I have spent the last 6+ years studying the SaaS business model and I realized early on that it’s critical to separate out the drivers behind ARR according to their operating levers. In order to better understand how a business is running (i.e. diagnostic metrics) and then help it improve (i.e. operating metrics), you need to thin slice the ARR into its fundamental components. Those fundamental components are:
New ARR: additional ARR from newly signed customers
Churned ARR: lost ARR from customers who have churned
Upsell/Expansion ARR: additional ARR from customers who are paying more than they did before
Downsell/Contraction: lost ARR from customers who are paying less than they did before
This is an example of an ARR buildup:
Splitting these out is one “cut” of the ARR build. It allows us to calculate ratios and make predictions in order to both assess the health of the business and project it forward. Is churn rate too high? Are upsells driving a significant portion of the growth? And… If we continue at a churn rate of 10%, where does the business go over time? If we keep upsells at 25%, where does the business go over time? These are important questions for both VCs and operators.
These are good “slices” because they map to specific operational levers inside a business. There is a spectrum of influence on each variable/ratio that drives the components of the ARR build. For example, churn may be characteristic of a market and very difficult to influence whereas new ARR might be a simple function of marketing spend.
This is a bit more detail on the operational components that apply to each part of the ARR build:
This breakdown may seem simple and straightforward, but it’s a super important first step to getting into the details of the business and gaining a better understanding of how it works and what drives it. After the first cut, the slices depend on the specific business, but the goal is to keep things in a format that allows for normalized comparisons and consistent metrics definitions.
The next slices are business-specific. The ultimate goal is to get to a point where the high level business goals are tied all the way down to specific metrics/ratios which are owned by a business unit or individual inside the company. Creating this top-to-bottom alignment helps every business operate (and report) much more efficiently. The earlier on in a life cycle this exercise is started, the better off the company will be in the long term as it can impact every pricing, hiring, product, marketing, and engineering decision.
Many of the people I have spoken with over the years about the operational and strategic finance initiatives I work on inside companies assume I focus on later stage business who have more data to work with. The reality is that I much prefer to work with early stage companies either before or shortly after commercial launch. The reason is simple: get it right from the start. If you start off on the right foot with the right metrics and goals in mind, the business will grow more effectively in the direction that you want. On several occasions I have met with later stage businesses who focused entirely on growing the top line without thin slicing their key metrics and aligning the entire business. The results vary, but on a few occasions, the companies simply hit a wall because they thought working on X was driving their growth when in fact it was Y - the results were poor hiring decisions, bad financial planning, misguided product prioritization and inefficient resource allocation. The work then becomes a highly political heavy lift that involves many painful conversations and is often even more delayed due to the inertia of the operation and the inherent difficulty in making a meaningful change.
The takeaway is simple: it’s never too early to look at a business through the financial lens and getting the thin slices right is very important - it may save you months or the entire company down the road.