The ARR Seduction

The favourite metric of software companies; is it created equal?

Let's kick things off with a guessing game. Take a look at this screenshot from an announcement made on the market on July 26, 2018.

Which Saas company, beloved by the market at the time and still trading today, released this announcement? Here’s a hint to help you out: The company's name begins with the letter 'L.'

Only six months after this announcement, this company's Annual Recurring Revenue (ARR) growth showed no signs of slowing down, and reached a whopping $34.5 million. It quickly climbed to $50M afterwards.

Here's the next question: If this company was achieving ARR growth rates of over 100%, even considering the natural slowdown over the years, how much ARR do you think they're making today?

The answer is that no one knows.

In case you haven't guessed it by now, the company in question is none other than Livetiles Ltd (ASX: LVT). Following this announcement in 2019, where they managed to increase their ARR tenfold in just two years, the company's market cap skyrocketed to nearly $500 million.

Fast forward to today, and Livetiles' market cap currently stands at $7 million. 

So, what exactly happened? Well, I think we need to chat.

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ARR: What it is, and Why we love it. Until we don’t.

Annualised Recurring Revenue (ARR) is the total revenue a company anticipates earning from all its customers who are subscribed to its software for a year.

Let's break it down with a straightforward example:

• Imagine your company has 10 customers, each paying $10,000 per month for your services. That sums up to $100,000 in Monthly Recurring Revenue (MRR).

• To calculate ARR, you would take the MRR ($100,000) and multiply it by 12 (for the 12 months in a year). So, in this case, your ARR would be $1,200,000.

Your ARR provides a snapshot of the revenue you expect to generate in a year from all your subscription customers.

Now, here's why ARR and reported revenue figures usually don't align perfectly: every new customer is immediately added to the total ARR, but accounting rules dictate that you can only account for the revenue you've earned during that specific year.

So, let's go back to our example:

• You’re currently at $1.2 million ARR and your financial year ends in December.

• If you close a customer for $10,000 per month in December, your year will end with ARR of $1.32 million.

• However, since the customer only came on board in December, they've either added no revenue or only one month's worth of revenue for your financial year, depending on your billing practices.

Investors have a soft spot for ARR because it provides insights into the stability and growth potential of a company's revenue stream. A high and steadily growing ARR should indicate a successful business with a reliable income source from its customers. It's a valuable metric for assessing a company's financial health and growth prospects.

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ARR: Why we love it until we don’t.

If the statement in the previous paragraph holds true, then what on earth happened with Livetiles?

First and foremost, let's address the elephant in the room: Livetiles encountered a multitude of problems. The previously mentioned announcements revealed some concerning cash burn figures. In the fiscal year 2019, the company reported a net loss of $42 million on revenues of $18 million. There’s also the problem that much of this growth was acquired. We haven’t even talked about unit economics yet or competitive dynamics…

But, let's dive deeper into the ARR figure because we all know it's a red flag when a company's star metric begins to fade. Unfortunately, that's precisely what occurred at Livetiles.

Over the past 12 months, there's not a single mention I could find in the company's announcements regarding ARR.

What was supposed to be a dependable source of recurring income took a sharp turn, leading the company to report a staggering 42% year-on-year revenue decline.

Livetiles offers a suite of products, combining an intranet seamlessly integrated with the Microsoft 365 suite, an employee communications app, and a corporate directory featuring an internal org chart publication. On the surface, these are undeniably useful tools. However, I see a few potential challenges. Larger organisations might opt to develop their bespoke versions of such a combination, while smaller companies may find their needs well met with a blend of Slack and email. This leaves a viable customer profile in the mid-market, but therein lies a crowded landscape of competitors, including good products like Atlassian's Confluence, Microsoft's Yammer, ClickUp, and plenty more. The moat around Livetiles was likely not as robust as needed, especially when economic hardships prompted organisations to scrutinise their software expenditures more closely.

I don’t know the whole story here, this is purely my speculation. To be absolutely clear, I'm not here to pass judgment on Livetiles. I understand the challenges that come with running a software startup (more on this in the conclusion). It's far from a cakewalk, and they must have faced their fair share of hurdles. The meteoric growth of LiveTile’s story is somewhat incredible.

Within this challenge, there lies an important lesson: the primary issue with ARR is that it's at the company's discretion to categorise revenue as ARR, and, as it turns out it some instances, it can vanish as swiftly as it comes in.

So in the next short paragraphs, I’ll share a few things I like to do to understand more what makes up the strength of this recurring revenue.

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Who’s the user, and what does he do with it?

The first thing I try to understand is the product.

Principle #1 - It needs to be (relatively) easy to understand the software - If it’s very hard to understand what the software does, and who the user is, that’s normally a bad thing.

A good way to get to the heart of this is to look at a demo on the company’s website or on Youtube. If the company is making upwards of $5M in ARR and you can’t easily find a demo, that’s normally a bad thing.

On 26 June 2023, Xpon Technologies Group (ASX : XPN) told the market the below:

Only a quarter before on 28 April 2023, the company reported an ARR figure of $18M. Now, ARR was down $9M. What happened here? Well, let’s go to principle number 2.

Principle #2 - Software vs. Service - If the so called software sounds a awful lot like a service “ie. we’re developing custom mobile applications”, that too may be a bad thing. The contract lenght of a service can be over multiple years, therefore, it can be annualised to look and feel like ARR. But the problem is that the service typically is more like a project, rather than a tool you use everyday to do your work. So the service-type ARR can dissapear faster than you might think, as was the case with Xpon.

True software should be a staple in your toolbox, not a fleeting project, ensuring a more reliable and sustained revenue stream.

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Candy, Vitamin or Painkiller

There’s a multiple of different types of software business models, and I won’t go into all of them here.

Principle #3 - Candy, Vitamins, or Painkillers: In this step, we aim to classify the software within the spectrum of "candy," "vitamins," and "painkillers." While there's nothing inherently wrong with "candy" (just look at the staggering $1.21 billion in revenue reported by Candy Crush in 2021), when it comes to enterprise software, "candy" is often less robust than something truly mission-critical for your workflow. On a related note, I tend to approach management teams cautiously when they overuse "mission-critical" to describe their software.

We divide business plans into three categories: candy, vitamins, and painkillers. We throw away the candy. We look at vitamins. We really like painkillers. We especially like addictive painkillers.

Kevin Fong

Principle #4 - Horizontal vs. Vertical Software: The second part of this classification involves determining whether you're dealing with horizontal or vertical software. In broad terms, horizontal software can be used by various user types across multiple categories, such as Slack or Microsoft Teams. On the other hand, vertical software is tailored for specific industries or even user roles within those industries. Examples include software for theater bookings or solutions for reliability engineers in manufacturing. While this is a generalisation, vertical software can often be stickier due to its tailored nature, as users might find it challenging to accomplish their unique tasks using horizontal software. This classification can offer valuable insights.

Principle #5 - Average Deal Size: As a high-level rule, you can hypothesise that the larger the average deal size, the more challenging it will be to acquire customers and the harder it will be for them to switch to an alternative solution.

Conversely, smaller deal sizes might indicate a lower barrier to entry and exit. When you analyse a company's ARR, keeping this principle in mind can help you gauge the software's stickiness.

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Step 3: Forget about CARR or ACV

Let’s go with another guessing game.

Who is this company that was growing ACV at 60%+ YoY and showed no sign of stopping?

Take a look at that graph – it's a thing of beauty. But wait, oh shit, there’s a problem.

The gap between cash collections and ACV widens with each passing quarter.

And then, like a magic trick, the graph vanishes in the next quarter.

But wait, you might be wondering, aren't ACV and CARR both cousins of ARR? Why the distinction?

CJ Gustafson

explained the difference well in a recent article:

What is CARR? It stands for Contracted Annual Recurring Revenue.

You see, in software land, you can sell multi year contracts. And the first year may not be the same value as, say, the third year.

Many companies will claim the larger, exit year Contracted ARR (CARR) as ARR. However, CARR will not track to current period GAAP revenue or billings.

Why does this disconnect exist in the first place? There are a few reasons:

First year discounting: You offer a customer 25% off in the first year, and then return to the base price for the out years, decreasing the revenue you actually get in year one.

License ramp: You negotiate for the contract to increase in license count over time, with the objective of aligning to the customer’s anticipated headcount growth, hence increasing the revenue you get in the out years.

Embedded price increases: You add in a lever for inflation that kicks in during subsequent years, increasing future contracted revenue.

• CJ Gustafson

My process here is that I tend to completely discount any mention of ACV and CARR, unless the company as got a track record of multiple years of converting CARR in ARR within 12 months. If that hurdle is not met, than forget about it.

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Conclusion

In hindsight, it's clear that investors may have become overly enamored with ARR two years ago, embracing it as an infallible metric. The truth is, it's not.

On the flip side, I believe that today's average public investor might be too quick to dismiss all the incredible advantages that stem from a business model generating recurring software revenue.

The real challenge lies in distinguishing those companies with a genuine secret sauce, the ones poised to enjoy the benefits of operational leverage over the long haul. It's a task that's always exceptionally challenging.

In the future, I'll delve deeper into my thoughts on this matter. In the meantime, I'd love to hear your thoughts and engage in a discussion. Please feel free to share your insights.

Stay tuned for more, and let's keep the conversation going.

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Change of Pace - Going to Monthly

It's hard to believe that it's been a year since I started this blog. My original goal was simple: to write about investing and interesting companies every week, not only to expand my network in this space but also to put my own beliefs and ideas to the test. Looking back, I'm genuinely pleased with the progress I've made.

It's been an incredible journey, and I've had the privilege of meeting some of you who read these articles in person. Even more rewarding has been the chance to learn from you. I'm immensely grateful to the investors I deeply admire who reached out, shared their time and wisdom, and even offered assistance with my startup.

Throughout this year, my writing routine has remained consistent. I carve out a brief window on Saturday afternoons, during my girls' naptime, and spend those precious hours clacking away on the keyboard. Time is a luxury, and this writing endeavour has served as my escape from the demands of both startup life and parenting (both of which I absolutely love btw, no complaining here).

However, since I started on this writing journey in January, my life has changed. We're now a family of five with three daughters under the age of three, and nearly every minute I'm not with them is devoted to steering my startup through its very early days.

To ensure that I can sustain this writing venture for many years to come, I've decided to change my pace.

Moving forward, I'll be shifting from a weekly schedule to a monthly one.

If you find yourself deeply disappointed by this change, I have a few suggestions:

1. Start writing: Consider creating your own original content. That’s how I started at the beginning of the year. You'll gain valuable insights along the way and potentially contribute to the broader discourse.

2. Explore other exceptional Substack writers: There are many consistent writers who share high-value content on this platform. Dive into their work and expand your horizons.

3. Take a break: You’ve earned one brother. Go for a surf and listen to a Beatles album. That’s pure joy, ain’t it?

As always, I'm immensely grateful for your time and attention. Here's to delivering more quality content over the next few years. Thank you for being a part of this journey.

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Sources

• Livetiles announcement in introduction of $15M - Link here

• Livetiles grows ARR by 10x in 2 years - Link here

• Xpon Business restructure update & ARR Update - Link here

• Pointerra’s 29th of April 2022 - Enterprise Sales & ACV Update - Link here

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