Episode 36: Unearned Revenue Might Be Killing Your Business

Creative entrepreneurs often suffer from a liability that slowly digs them into financial holes. It’s called the unearned revenue problem. This liability is exacerbated if you bill your projects half up front and half on completion—and if you don’t compensate for it, you’ll be sinking deeper and deeper into debt.
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Creative entrepreneurs often suffer from a common liability that slowly digs them into financial holes they can’t dig out from. It’s called the unearned revenue problem. This liability is exacerbated if you follow the common practice of billing your projects on a half up front and half on completion payment schedule. If you bill this way, or something similar, you’re highly vulnerable to this problem—and if you don’t compensate for it, you’ll be sinking deeper and deeper into debt.

Have you ever found yourself working harder than ever, and yet your bank account and your cash flow seem to get tighter and tighter? This reflects a fundamental profitability problem. And it gets masked by the unearned revenue distortion that stem from your billing practices. If your business model is unprofitable, then no matter how hard you strive and toil you’ll only be breaking even, or worse—you might be slowly sliding into debt.

When you receive a 50% deposit payment from a client, that money enters your bank account, which makes you feel like you have an asset, namely the cash in the bank. But in fact, that payment has to be offset by a corresponding liability that doesn’t get recorded—but is very real. You still have to earn that payment, and until you do you have a debt to that client, a debt of labor, and all the costs that go into your labor. Until you fulfill that obligation, that money represents a liability—not an asset. And if you’re cyclically using your deposits to cover yesterday’s expenses, you’re stuck in a downward cash flow sinkhole.

One of the benefits therefore, of tracking your cash flow, alongside your expenses, in a spreadsheet that projects the ins and outs over time, is that you’ll be more able to detect this pattern, and hopefully fix it. By utilizing a cash flow spreadsheet, as I’ve been describing over the past couple episodes, you’ll become more aware of this dynamic, and understand its implications, hopefully leading you to fix the underlying problems.

Here’s one way that this might show up in your cash flow projection. Let’s say you’re looking out into the coming month and you see that you’re facing a cash flow deficit. But you know that you have a couple potential projects in your pipeline that could potentially fill that hole. While that may feel like a hopeful scenario, it actually represents the effects of the unearned revenue distortion. Because even if you do land one of those projects, and get a deposit payment to fill that hole, all you’ve really done is to fill one liability with another. Because while that check will enable you to meet your expenses, you’re doing it with the labor that you won’t get to until much later—and over the time it takes you to do this labor you’ll be mounting up more expenses, and find yourself in the exact same position the next month. And as you operate in this fragile and risky basis, it only takes one disappointment from your pipeline to land you in big trouble.

These cycles of using unearned payments to cover current or past expenses simply kick the unprofitability can down the road a little further. You need to break this cycle, and practice more realistic cash flow projections, and fix whatever underlying issues there may be with your business model that are causing a lack of profitability.

Here are some things you can do that won’t fix underlying issues, but will at least keep you from fooling yourself when it comes to projecting cash flow. First of all, change your payment process. Instead of 50% 50% billing, break your progress payments into thirds, or fourths, or more for longer term projects. This will help to balance out the timing of payments with the times when you’ve actually earned those payments.

This idea might sound terrifying to you if you’re stuck in a cycle where you are desperate for the next 50% deposit to meet your mounting expenses. But it will force you to adjust your expenses to match your current profitability levels, or to increase your rates and fees. Another similar option would be to take your initial payments and rather than depositing them into checking put it in a savings account instead. Then move portions of it back into your checking account for operational expenses only when you’ve earned that portion of the fee.

Solving the unearned revenue problem may be painful at first, but once you’ve fixed it, you’ll be able to focus on the urgent underlying issues that contribute to a lack of profitability in the first place. And we’ll talk about some of those next week.

Until then: don’t let the business of creativity overwhelm your creative business.