I believe that the fastest and most accurate way for business valuation is going to be found through the web 3 and blockchain companies, as they are not only more tied directly to their user base and investors, but also have a higher degree of transparency on their operations, making it verifiable. At some point, even small investors will not put their money in, unless there is proof of activity and viability.

We might be a few years away from that point though and in between, there is going to be a lot of churn. Though, they will all eventually return to the crypto fold, because they will learn that it is far more trustworthy than the alternatives.

Taraz
[ Gen1: Hive ]