Applied Science 4.5: On Profit (semi-briefly...)

“Broke? Then fix your pockets/ All I do is profit” - ScHoolboy Q

When we launched the Deal Simulator in September, one of the most consistent points of confusion and disagreement concerned our definition of profit. Numerous users and commenters felt it misleading that the artist’s advance was not calculated as part of the artist’s profit. 

It’s a fair question: Why shouldn’t the money a label puts in the artist’s pocket count towards the artist’s profit?

This line of questioning from users led me to think: Do we teach people clearly and properly what profit is? Are we supposed to understand it via capitalistic osmosis, absorbed through daily exposure to society’s obsession with generating money? Is profit a simple equation or a complex concept? 

These questions entangle endlessly, forming large corners of entire fields of study. I can’t possibly illuminate them all (partly as I’m still learning). Please consider that when reading this reflection. Also, be warned: Defining profit might not get your heart pumping, but understanding it is crucial for building a sustainable career roadmap. 

In our simulator, profit comprised net income after deducting expenses (including the loan known as an “advance”). The definition of profit, according to my MacBook’s dictionary: “a financial gain, especially the difference between the amount earned and the amount spent in buying, operating, or producing something,” You could represent that in the formula Revenue - Expenses = Profit (or Income - Expenses = Profit). One thing to note: In the simulator, we’re only looking at one slice of an artist’s (and a record label’s) overall income. We make that slice even narrower by reducing it solely to streaming income. Also worth noting that an artist’s profitability in a royalty deal isn’t dependent on the flat repayment of expenses, but rather the artist repaying expenses from their share of royalties (so if an artist is on a 20% royalty, and their deal cost $1m, they need to generate $5m in order to break even). Costs still need to be repaid, but the calculation of profit is dependent on royalty splits and stipulations of recoupment as much as it is on income. The deal simulator’s design intended to illustrate that until certain thresholds were reached, an artist’s deal could not be profitable, though their music may be.

One answer to the question of whether or not an advance is profit can also take the form of another question: Do you consider a loan profit? (More on this at the end, because this was not the only concern about how we classified advances)

Profit is not revenue (or earnings, or income, or any synonym you choose for “money made”); it is not necessarily the money in your bank account, nor is it perceived future gains. It’s certainly not the amount you see when that first direct deposit hits from your label, distributor, or publisher. 

Profit can be divided into gross profit (revenue minus the costs of manufacturing goods or performing services) and operating income (profit after the deduction of recurring operating costs). These definitions cast shadows that enable clever accountants to move money in ways that can make a company definitionally unprofitable for the sake of lowering tax burden (a concept you might familiarize yourself with by looking at Donald Trump’s tax returns, for example). Profit, which carries an almost universally positive implication, can contort into a kind of liability for those bobbing and weaving with the IRS. 

Part of an advance likely forms some profit—after accounting for commissions paid to team members (lawyers, managers, business managers), living expenses, business costs, and, last but almost never least, taxes. Thinking of an advance as pure profit is fanciful, as if presupposing a scenario in which none of the advanced money would go towards running the business of an artist, songwriter, or producer’s career and, more importantly, as if none of it was taxable income.

My brilliant friend Ethan Jones provided me with insight on profit during a text exchange about questions I tussled with for this piece. Ethan manages the inimitable, hilarious Zack Fox and Alex Russell; he studied business in college. I, on the other hand, studied film. We both developed much of our business acumen through trial by fire, but Ethan carries the blend of philosophical concepts and hardcore pragmatism that I didn’t pick up while breaking down screenplays and watching silent Russian films from the 1920s. (You should subscribe to his brief, humorous, heartfelt, and highly informative newsletter Tools for MGMT if you want to learn how to manage a business of any sort, but particularly an entertainment business).

Ethan noted that a lot of people leave profit to chance, particularly when starting businesses. Rather than setting profit targets, they generate income, incur costs, and end up with whatever’s left. Profit targets, as Ethan put it, “create artificial constraints” that can also help set expense guidelines, encouraging business owners (in this case, artists and their teams) to understand their business primarily from a cost perspective. 

Ethan provided this formula (adapted from Mike Michalowicz’s Profit First; the classic equation for Profit is “Revenue - Expenses = PROFIT”; the Profit First equation is “Revenue - Profit = Expenses”) with two key insights:

Advance + Revenue - [PROFIT] = Taxes + Commissions + Owners Compensation + Contractors + Operating Expenses + [RUNWAY]

1) You gotta know RUNWAY or Burn: how long you have to get to the next check. Not to stretch tech analogies too far because that is annoying, but runway is literally the most important metric in any nascent venture. 

2) PROFIT is something you have control over because you can adjust everything on the right side of the equation. If you don’t plan to have a PROFIT, it’s hard to do so…you don’t create that buffer and just spend through it (often).

A few additional definitions (my own, not Ethan’s):

  • Advance - an amount of money given as a loan against future earnings.

  • Revenue - income or earnings.

  • Taxes - what you owe the government from your revenue.

  • Commissions - what you pay your team (managers, lawyers, business managers, etc.).

  • Contractors - someone you hire to do work for your company, but typically not a full time employee (ex. graphic designers, directors, engineers, etc.); the people you’ll need to send 1099’s to at tax time. 

  • Operating Expenses - the regular costs of running your business (ex. staff salaries, software subscriptions, rent, etc.)

As a person still recovering from getting a C in Econ, equations like this one can be a bit daunting for me. My first question: What is Owner’s Compensation and is it a necessary piece of this calculation? Here’s Ethan again to shed some light:

Owner’s comp I’d define as the money taken OUT of the business to pay the owner, such as a regular transfer from a biz account to a personal account. Or if the owner is on the payroll of their own biz, the funds allocated for their salary. I think less important for many artists given that a common structure is a single member LLC that both business and personal expenses come from. Not ideal from an accounting standpoint...but common nonetheless. One consideration here could be that owner’s compensation is essentially the same as the profit...where the money left over is what the artist actually LIVES on.

So to simplify if needed: Owner’s Comp = Profit = what the artist lives on. Profit/Owner’s Comp are really two sides of the same coin—The spoils that go to the owner. But to me - the important distinction is that I want businesses that I’m involved in to be:

1) profitable 

AND

2) able to compensate their owners well

So the owner’s compensation is a salary component (for working on the business). And profit is an extra distribution - a reward for being the owner of the biz.

For the sake of simplicity, we can remove owner’s compensation temporarily and restate the equation as:

Advance + Revenue - [PROFIT] = Taxes + Commissions + Contractors + Operating Expenses + [RUNWAY]

If that is confusing to you, then that probably means you’re a breathing human being who isn’t an accountant (like me). It’s a concept worth straining to understand. That equation forms a powerful foundation for running a business. It won’t stop you from lighting money on fire, but it at least gives you the formula for how to either light money on fire or not. None of this detail is captured in our simulator (mostly because it was beyond the scope of simply visualizing recoupment in a record deal; it is on our minds). Ethan’s assessment also subtly underscores the issue with the way many in music think about money. 

The culture of the music business tends to oversimplify financial roadmaps to the big scores that light the way—record deals, publishing deals, endorsement deals, and the like—checks that come infrequently, landing in bank accounts with considerable impact. Whether they know it or not, artists and managers adapt to this irregular rhythm, thinking primarily of the checks themselves, but not the costs required to cover the path between them. Career beginnings can be particularly spotty, when residual income from master and publishing royalties may be scarce or nonexistent. The narrative apparatus of the industry—the press stories that build up mega-deals, the selectively showy culture of Instagram, the songs about expensive habits and constant winning, the backroom conversations in which established and aspiring executives alike gossip about who spent what and who’s earning what—make a self-fulfilling prophecy of this blind check-chasing. Many factors feed into misperception of profit, but I think lack of specific directive and clarity within corporate label infrastructure and miseducation of young managers warp comprehension. 

At labels, financial decisions often occupy adjacent silos—a&r here, marketing there, advances and miscellany there. Even in those silos, junior executives might only know a budget in bits and pieces or in the broadest sense; they don’t have visibility into how that budget sits alongside other budgets and operating expenses (nor do they often have a clear picture of the income being generated from their work, for that matter). Profit forms a nebulous goal, divorced from the decisions of daily work and the operating expenses tabulated by the dreaded finance department. It looms over each weekly meeting’s calls to “break more artists” and control more market share—elusive check points on the path to ensuring Sony, Warner, or Universal is profitable to someone.

A&R’s are simply told to go out and sign shit—try to get it cheap and early, but throw the kitchen sink at it if the deal gets hot. Budgets don’t often come with instructions, instead being wielded as lines in the sand paired with amorphous punishments for transgression; if you overspend and have a hit, who’s going to notice? The practical lessons of books like Anita Elberse’s Blockbusters and Derek Thompson’s Hit Makers embolden this sort of thinking, justifying the expense of mega-hits and pushing high level strategy to the zero sum logic of “hit or bust” that often leads to label executives eschewing economic logic as they chase the next big thing (though, to be clear, this strategy can work really well: It has made a mint of Republic Records and Columbia Records in recent years). This culture of the hunt informs the dialogue about deals and artist development, excising business education from casual conversations, turning virtual panels and interviews into parades of platitudes that seldom explore, for example, how an artist’s economic runway can affect their creative development.

For managers, especially young ones, building an artist’s career might be their first brush with running a business. Pre-tax income, 1099s, and a host of expenses that a corporate job might typically handle—all potential pitfalls that can make tax time tenser. If you don’t understand how much money needs to be set aside from income for taxes, you naturally accrue unexpected debts to the government. Managers are seldom trained to run client’s careers like the small businesses they are; most artist managers don’t have MBA’s or accounting certificates. Through observation, we learn that the path is paved with one novelty-sized check after the next, flipping deals without being pushed to think of the daily costs that come between. Wondrously, this perception fits snugly into the mold of the label system’s ravenous appetite for signing shiny new things. 

The dopamine hit of the big score obscures good business practice; cashing a check gets conflated with the actual preservation of profit. Worse yet is the education vacuum concerning business optimization and retirement planning that leaves many artists (and managers) without a clear understanding of what they could and should be doing with their profits to forge long-term financial stability. Much blame can be lobbied at business management firms that are typically more adept at keeping money moving into bank accounts and commissions flowing than teaching artists and their personal managers how to smartly structure their organizations.

There is much more to say on why labels and big management companies don’t educate employees about profit and operating expenses; fundamentally, junior employees (and even some senior ones) don’t need to comprehend these concepts in order to do their jobs. Could they do their jobs better if they did? In most cases, absolutely, but these are the sorts of unsexy ideas that feel divorced from the romanticism of the recording studio and the electricity of the stage. Understanding and implementing this thinking can help build more sustainable systems, invisible rails that allow creation to run uninterrupted—budgeting and forecasting, operational knowledge running silently in the background, allowing great music to be made.