Freelancers Aren't (Yet) Business Owners

I originally posted this on my blog a couple of weeks ago. It's the first in a series I've been publishing, called "the business of freelancing," about freelance app dev.

The idea for this post started as an idea for a tweet, and actually grew into an idea for a series.  (Or, perhaps, even a book, in a world where I can semi-retire for a while and have more time.)  But, lest I get too ambitious, let's start with just a post.

And let's start that post with the tweet that popped into my head.

"Freelancer" isn't a career destination.  It's an intermediate step along one of two career paths.

Path A: Employee -> Freelancer -> Employee

Path B: Employee -> Freelancer -> Business Owner

If you're not consciously on path B, you're accidentally on path A.

Here's a graphical representation, if crude ASCII arrows aren't your thing.

Now, the problem with this as a tweet is that it would have invited enough legitimate questions and discussions so as to make me break with my normal Twitter conversational pattern of "sporadic, at best."  I can picture the objections/questions now:

1. What, exactly, do you mean by "business owner?"
2. That's ridiculous, I've been freelancing for 20 years!
3. What, exactly, do you mean by "consciously?"
4.  Aren't freelancers business owners by default and by definition?

And so on and so forth.

So, rather than try to sort all that out in a flurry of confusing Twitter threads, let me lay out my case here.  That way, I can tweet my tweet and then just reply to it with a link here, thus preserving "sporadic, at best."

What Is Business Ownership and What's It Worth?

Let's start by defining business ownership.

In the literal sense, business ownership happens when you fill out some paperwork and send a payment to the government.  You don't need to make any money or, really, do anything.  The government is happy to consider you a business if you simply pay them for the distinction.

So, for the rest of the post, let's abandon that definition.  In other words, the fact that you have an LLC/S-Corp/C-Corp/whatever doesn't matter.  Business ownership, in the sense that I'm talking about in my tweet/graphic, requires higher table stakes than "well, if you ask some government, they'll tell you that I own a business."

And herein lies the essential problem with freelancers that (aspirationally) refer to themselves as "business owners."

The freelancer, who forms a corporate entity, and then takes on sequential time-and-materials engagements, technically owns a business in the "file and pay dues" sense.  But this is the equivalent of someone buying a guitar and immediately calling himself a musician.

This "business" technically exists, but is completely worthless.  And I don't mean that in the pejorative sense, the way I might watch my favorite basketball team in a particularly lackluster affair and then say, in frustration, "the Bulls are worthless."  Rather, I mean that the freelancer's business is worthless in the sense that it has zero economic value.

So let's form a more rigorous definition of business ownership.  Business ownership means filing the paperwork and fees, but also creating an entity with economic value.

Let's now dive into "economic value."

A Simple House -- Understanding How Businesses Make Money for Their Owners

The idea of the "economic value" of a business might seem a little abstract or wishy-washy.  So let's get right to the point with a concretion.  Consider one of the simplest imaginable business ventures.

Let's say you happen upon a house on a lake, listed for $100,000.  You're neither looking for a primary residence nor a vacation home.  Rather, you buy the property because:

1. You have enough cash laying around for a down payment and
2. You think the house is way under-valued at that price.

Whether you form a corporate entity or not, when you buy this house, you're creating a very simple business with a profit motive.  With your money and your purchase, you become the single shareholder (owner) in this business.  And you're planning to make money in two possible (non-mutually-exclusive) ways:

1. Appreciation: you assume that you can, at some later date, sell the house for more than you paid.
2. Dividends: you rent the house for more than you pay in mortgage and maintenance, and the difference is cash in your pocket.

And, while we're at it, let's throw in one more business-y term. Your equity in this business is the value of your ownership: the worth of the place, minus what you owe on the mortgage and what maintenance costs.

So, circling back to the idea of economic value, the economic value of your "Imma buy this house!" business is your equity in the house.  The "what I owe" part is easy to calculate, but the "worth of the place" is more complicated. The place is worth is what buyers will pay for it, based, among other things, on the dividends you earn, and their take on its appreciation.

Now, with that in mind, let's consider the freelancer's worthless business.

A Freelancer's Business is Worthless

Drawing on the "Imma buy a house" example, let's consider the freelancer's business.

On the cost side of the ledger, there's usually very little. Maybe hosting for your website, bookkeeping software, and a few other nominal expenses.  You might have the odd other thing here and there, but when you sell your hours for dollars, there tends to be little complexity.

On the asset side of the ledger, you have what clients pay you.  Hours at an hourly rate rolled up into weeks or months.  Let's assume that you bill $100/hour and manage to (impressively) bill 30 hours per week.  That's $150,000 per year (assuming 2 weeks vacation).

So, then, presumably, your profit (revenue minus expense) for a year is $150,000 minus your nominal expenses.  Let's call it $148,000.

Wait, so how can I call that business worthless!?  That's an annual dividend of $148,000 (notwithstanding taxes)!

Well, is it?  Is it a dividend?  Or is it a salary (and thus a cost)?

Think of it this way.  Let's say that the individual human freelancer's brain split into "freelancer as business owner" (call her Faith) and "freelancer as employee" (call him Fred).  And then, let's say Fred burned out and quit.

What would Faith do? Fold? Give up?

Nah. Probably hire a replacement.

And what would it cost to replace Fred?  What would it cost to find someone with Fred's experience and expertise?  Probably about what Faith was paying Fred.

So let's look at the business again, but this time considering the freelancer's salary as a cost rather than profit.  This business takes in $150K per year, spends $2K of it on miscellaneous expenses, and then $148K on salary, meaning it has $0 profit.

It is a worthless business.

A By-Design Worthless Business? Not a Thing

Now, worthless businesses come in all shapes and sizes.  In fact, consider our previous example of the lake house.

"Worth" is determined at the moment of purchase.  So when you pay $100K for the house, you fix the value of the house (the business's assets) at $100K.  And, at that moment, you have no rent income, meaning that your assets and liabilities offset, meaning, in turn, that you have a worthless business.

You hope that you'll find a renter.  You hope that the property will appreciate (meaning someone will later offer you more than $100K).  Heck, you hope both, because the business plan calls for both.

Contrast that now to the freelancer's business plan.  That "business plan" calls for the same basic pattern year in and year out: maximize billable revenue, pay off any expenses, and dole out the rest in salary.

The freelancer's "business" will never have profit, by design. It could never pay dividends, and it could never appreciate.  If the freelancer went to a venture capitalist and offered to sell her business, the venture capitalist would channel Michael Corleone and say, "my offer is this: nothing."

And thus we arrive a central axiom of my tweet. A freelancer may be a business owner in the literal, government definition sense.  But a freelancer is not a business owner in any meaningful sense.

Rather, a freelancer exists in the limbo between employment and business ownership.

Path A: Freelancing is Basically Having a Job, And Often Leads You Back to Salaried Employment

Let's return now to the graphic and career paths. I'll get to path B shortly, but first let's consider path A:

Path A: Employee -> Freelancer -> Employee

What I'm really saying here is that if you approach "freelancer" as an end-state, you're setting out with the goal of building a literally worthless business.  And when you do that, you'll either wind up eventually tired of the grind, in which case you'll re-enter the ranks of salaried employees, or else you'll limp along indefinitely, owning a business with no value.

In the latter situation, you are a business owner in letter, but not spirit.  Rather, you're a de facto employee.

To understand why, set aside a few cosmetic differences.  Your employers clients send you 1099s, rather than W2s. Your employers clients don't pay your health insurance or issue benefits.  And you change jobs gigs more frequently.

But, other than that, what's the difference?

You'll generally work 40 hours per week for your employer client, only having bandwidth for one such job gig at a time.  Termination of the work leaves you scrambling to find the next paycheck.  As soon as you stop working, no money comes in and, if you stop indefinitely, the "business" ceases to exist.

What's the exit strategy here? Well, you do it year in and year out, until you can set aside enough money to retire.  And doesn't that sound an awful lot like salaried employment with slightly different paperwork?

Path B: Setting Business Ownership as the Goal

By contrast, let's talk about path B:

Path B: Employee -> Freelancer -> Business Owner

When you leave the world of the employed, freelancing is a very natural first step.  After all, the dynamics are incredibly similar to salaried employment, letting you form a plan for ocean traversal while still in the relatively safe waters of the bay. There's nothing wrong with freelancing at all.

But, as I've said, it's an interim step and not a destination.  As a freelancer, you're not a business owner, but you should start to think about how to become one.

In the beginning of this post, I mentioned that I could see this becoming a series or a corpus of content.  And the reason I say this is that I'd like to take a deeper look at the path from freelancer to business owner.  The formulation and execution of this plan, after all, encompasses so many of the reader questions that I get:

• "How do I pick a niche?"
• "What's a good way to find clients?"
• "How do I move away from billing time and materials?"

And plenty more like these.

I'm not (yet) going to elaborate on all of the components of flipping the bit from freelancer/indie to business owner.  Way too much content for one post.  But I will close with the absolute first step necessary.

The Absolute First Step to Business Ownership: Reasoning about Profit

You can do this right now.  It's actually extremely simple (if subtly hard to fully grok immediately).

You need to define and track profit in your business's finances.

I would argue that this alone -- attempting to define profit -- is the keystone difference between paths A and B.  As soon as you take a step in this direction, you're leaving path A and heading for path B.

Why is this?

Well, it's the first step toward having either dividends (writing yourself, the business owner, a quarterly dividend check) or toward appreciation (profit will convince others that your business could be worth purchasing).  Profit is the distinguishing characteristic of a non-worthless business.  (Let's leave charitable orgs and nonprofits aside for the purposes of this discussion as scratching a fundamentally different societal itch.)

Reasoning about profit also has another important characteristic: forcing you to reason about the viability of your business now, rather than when you're burned out and capped out on hourly rate in 10 years.  Here's what I mean.

Say you look at your $148K freelancing business and say, "I can't put money aside as 'profit for shareholders' -- that's less than I want to make in salary!"  Well... that should tell you something. It should tell you that, if you think the going rate for your role should be higher, you're bringing in less in revenue than you should be paying in salary.

And that, my friend, is not a viable business.

With that in mind, you can start thinking about raising your bill rates or paying your employee less, in order to make it viable.  Or, maybe, you start to brainstorm other ways to generate a profit.  And when you do that, you're starting to see a path off the limbo-treadmill of freelancing, and into the value-building world of business ownership.

If this seems like an interesting line of posts, please let me know.  I'd like to, and probably will, delve more into how to execute "Path B" either way.  But if there are specific questions/topics you'd like to see, I'd love to here about them.

If you'd like to ask a reader question, you can do so at the "ask me" page.