In this article, we will consider various opportunities investors have to invest in motion pictures in the United States. However, before discussing specific types of investments that are available, it would be useful to provide a general overview of the economics of film production and distribution.
Motion pictures that are produced in the United States (or which are produced by US based producers but filmed abroad) typically fall into one of two categories. There are those that are produced by, or under the auspices, of one of the major US film studios (20th Century Fox, Paramount, Warner Bros., Universal, Sony and Disney) and those that are produced by less prominent film studios and by independent producers (i.e., producers who are not affiliated with a major studio). The financing and revenue models for films produced by major studios and those produced by independent producers are different. Major studios typically do not arrange for financing on a film-by-film basis and, to the extent they do not finance their films out of their own resources, they will often rely on hedge funds, established private film funds and other corporate financing ventures to provide the financing for their projects. As a result, there are very few opportunities for an individual investor to invest in major studio films. Because of this, the primary focus of this article will be investments in independently produced films.
The two main items of cost that are incurred in producing and distributing films are the actual cost of production and the distribution expenses incurred in connection with the film’s initial release. Raising the money to fund the production cost is the producer’s primary responsibility and a producer often has to be quite creative in order to raise these funds. Typically, a film’s distributors are responsible for funding the distribution expenses. Distribution expenses fall into two primary categories; the advertising costs for the film’s initial release and the cost to manufacture the physical materials (such as 35mm prints) that have to be delivered to the film’s exhibitors. Interestingly, these two types of costs have been moving in opposite directions over the last several years. Advertising costs have increased exponentially over the past ten to twenty years as the explosion of media markets has necessitated purchasing ever more advertising. Conversely, the development of new technology (such as digital delivery to theatres, the rise of streaming services and the diminished popularity of DVDs) has drastically reduced the need to make numerous physical copies of a film. Nonetheless, for a film that is being released theatrically in the US, the distribution expenses the distributor incurs can easily equal or exceed the film’s production costs.
Assuming that a producer is fortunate enough to be able to raise enough money to fully fund a film’s production cost and has found a distributor or distributors who are willing to release the film, the next step is to figure out if all of these costs will ever be recouped and if the film might eventually earn a profit. For this part of the discussion, I will separate out the analysis of exploitation revenues into two pools; those derived from the exploitation of a film in the US and those derived from international exploitation.
The entertainment media is very enamoured with reporting the theatrical box office revenues of the higher profile films that are released in the US. When one looks at the numbers, it would be easy to assume that a film which cost, say, $50,000,000 to produce and that had earned $100,000,000 in theatrical box office revenues would most certainly have earned a profit. Unfortunately for the film’s investors, that would be a sadly mistaken assumption.
Let’s start with that $100,000,000 in box office revenue and look at how that money flows. First off, box office revenues are split between the theatres that show the film and the theatrical distributor. While the splits are all negotiated and will vary from film to film, on average the split is about 50/50. This means that, of that $100,000,000, the theatres will keep around $50,000,000 and the other $50,000,000 will be paid to the theatrical distributor. A theatrical distribution agreement typically provides that, after the distributor receives any money from the exploitation of a film, there are numerous items that are deducted from that money and retained by the distributor before anything is paid to the producer or the film’s investors. First, the distributor will deduct its distribution fee. This is a fee that the distributor charges from providing its services and expertise. The amount of the fee may vary depending on whether or not the distributor has made an upfront payment (known as a minimum guarantee) to the producer (this will be discussed in more detail later). Customary distribution fees on theatrical revenues range anywhere from 20% to 35% of the distributor’s gross receipts (with the fee being on the lower side if no upfront payment was made). For our purposes, let’s assume the fee is 20%. This means that the distributor will first deduct $10,000,000 as its fee, leaving $40,000,000.
Next up are the distribution expenses. This means all of the out of pocket costs the distributor has incurred in connection with releasing the film. While, as mentioned above, the bulk of these costs are related to advertising the film and delivering it to the theatres, these costs would also include costs to dub or subtitle the film into other languages, costs incurred to collect money from recalcitrant theatres who do not pay promptly, etc. Some distributors even go as far as to charge an overhead charge on the amount they spend on advertising (which I find to be rather greedy, but many producers are not able to negotiate this out). And, as I mentioned before, these distribution expenses can often equal or exceed the cost of production of the film. For our purposes, let’s assume that the distributor spent a modest $30,000,000 in distribution expenses. It would then deduct this amount from the $40,000,000 that was remaining after it had deducted its fee. The balance of $10,000,000 would be considered the distributor’s net receipts and would be available for further distribution.
What happens to that $10,000,000 in distributor’s net receipts depends on several different factors. In what’s known as a “straight” distribution agreement (i.e., one where the distributor does not pay a minimum guarantee), unless agreed otherwise, all of the distributor’s net receipts would be paid to the producer and could be applied to repay the production costs. If the distributor has agreed to pay a minimum guarantee (which is, in essence, a guaranteed minimum amount that the producer will earn from the film, regardless of how well it performs at the box office) then the distributor will first deduct the amount of the minimum guarantee, plus interest, from the distributor’s net receipts before making any payments to the producer. In this case, except for the interest, this is a wash for the producer, since it will have already gotten the money that is being deducted. That said, in some instances where distributors have excessive bargaining power, they will also negotiate a split of the distributor’s net revenues between the distributor and the producer. This could, potentially, reduce the share of net revenues the producer receives by anywhere from 20-40%.
So, if we assume our hypothetical producer has a straight distribution agreement, then, out of that $100,000,000 in box office revenues, the producer will get approximately $10,000,000, which could then be applied to recoup some of the film’s production costs. Now it’s important to keep in mind that this is not the only money the producer will receive from the film’s US distributor. As the film works its way through the ancillary markets (pay-per-view, video-on-demand, what’s left of the DVD market, streaming video services, pay cable, free cable, etc.) and generates additional revenues, after deducting fees and expenses, there will be further monies that are payable to the producer, but, unless the film is a huge hit, most likely the US revenue alone will never be enough to allow the producer to fully recoup the production costs. This is where international distribution comes into play.
In addition to licensing rights to a US distributor, an independent producer will also seek to license rights on a territory-by-territory basis in all the other countries of the world. This is markedly different from how major studio films work. Major studios will typically acquire worldwide distribution rights and then will distribute a film internationally through its international subsidiaries or through local distributors with whom it has existing output arrangements. Most independent producer do not have access to these types of global networks. Instead, they engage the services of an international sales agent, which is a type of distribution company that specializes in selling right to films to international distributors. The agreements that a producer will enter into with the international distributors are all very similar. Typically, the distributor will agree to pay a minimum guaranteed payment which is due on delivery of the completed film to the distributor. The distributor will then recoup this payment (after first deducting its fees and expenses) from its distribution revenues, and if there is anything left over (which there rarely is), the distributor will pay the remaining amount to the producer. If a film does well, the producer’s share of the combined distribution revenues, together with components of the production costs that do not have to be repaid (such as production incentives), will be sufficient to repay the investors in full and turn a bit of a profit.
Now that you understand a bit about how the cash flow structure works, I want to discuss how an independent producer assembles the production financing. These days, the components that comprise the financing plan for a typical independent film fall into three categories. First there is debt financing. This would take the form of a loan made by a bank or other lender, which is typically secured by a first priority lien in all of the rights related to the film and all of the revenues derived from its exploitation. If a producer wants to obtain a film production loan, it will either have to sell some or all of the distribution rights prior to production and pledge the receivables from those sales to the lender. While this is typically a lower cost form of financing (depending on the security), producers prefer to keep the debt financing component as low as possible, because the pre-sale market is particularly tough, and the conventional wisdom is that a completed film will earn more in international sales than one which has not yet been filmed. I will not go into a lot of detail here about secured production loans, in that they are almost a whole separate article by themselves.
Next a producer will attempt to piece together as many different production incentives as possible. Production incentives are financing provided by a local, state or federal government to encourage film production in their locale. Production incentives can take the form of tax credits, rebates or outright grants. Producers particularly like production incentives because this is “free” money in that it does not need to be repaid. If a producer chooses the right jurisdiction and can structure the film so that it complies with as many of the jurisdiction’s content rules as possible, it is possible that a producer may cover as much as 40% of its production costs with incentive revenues. The one wrinkle when it comes to incentives is that they are usually not paid until after the production is completed. So, usually the producer will need to have a third party lend or advance money to fund that portion of the costs and then recoup that amount out of the incentives when they are paid.
Finally, if a producer cannot fully finance a film through debt (or chooses not to) and incentives, then the producer will look to equity investors to fund the remaining portion of the film’s budget. Equity investments in film are among the riskier investments one can make. More often than not, an equity investor will lose all or a large portion of the investment. However, when a film does well, then they can be quite lucrative.
The basic economics of an equity investment in a film are pretty standard, but the method for making the investment will vary on a case-by-case basis. First, you must understand that an equity investment in a film is the first money in and the last money out. An equity investor recoups its investment only after all of the debt or other secured financing has been repaid. This is why it’s the riskiest. Typically, a film’s equity investors will first receive the full amount of their investments, then a preferred return on the investment (which is generally around 20-25% of the amount of the investment) and then a share of the film’s net receipts. Generally, 50% of a film’s net receipts are paid collectively to the investors and 50% to the producer and talent participants, although this amount can vary depending on how much of the film’s budget was financed by the equity investors.
The structure of an equity investment in a film can vary a bit depending on the structure the producer is using for the production and the status and needs of the distributor. The most common and simplest form of investment is a straight investment contract between the investor (or the investor’s financing company) and the production company. This is a (relatively) straightforward agreement between the investor and the production company in which the investor agrees to provide the production company with a certain amount of money in return for receiving a portion of the film’s revenues equal to the amount of the investment, the preferred return and the investor’s share of the film’s net receipts. An agreement of this type may provide for the amount of the investment to be funded into an escrow account, and it will also include certain protections for the investor (discussed in more detail below).
As an alternative to the structure discussed above, the investor may purchase an ownership interest in the production company, with the understanding that the proceeds from the purchase will be used to fund production costs. There are both benefits and burdens to an investor from using this type of structure. Among the benefits are that, if negotiated for, the investor can have a bit more control over the production company and the individual producer, which might be more comforting if the investor has questions about the producer’s ability to deliver. Also, by owning an interest in the production company, the investor is generally assured of being able to participate in any revenues that may be generated from merchandising, remakes, sequels, etc., which may not be the case with a straight investment agreement. On the other hand, an investment of this type means that the investor will have to deal with the consequences of being an owner of a US company and all that entails. The main concerns here are tax related, and since I am not a tax attorney, I cannot offer any advice on tax issues. If an investor is offered the opportunity to invest in a film by purchasing an ownership interest in the production company, I strongly recommend that the investor consult with qualified tax counsel before making the investment.
Next, there are equity investments that are made for strategic purposes by the investor, based on the nature of their activities in the film industry. For example, a company that distributes films in a territory may agree to invest a larger amount than it would normally pay as a minimum guarantee in return for receiving distribution rights in its territory as well as a participation in the worldwide net receipts. Or a company that provides production services (such as a post-production facility) might agree to provide services at no cost (which reduces the overall amount of the budget) in return for a share of net receipts. While these types of agreements are rather specialized, they are also good alternatives for investors who are positioned to take advantage of them.
So now that I’ve told you how risky film investments are and the different ways you can make them, I thought I would wrap this up by offering some advice on what an equity investor can do to protect itself as best as possible. First and foremost, if you are investing in an independent film, you must insist on the producer using a collection account established with a reputable third-party collection agent. This is single most important piece of advice I can give to an equity investor. If a producer refuses to use a collection agent, walk away from the deal. A collection agent is a company that sets up a dedicated bank account that all of the film’s distributors are instructed to pay their revenues to. The collection agent then calculates how that money should be allocated and pays out to each beneficiary its respective share. If you don’t have a collection agent, you have no way to independently determine what money has come in and where it has gone. This is an invitation to the producer to steal from you.
Next, if you can get it, is to take a security interest in the film as security for the producer’s obligation to pay you what you are due. While a security interest is good, please keep in mind that it will be subordinated to the production lenders and perhaps to other parties. But it is a benefit if, for some reason, the production company files for bankruptcy. In that case, it is always better to be a secured party than not.
And if there is a production lender, always keep open the option of buying the production lender out and stepping into its shoes. When it comes to the recoupment pecking order, the production lender is always in first position. If things are looking bad and you as an investor have the opportunity to buy the production lender out, it could be the difference between recouping and not. If nothing else, stepping into the production lender’s shoes (and security interest) will put you ahead of any other equity investors and, in the worst-case scenario, would give you the ability to foreclose and take over the film.
So, this, in a nutshell, is the world of investing in Hollywood films. If I can leave you with one last piece of advice, it would be, if you think you want to do this, please find a lawyer who is knowledgeable in film financing to assist you. Don’t use your general corporate or family lawyer, no matter how good he or she is. This is a highly specialized area of law. In the same manner that you would not go to a general practitioner for brain surgery, you should not go to a generalist for advice about financing films. And if, after all of this, you do decide to take the plunge, I wish you the best of luck.
Author:
Raymond Gross
Gipson Hoffman & Pancione
rgross@ghplaw.com
+1 310 556
