Deconstructing Pop Culture

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A Template for Independent Film Financing

November 15th, 2006 by David Kronemyer · No Comments

Executive Summary

Inspired by fixed asset securitization techniques, we have devised a new way to fund motion picture investment. We intend to focus primarily on independently-produced pictures with a negative cost of less than $25 million, which we believe to be an extraordinarily profitable market segment, subject to appropriate controls.

We will assemble the various components typically used by producers to partially monetize a picture’s negative cost, and use them as collateral to support draw-downs from a credit facility. The result will be a diversified portfolio of film assets, which we will own. We also will be in a position to capture and retain a significant portion of net proceeds, subject to third-party participations.

We will follow rigorous criteria before financing a picture using the facility, the main one of which is that the picture must be fully collateralized. We do not anticipate this will be an onerous requirement, however, due to the unique dynamic that exists between producers and potential collateral suppliers. This dynamic presently is dysfunctional, because there is no assurance that, at the conclusion of a complex process in which both counterparts must engage, there will be funding to produce the picture – a problem that we will be able to solve.

We anticipate there will be significant industry demand for the facility, both from independent producers, and even from major studios looking for additional sources of off-balance-sheet financing. We would like to establish the facility in the amount of $250 million, comprising a senior piece of bank debt equal to approximately $175 – $200 million, and a mezzanine or junior piece equal to the balance.

I.
Industry Demand, Overview

This is a time of tremendous change and opportunity in the market for filmed entertainment properties. As shown at Figure 1, since 1970, annual domestic theatrical box office gross has increased on an inflation-adjusted basis from $5.5 billion to $9.5 billion.(1)


This increase, however, is not due to higher ticket prices; during the same period, again on an inflation-adjusted basis, they increased on average only by five cents, from $5.98 to $6.03. Nor is it due to the number of movies being released. If we were to imagine a world where audience demand was relatively constant on a per-movie basis, then an increase in the supply of movies released should result in a corresponding increase in attendance. This might have been the case domestically in the 1930s – 1940s (2), and still may be the case in some countries, such as India.(3) However, as shown at Figure 2, while the number of movies being released per year has increased by 55% since 1970, there is poor correlation with yearly attendance.


Rather, the prime drivers of increased attendance are an increase in the number of movie screens, from 13,750 in 1970 to 35,786 in 2003 (Figure 3); and, an increase in average normalized P&A spend per movie, from $4.24 million in 1970 to $39.1 million in 2003 (Figure 4).



Both of these phenomena strongly suggest that people will continue to go to see movies, so long as (a) there is somewhere reasonably convenient to do so; and, (b) they are properly motivated to do so, by timely and efficient advertising and promotion.

A parallel development is the dramatic increase in other forms of consumer entertainment hardware and software, such as DVDs, pay cable, personal computers, and broadband Internet access. The markets for films have been undergoing rapid changes due to these technological innovations. As a consequence, the sources of revenues available have been changing rapidly. The relative importance of the various markets also has changed, and can be expected to continue to change.

In 2003, 108.4 million U.S. households (98.3% of the total number of U.S. households) had a television set, and 98.4 million (90.8% of the TV households) had a VCR. 46.7 million households (43.1% of the TV households) also had a DVD player. 33.7 million DVD players were sold in 2003 alone, resulting in an installed base of 90.2 million players. 293.6 million VHS cassettes and 1.1 billion DVDs were shipped to dealers for sale or rental in 2003; presently there are 29 thousand DVD titles available. 73.9 million U.S. households (68.1% of the TV households) receive basic cable, and 40 million of them (36.9% of the TV households) subscribe to pay cable. There presently are 283 domestic cable and satellite channels. 67.1 million U.S. households (60.8% of all U.S. households) have a PC; 50 million PCs were shipped in the U.S. in 2003 alone, adding to installed base that has been estimated as at least four times that size. 62.2 million households (56.4% of all U.S. households, and 92.7% of the PC households) have some form of Internet access; and, 21.7 million (34.9% of the Internet households) have a broadband connection.

This explosion of secondary media channels primarily is driven by movies. Hollywood-branded entertainment is the primary engine influencing modern pop culture. Indeed, half a dozen television shows (and at least one entire cable network) now are devoted to dissecting the larger-than-life personas of pop culture figures, primarily, actors and actresses. The foreign market for U.S.-originated films continues to increase, as media continues to globalize and infiltrate new markets, such as China. As with recorded music, where U.S.-originated repertoire accounts for about 50% of all records released worldwide,(4) U.S. movies dominate international cinema.(5) Domestic theatrical attendance therefore only is a rough proxy for the total number of consumer impressions that any movie prospectively is capable of achieving, which assuredly is several multiples larger.(6) These trends all indicate that demand for filmed content will remain strong, even as the means by which it is delivered continue to evolve.

II.
Two Financing Paradigms

There now is a dynamic stratification in the marketplace between films that are funded and promoted by the major studios; and, everybody else. In fact, major studio films are so different from independently produced films that it hardly makes sense to conceive of them as part of the same business. Major studios are multinational, mass marketing, corporate groups, which own their distribution channels around the world. The independent sector, on the other hand, primarily comprises individually financed projects, with ownership retained by the producers, who then license the film rights. This difference in distribution modes in turn has profound consequences for their respective financing templates.

A. Holding a Long Position

Major studio films have a negative cost that typically exceeds $50 million, and that will require upwards of $50 million more in domestic P&A expenditure to market and promote. The major studio typically invests in producing such a film on a movie-by-movie basis. Once a project has been acquired, developed and cast, it simply starts spending money. This might be called holding a “long” position in a film, similar to the way that a shareholder might hold a long position in a stock. The shareholder owns the stock, and is subject to the fluctuations and vicissitudes of the marketplace. If the stock goes up, then the value of the shareholder’s holdings goes up. If the stock goes down, then the value of the shareholder’s holdings goes down.

In much the same way, when a studio holds a long position in a film, it takes subject to the risk that the film might not be commercially demanded and result in sufficient net proceeds from the exploitation of media rights to pay back the cost of creating the film and the studio’s implicit cost of funds. Given this, it is inevitable that from time to time large-scale disasters will result. Among the 10,000 movies released by the major studios during the period 1970 – 2003 were Heaven’s Gate (1980); Ishtar (1987); The Last Action Hero (1993); Waterworld (1995); Battlefield Earth (2000); Glitter (2001); Swept Away (2002); and Gigli (2003), to name just a few that achieved both commercial (7) and critical notoriety.

Such a consequence is particularly dire in an era when most productions are structured as stand-alone, independently-viable profit centers. Long gone are the days when a studio could count on one “hit” to amortize a dozen “misses.” Rather, studio-talent contractual relations have evolved into a far more efficient process – though not quite as efficient as the New York Stock Exchange – with the price for talent much more closely calibrated to demand. As a result, much of the net proceeds of a commercially demanded film will be distributed to gross receipts participants (though surely not the loss of an unsuccessful one).(8) Regardless of the magnitude of sums involved, this transactional outcome in and of itself forces the studio to become more selective as to the projects it develops, produces and releases.

Furthermore, there is a huge notional interest cost, even when a film is successful. Film investment is not amenable to internal rate of return (“IRR”) analysis, in that cash flows are not periodic. In this respect, film investment is not like owing, say, real estate, where cash flows are stable and predictable. Rather, with film, it is necessary to expend a large amount of cash “up front” to make the movie. Net proceeds derived from its commercial exploitation then might not be realized for some considerable period of time, often as much as 18 to 36 months thereafter.(9) This results not only in high notional interest cost, but also opportunity cost – what the studio could have been doing with the money, had it invested in something else.

The magnitude of required expenditures precludes too much solipsism in the movie-making process. Therefore, rather than articulating a singular aesthetic vision, the typical studio picture attempts to forge what might be referred to as an artistic consensus. The executives employed by the studio attempt to imagine what the public might want to see, or what elements it might find appealing, and then attempt to iterate or instantiate these desiderata in the film. Note that this is (at least) a two-step process; even if the objective is correct, the execution may be flawed. The primary measure of a studio executive’s success is the extent to which he or she succeeds at doing so, somewhat akin to latter-day alchemy (i.e., uniting “art” and “commerce”).(10)

A good argument can be made that this in turn stifles creativity and results in a “lowest common denominator” aesthetic, when viewed from an industrial organization standpoint. For this reason, the major studio has been described as fostering a “culture of organizational risk-aversion” that relies primarily on proven methods such as “star power and sequels, accompanied by huge marketing budgets and pre-release promotions.”(11)

Though not produced by a major studio, the best recent example of holding a long position in a movie probably is The Passion of the Christ, solely financed by Mel Gibson’s company, Icon Productions. Icon reportedly spent $30 million producing it;(12) the domestic theatrical box office gross was $369,336,919, “defy[ing] earlier predictions,” to quote Daily Variety.(13) At a press conference held in 2002, Gibson is reported as saying, “They think I’m insane – maybe I am.”(14) Had the movie not met with commercial success, Gibson would have sustained a loss equal to the difference between the film’s negative cost and its net proceeds (at the Icon or production company level).

Regardless of commercial considerations, Gibson wanted to make a point, and he had the means and opportunity to do so. No matter what one thinks of the movie, Gibson must be congratulated, in that, setting ideology aside, he had his ear close to the ground and his finger on the pulse of the marketplace. His artistic vision corresponded with marketplace demand.

B. Hedging

Because of the magnitude of financial resources required to make a movie, however, most independent films are not financed using this template, nor should they be. Rather, instead of holding a long position in the film, a better strategy is to hedge forward exposure risk, in much the same way an owner of stock (or a currency or commodities trader) might hedge exposure using futures contracts.

A futures contract is an agreement between two parties to buy or sell something in the future at a specific price. The buyer and seller agree now on the price for the product that will be delivered and paid for on a set future date. The primary advantage to the seller is that it has “hedged” its risk by “locking in” a contractual price. If the price of the commodity in the future turns out to be less than it is today, then the seller has protected its downside and knows that it will have sufficient funds on hand to manufacture the product. On the other hand, if the price of the commodity is greater in the future than it is today, then the buyer of the futures contract will profit, because it has acquired something that is worth more on the market than it costs to acquire.

This approach is particularly useful for film. There are a number of factors that potentially affect the commercial value of a film property. These include, at a minimum: the screenplay; the cast; the director; and the production value. These factors are dynamic and change over time, depending upon public perceptions. It is not possible to predict them in advance. They are not “objective” (in the way that “1 + 1 = 2” or “all bachelors are unmarried” are objective), which permits a wide divergence of opinion. There is a wider range of expectations as to the performance of a movie than there is regarding, say, the performance of General Electric stock. (15) “Motion pictures are risk-intensive by nature, with only three to four out of ten studio movies breaking even or becoming profitable.”(16) Furthermore, unlike (say) nuclear physics, almost everybody has an opinion, because almost everybody goes to movies. All aesthetic media are inherently indeterminate. This makes them difficult to value.

For these reasons, the most prudent and risk-averse strategy in any film financing is to hedge risk. The motion picture business differentiates itself from other forms of exploitation of intellectual property rights, in that it generates cash flows that can be reliably monetized. These anticipated future proceeds from the commercial exploitation of the film are assets, suitable for use as collateral, in order to secure funding to make the film itself.

The distinguishing feature of this approach is that it requires the producer to submit its judgment with respect to material and cast to the marketplace, in advance of production, in order to ensure sufficient consumer demand for the resulting property. The movie must be brought to the marketplace. The major studio holding a long position in a film, on the other hand, typically attempts to bring the marketplace to the movie. Because of these checks and balances, independently produced films with a negative cost of, say, $25 million or less, frequently out-perform (on an ROI basis) major studio films costing upwards of an order of magnitude more (see §IV, infra).

There are several ways to hedge forward exposure. The first is to pre-sell rights. This means that a media outlet in a specific territory agrees to make a certain payment to the producer, upon delivery of the film. The producer then can take this commitment to a bank, and borrow against it in order to fund production of the movie. The buyer’s commitment is collateral for the production financing loan. In order for this to be feasible, the buyer must be sufficiently credit-worthy, such that the bank will accept the buyer’s promise as collateral. Sometimes the buyer is required to make a down payment (e.g., 25%), or to post a standby letter of credit as additional collateral. Under a standby letter of credit arrangement, the issuing bank in effect substitutes its promise to pay for that of the buyer.

Since the movie has not yet been made, there is a genuine sense in which the buyer does not know what it will receive in consideration for the purchase price. For this reason, both the screenplay and the cast attachments must be sufficiently attractive for the buyer to know with some degree of certainty how the project most likely will turn out. One of the main reasons why some actors make more than others is because, historically, their name has been associated with successful projects. This creates value because the actor is a “proven commodity.” While it still is possible for the actor to make a bad movie, at least there is a track record for the buyer to rely upon.

If the proposed screenplay and cast cannot support sufficient pre-sales, then there is a profound sense in which the movie should not be made. In this way, the decision about “what pictures to green-light” (i.e., approve for production) tends to be self-equilibrating. Those that get approved are those that have material and lead casting sufficient to secure indicative pre-sales. It is not really necessary to consider whether a screenplay is “good” or “bad,” since the only question really is if it has attracted lead casting, which in turn will drive the pre-sales, which in turn drives the production financing. There is no such thing as a “good” movie or a “bad” movie per se. Rather, there only are finance-able movies and those that cannot be financed. Put slightly differently, if a movie has to be “good” in order to succeed, then most likely it should not be made.

If the producer can pre-sell rights from several territories for, say, 30% of the film’s budget, then the same bank that lends against the pre-sale contracts also typically is willing to make a loan for some additional amount. This loan is called a “gap” loan. The “gap” refers to the difference between the film’s budget, and the value of the pre-sold rights. Thus, for example, if 30% of the budget is pre-sold, the “gap” is 70%.

No bank will loan the entire amount of a 70% gap. Most banks specializing in this type of loan restrict their participation to 20% – 35%. The amount depends upon the bank’s assessment of the value of the unsold territories. Typically, the bank also will want “cover” in case the sales estimates for the unsold territories do not materialize. Thus, e.g., a bank making a 20% gap loan may require 40% cover (a 2-to-1 ratio). Since this loan typically is non-recourse, the bank wants to make sure it is adequately collateralized.

The borrower of the gap loan will be a special-purpose entity (“SPE”) established to produce the film. While fully secured in a senior position by all of the SPE’s assets, including the film, its mechanical components, and the screenplay, it will be non-recourse to the SPE’s members or shareholders (depending upon the SPE’s organizational structure).

The balance of the negative cost typically comes from four sources:

1. Domestic Distribution Agreements. It is possible to get a domestic distributor to pre-buy rights in the range of 15% – 20%. This commitment in turn can be banked, just like a foreign pre-sale contract.

2. “Soft Money”. A variety of jurisdictions offer tax, subsidy, and related benefits. For example, the reason why many films now are shot in Canada is because it typically is possible to obtain 7% – 8% budget contribution from the Canadian government. If Canadian “content” is used (i.e., the writer of the screenplay, the director, or key actors are Canadian), then this can go as high as 30%. There is a type of transaction that can be structured out of the United Kingdom called a “sale leaseback,” which can yield upwards of 15% budgetary contribution. When combined with tax incentives from another jurisdiction (e.g., Canada), this yields what is called a “treaty co-production,” and “soft money” subsidies can go as high as 30% (15% Canada + 15% UK). The significance of this is that it only is necessary to recoup 70% of the budget before the film is in profit. Like foreign pre-sales, this anticipated tax credit can be factored, and the cash used to finance production.

3. Payments in Escrow. Frequently it is possible for the production to acquire certain elements at a discount from budget, or to defer them until recoupment of financing. Examples are the cost of post-production sound design, or computer-generated graphics. Rather than calling these “deferments,” it is preferable to characterize them as “payments in escrow.” In other words, payment is made at the full budgeted amount, but it is paid into escrow, rather than to the vendor or service provider. In this way the payment becomes cash collateral supporting the production loan. Payments in escrow also synchronize with the film’s cash flow schedule. Because they typically are not required to be made until the tail end of the post-production process, which could be approximately ten months following commencement of pre-production, they typically can be substituted with other collateral, such as sales contracts, and then released.

4. Producer Contribution. Finally, producer financing sources support many projects. In most instances, it will not be necessary for this component to exceed 15%. Put differently, if it does, then the financial structure of the film should be revisited. In many instances, it is not necessary for a producer to put up cash. Rather, a bankable corporate guarantee or standby letter of credit usually is sufficient. This in turn becomes one of the collateral elements securing the bank making the production loan. It is important to note that, from the bank’s standpoint, any producer contribution should be characterized as a subordinated debt component of the film’s financing package, and will be evidenced either by cash, a bankable corporate guarantee, or a standby letter of credit.

It is not necessary for all of these elements to be present in each instance. Rather, it simply is necessary that the value of all of these elements add up to the picture’s total negative cost, plus financing. Many pictures are able to achieve this target using a combination pre-sales, gap loan, syndicated tax benefits, and domestic distribution contracts.

III.
Film Funding’s Role

Sensible though it may seem, this effort is fraught with peril. First, it takes considerable time, effort, resources and energy for a producer to put together a combination of material and cast that will attract financing commitments. The producer does this in a vacuum, not knowing if financing will be available, once the requisite package has been assembled. Even if financing can be obtained, the package is inherently unstable, and might fall apart in the meanwhile; for example, actors typically have various windows of availability, and unless those coincide with access to financing, there is significant risk the actor may have other commitments.

Second, likely financing sources – such as prospective licensees of media rights, both foreign and domestic – understandably are leery of these efforts. They unquestionably recognize that their commitment, even if conditional, is a valuable asset. However, they typically do not want to be put in a position where they spend time, effort, resources and energy, in order to assess the economic value of a proposed package; only to have the conditions precedent frustrated when, for example, the promised cast no longer is available.

For both buyers and sellers, then, there is considerable entropy in this process. It results in significant transaction costs in an uncertain lending environment. Recently, this condition has been exacerbated as major film studios increasingly pursue joint venture and co-funding type relationships with producers, where the studio may be willing to guarantee distribution, but not necessarily participate in the film’s production financing.

We have devised a methodology to securitize this process. We propose to establish a credit facility (the “Facility”) for the production of qualified films (each, a “Film Property;” collectively, “Film Properties). The Facility will be structured as a line of credit on terms t/b/d. As Film Properties to be designated meet the rigorous criteria we have established (the “Facility Criteria”) (see Appendix A), funds from the Facility will be disbursed on a line of credit basis to the applicable SPE debtor formed to produce the applicable Film Property (each, a “Loan”). Each Loan will include an appropriate interest reserve, expressed as a percentage of the Loan amount, to cover production-period and pre-market financing. In consideration for this transaction, the SPE will assign equivalent Film Collateral to the Facility to secure the amount of the Loan.

“Film Collateral” will comprise primarily noncancellable, irrevocable standby letters of credit, and bankable corporate guarantees, assembled by the producers of the applicable Film Property. Producers typically will not be able to obtain Film Collateral unless the screenplay for the Picture attracts sufficient talent elements, which in turn attract the financing. The requisite letters and guarantees will be put up primarily by those having an interest in the commercial success of the film property – entities such as foreign and domestic distributors, governmental jurisdictions offering syndicated tax benefits in consideration for filming in their applicable territory, and specialized banks or other lenders.

While this procedure is not necessarily a guarantee of making “good” movies, at the least it is a guarantee that the negative and financing cost of each Picture to be produced using the Facility will be in hand prior to the commencement of pre-production. Film Collateral will be assembled for each Picture to be produced using the Facility on a picture-by-picture basis. When a Film Property is fully collateralized, and only then, it will become an appropriate candidate for production using funds to be supplied by the Facility.

The SPE will be the nexus or fulcrum for all rights to the Film Property. It will enter into contracts with producers and actors, on the one hand, and with distributors and media buyers, on the other. It will be the borrower or obligor on the Loan, on a non-recourse basis. The SPE will own the worldwide copyright to the Film Property, and be entitled to all of the revenue from its commercial exploitation, in perpetuity. The SPE will enter into an appropriate Loan and Security Agreement, and copyright mortgages and UCC-1’s will be filed in order to perfect this security interest. The security interest will be subordinate only to that of guilds and unions requiring a security interest in order to guarantee payment of residuals; and the lender (if there is one) factoring the pre-sale contracts, the syndicated tax benefits, and making the gap loan. In such event, the Facility’s subordinate position presents no risk to the integrity of the Facility’s collateral, as that lender (if there is one) will make equivalent cash payment to the Facility, instead of to the applicable SPE.

The following figure depicts these relationships:


While the exact composition of the collateral portfolio will vary on a picture-by-picture basis, it always will equal 100% of the applicable Film Property’s final approved budget prior to commencement of pre-production. If the combination of all of the collateral elements is insufficient to fund the budget of any proposed Film Property, then we simply will not lend to the applicable SPE. The Facility never will take a position in the film; the notion of “equity investment” does not apply to any aspect of our business plan.

Rather, in principle, the Facility will function in much the same way that banks or savings and loan associations securitize their loan portfolios. For example, large savings and loan associations frequently assemble their mortgages into pools, and then sell notes secured by the entire portfolio. They then reinvest the proceeds of the notes into additional loan assets. The purchaser of the note is not acquiring a specific mortgage; rather, a collateralized risk-return characteristic of the over-all portfolio. Our proposal is novel in that it essentially will securitize Film Collateral in much the same way that participations are offered in any other asset-backed security. This same financing technique has been used with everything from equipment leases to credit card debt. While producers long have used individual collateral items to support funding for their projects, to the best of our knowledge, these securitization principles never have been applied to film.

We propose that the Facility have a term (the “Term”) of five years. The longest Loan to be made by the Facility will be for a period of time that is co-extensive with the expiration of the Term. We anticipate that most of the Loans will be for a period of three years, which encompasses not only the pre-production, production and post-production periods for most films, but also their “first-year market cycle,” i.e. the period of time during which the film is actively marketed and distributed domestically and internationally at the major film markets such as AFM, Cannes and MIFED.

We further anticipate that, subject to the availability of qualified Film Properties, most of the Loans will be made during the first year following the date upon which the Facility is established. Upon the Facility thus having been fully expended, we will hold Film Collateral in a variety of diverse film properties. While of course no guarantees can be made, we anticipate that the combination of these Film Properties will develop a portfolio or “mutual fund” effect. All of them will be fully cross-collateralized, insofar as the Facility is concerned, i.e., excluding third-party participations. This means that positive revenue from any one Film Property may be used to offset any revenue deficiency developed by any other Film Property. Each of the Film Properties to be produced using the Facility will be fully secured by Film Collateral prior to the commencement of pre-production. Thus, this portfolio effect offers an additional degree of credit support, in a way not found with ad hoc purchase of a single debt instrument.

IV.
Are Films that Cost Less than $25 Million Profitable?

We propose that the Facility concentrate primarily on independently-produced films with a negative cost of $25 million or less. The primary reason for this restriction is because $25 million is the upward budget limit of most films being produced by the independent sector. Additional factors are the readier availability of Film Collateral in this budget tier; and, our desire to achieve a portfolio effect by comprising a diversified slate of Film Properties. Finally, we believe that films with a negative cost of less than $25 million are as profitable, if not more so, than films costing two, three, or four times this amount.

In order to test this last hypothesis empirically, we examined every movie that was released theatrically in the U.S. during the period 2003 – 2004 – a total of 999 movies in all. We eliminated from this population (1) 597 movies with a domestic theatrical box office gross of less than $1 million, on the grounds that these most likely were “platform” releases, designed primarily to attract the attention of video distributors and television broadcasters, as opposed to constituting a stand-alone, independently viable theatrical release; (2) 139 movies that had not yet been released on video, because this is such an important part of the total revenue stream (by and large these were all of the movies released in the last quarter of 2004); and (3) three IMAX movies, because they are not representative.

This left a sample of 260 movies. We then compiled the following data for each of these movies from a variety of industry sources: total domestic theatrical box office gross; total foreign theatrical box office gross; total foreign video and television revenue; total domestic video rentals; total domestic DVD sales; total domestic VHS sales; and total domestic television revenue. It is important to note that this comprises each movie’s “gross” revenue stream, without adjustment for retail margin, distribution fees, P&A, and other marketing, promotion and publicity costs. Because the terms of individual transactions vary so widely, no attempt was made to evaluate the “net” profitability of any movie, after allowance for these costs centers. We also obtained each movie’s negative cost (“NC”), i.e., the cost to create the film negative.

We then divided the sample into four sub-groups or series, as follows (dollar amounts are in millions): {NC = $0 – $25}; {NC = > $25 – $50}; {NC = > $50 – $100}; and {NC = > $100}. By doing this, we comprised a kind of “virtual portfolio” of movies in each applicable NC range. For each movie in each series, we calculated the total of all of the revenue sources identified above (“∑”). For each movie in each series, we then calculated ∑/NC to arrive at what might be called the movie’s “gross profitability” (“GP”). Because ∑ comprises all of the potential revenue sources available to each movie, without deduction of any counterpart cost centers (as per above), GP is positive for each movie. If any of the cost centers set forth above were deducted from ∑, then it is highly likely that, for movies at the lower end of the range, GP would be negative. We then calculated the median GP for each sub-group (“Md”) (we elected not to utilize mean GP for this purpose because such an approach would unduly weight outliers). To evaluate the consistency of GP (as a proxy for the “riskiness” of achieving GP), we also calculated the standard deviation of GP (“s”) for each NC series.

Figure 5 depicts low, high and Md GP for each series of NC. It is easy to discern from Figure 5 that movies where {NC = $0 – $25} significantly out-performed all other series. In fact, in order to present an intelligible graph, it was necessary to chart Figure 5’s y axis on a logarithmic scale, because the GP of four movies in series {NC = $0 – $25} was so extraordinary. In three of these cases (Better Luck Tomorrow, Clifford’s Really Big Movie and Osama), this mainly was because NC was quite low in relationship to ∑. For Super Size Me – the best performing (i.e., highest GP) movie in series {NC = $0 – $25} (for that matter, in any series) over the period – NC not only was low, but ∑ was high.


What also is illustrative about Figure 5 is the way in which Md GP decreases with NC. From this, we can conclude that, on balance, the more expensive the movie, the lower its potential gross profitability. Breaking down the ∑/NC ratio for each group reinforces this conclusion. For example, the best-performing movie in series {NC = > $25 – $50}, by almost a factor of three, was The Passion of the Christ. This only would have been the 10th best performing movie, however, in series {NC = $0 – $25}. Similarly, the best-performing movie in series {NC = > $50 – $100} was Lord of the Rings: The Return of the King; this would not even have made the “top 10” in series {NC = $0 – $25}. The situation is similar for the best-performing movie in series {NC = > $100}, which was Pirates of the Caribbean: The Curse of the Black Pearl. This would not even have placed it in the top one-third of series {NC = $0 – $25}.

It also is interesting to examine the worst-performing movies. In series {Nhttp://beta.blogger.com/img/gl.italic.gifC = > $50 – $100} that movie was, of course, Gigli. But it also would have been the single worst performing movie in series {NC = $0 – $25}; in other words, even the worst-performing movie in series {NC = $0 – $25} out-performed Gigli, with far less financial exposure (i.e., lower NC). The worst-performing movie in series {NC = > $100} was The Alamo; only three movies in series {NC = $0 – $25} did poorer.

Figure 6 illustrates the relationship between Md GP and s GP for each series (again, on a logarithmic scale for both axes). This shows an incredibly high correlation (R2 = .97) between “riskiness” (i.e., the standard deviation of gross profitability) and gross profitability (expressed as median GP for each series). In fact, it appears that movies where {NC = > $100} are, on balance, both riskier and less profitable than movies where {NC = $0 – $25}. From this, we can conclude that, given their potential profitability, the risk exposure of movies in series {NC = $0 – $25} is acceptable; and, certainly, on balance, no worse than that of any other category of NC.


V.
Examples of the Facility in Operation

We offer the following two examples in order to illustrate how the Facility will operate. In Example No. 1, the Picture has a budget of USD $25 million.


The film collateral comprises the following elements:

1. Bankable foreign pre-sales of 30%.

2. A gap loan secured by ROW ex N.A. of 20%.

3. A reputable N.A. distribution commitment valued at 15% possibly supported with P&A, contribution towards negative cost, and a recoupment corridor.

4. Syndicated tax benefits of 15% factored by an in-territory bank.

5. A private financing commitment of 15%, to be supported by a standby letter of credit in lieu of cash.

6. Payments in escrow of 5%. These are part of the film’s budget, but need not be paid until later in the production cycle – e.g., post-production – at which time they will be substituted with additional sales collateral.


What will we do with this package?

1. Evaluate the viability of the Film Collateral.

2. Perfect security interests in the Film Collateral, issue Notices of Assignment of Proceeds, etc.

3. Assign the package of film collateral to the Facility.

4. Fund the Picture’s negative cost on a line-of-credit basis, geared to the SPE’s cash-flow requirements.

5. All cash goes into a lock box, as received, to retire the line of credit. Some of this cash might be received immediately, e.g., proceeds from the bank gap loan, and anticipatory tax credit financing.

In Example No. 2, the Film Collateral comprises the following elements:

1. A domestic studio distribution commitment of 50% (theatrical, video and television all cross-collateralized).

2. A Foreign Sales Agent guarantee of 50%.(17)


What happens with this package?

1. The studio guarantees recoupment of 50% of negative cost, plus financing, at the end of three years.

2. The Foreign Sales Agent guarantees recoupment of 50% of negative cost, plus financing, at the end of three years.

3. We perfect security interests in the Film Collateral, etc., as with Example No. 1.

4. We will embargo all cash, etc., as with Example No. 1.

5. We will resort to the respective guarantees, only in the event there is a cash deficiency after year three.

There will be many different potential scenarios and combinations of collateral elements. They will be evaluated on a picture-by-picture basis. The rights and duties of the respective parties will be set forth in a comprehensive inter-party agreement. All projects, of course, will be supported by completion guaranties and production insurances (CGL, E&O, etc.).

VI.
What Are the Advantages of this Approach to the Parties?

In order to answer this question, we consider the interests of the bank lending the senior debt portion of the Facility; the syndicate or consortium providing the subordinated debt portion of the Facility; and, finally, the interests of the producer.

A. The Bank

1. The Facility will enable the bank to comprise a diversified portfolio of fully-collateralized film assets that is not specific to a single company.

2. The bank will be able to expand its business to a middle-tier clientele that might not warrant a separate credit facility.

3. The Facility will be in a position to provide tactical support on a project-by-project basis to the bank’s existing clientele.

4. The bank will experience multiple earning opportunities: interest on the Facility; as the administrator of all production bank accounts (i.e., the bank in effect will be lending money to itself until such time as it actually is disbursed to third parties); as a factor of domestic distribution and foreign sales agreements (again, the bank in effect will be lending money to itself); and, as a gap lender (if it desires to do so on a picture-by-picture basis – this is not necessary to the integrity of the structure).

5. In partial consideration for underwriting the Facility, we are prepared to create a separate class of Membership Interests in our company, which will enable the bank to experience additional revenue from unanticipated sources, at no additional risk. It is unlikely that any senior lender presently is positioned to take advantage of this type of opportunity.

B. The Mezzanine-Junior Piece

1. We will be able to arbitrage interest rates between our cost of funds, and the rate at which we can re-syndicate funds to SPEs. By complying with finance lender laws, California’s 10% usury limitation is avoided.

2. We will charge fees and points, on extending credit to an SPE.

3. We will be able to dispose (by sale, transfer, or merger) of each SPE’s 1st-year NOL. Due to the non-IRR nature of film investment, it is inevitable that SPEs will have a first-year NOL. The amount (thus value) of this NOL recently was enhanced by new Federal tax legislation. SPEs will be structured with two classes of stock (common and preferred), and we will have rights, preferences, and privileges as the financing entity and sole holder of preferred shares.

4. As the sole entity with basis in the SPE, we will own a diversified portfolio library of intellectual property assets (i.e., films) that will have significant residual value.

5. We will be able to take a position in the net proceeds prospectively realized by any given SPE. By convention, the financing party is entitled to half of net proceeds at the SPE level (i.e., following payment of all distribution and marketing costs, and recoupment of negative cost plus financing). Although this might be diluted somewhat by other parties supplying collateral elements, it still could be significant if any given Picture significantly out-performs.

There is no market risk because, by rigorous application of our Facility Criteria, each Film Project must be fully collateralized. There is no production risk, because each Film Project will have a completion bond. Thus, our position will be fully hedged. It is hedged on the downside, because we will have a fixed cost of funds for any given project; and, each SPE line of credit will be fully secured with Film Collateral. Considerable discretion will, of course, be necessary in order to insure the integrity of each collateral package. It also is hedged on the upside, because we will be a participant in net proceeds, should any individual picture experience unanticipated commercial success. We perceive that the only real risk is the potential attractiveness of alternative investment opportunities, which is implicit in any business venture.

C. The Producer

1. Producers spend considerable effort, time and resources to comprise packages of cast and distribution, but then are unable to secure financing. As a result, many commercially viable properties are not produced.

2. Concomitantly, many distributors are in a position to guarantee distribution, but not to make a contribution to negative cost. As a result, this commitment – which is completely significant to the Picture’s prospects – is not monetized.

3. Potential providers of Film Collateral elements will be incentivised to enter into commitments, because they will know that funding will be available, if they do.

4. Producers may have most of their financing package assembled, but still may be missing an element. It is likely that our conditional commitment will catalyze the remaining collateral elements.

5. A studio may wish to take advantage of this structure for off-balance-sheet financing of a particular project or projects.

VII.
Demand for the Facility

We anticipate industry demand for the Facility will be overwhelming. It will come primarily from two sources:

First, an increasing number of firms are electing to conserve or redeploy their internal corporate cash resources, and rely instead on outside financing for production. Studios spend the largest amount of funds available to them on making movies. Off-balance sheet financing enables them to free up this capital in order to undertake other activities. For example, in the 1980’s, Disney established Silver Screen Partners and MGM/UA established Star Partners.(18) More recently, Citicorp Securities, Citibank’s investment-banking unit, organized syndications for Fox (New Millennium Investors LLC) and Universal (Galaxy Investors LLC). These transactions varied the Star-Silver Screen model, in that the SPE’s borrowed against the potential asset value of the movies the studio intended to release during their term.

Recently, J. P. Morgan-Chase has specialized in lending to studios based primarily upon the present discount value of an anticipated future income stream over a defined period of time. Recent “library” transactions of this nature successfully completed by J. P. Morgan-Chase include DreamWorks, Revolution Studios, and Beacon Pictures. C.I.B.C. is in the process of concluding similar arrangements for Village Roadshow and Pandemonium. We expect the trend towards off-balance-sheet financing will continue, particularly for the “independent” divisions of major studios, such as Fox Searchlight, Warner Independent, Sony Classics, and Paramount Classics.

Significantly, all of the transactions mentioned above fund a slate of films sponsored by one studio; prospectively, at least, the value of the collateral depends upon that particular studio’s ability to successfully produce commercially-demanded pictures. In contrast, we propose to comprise a “virtual” slate of pictures that does not depend for its sufficiency or vitality upon the aesthetic proclivities of any one given studio. Unlike a single-company facility, it will be “out bred” and encompass a variety of different aesthetic perspectives, further promoting diversity and (from a portfolio management standpoint) covariance. It will be creatively agnostic. Furthermore, because it will comprise many different films with different delivery dates, cash flows will be smoother than with a single-picture or single-company facility. This significantly compensates for the non-IRR nature of film investment, discussed earlier, and thus implies additional credit support and defeased portfolio risk for the entire Facility. In a way, what we propose is an independent film version of the slate financing concept that lenders such as J.P. Morgan-Chase successfully have deployed.

Furthermore, the Loan made by the Facility will be fully secured by Film Collateral prior to the commencement of pre-production activity with respect to any given Film Property. In addition to the Film Collateral, in principle, all that would be necessary to activate funding on a per-project basis from a major studio is a corporate guarantee that at the end of three years the negative cost plus financing would be recouped. This would enable the studio to deploy proceeds from the Facility without utilizing is own cash, or jeopardizing the structure of its other financing arrangements.

A variety of split rights-type transactions also are possible with the studio’s foreign partners; for example, the studio might want to limit its guarantee to a percentage of the budget for North American rights only. Studios have used these types of co-financing agreements, with defined recoupment corridors for each party’s investment, for some time. “At its peak in 1995, 35% of movies produced by the major studios were cofinanced.”(19) The best recent example probably is Titanic (1997). Its domestic theatrical box office gross was $600,788,188 against an estimated production budget of $200,000,000. Its worldwide theatrical gross was $1,835,400,000, making it the most successful movie (financially) in history;(20) with video and television, total revenues exceeded $3.2 billion.(21) Titanic was originated by Fox, which, amidst reports of the picture’s escalating budget, entered into a cofinancing agreement with Paramount.(22) It has been reported that Paramount’s $65 million investment resulted in a $600 million return.(23) What has been missing to this point is a way to journal this process off balance sheet, which we will be in a position to provide.

Second, demand for production funding in the independent film sector never has been higher. As stated in a recent article by Ben Sheppard, a director in the Financial Advisory Services – Dispute Analysis & Investigations practice group at PricewaterhouseCoopers, who specializes in the entertainment industry: “The market for independent film financing has been in a depressed state for some time. A number of industry veterans indicate that the current market is one of the worst they have ever seen, especially following a period in which financing was readily available and a steady stream of independent films was being produced.”

At the same time, the number of independently-produced films with commercial premises and bankable stars never has been higher. Many independent producers negotiate incredible talent deals and go to extreme lengths to assemble attractive packages of material, cast and distribution, only to discover that financing is not available, despite the level of support. Furthermore, a number of extraordinarily adept firms such as Lion’s Gate, Think Films, IFC, Newmarket and Alliance-Atlantis now have the capacity to broadly distribute independent films in the domestic marketplace. While they may be willing to make a distribution commitment for an attractive property, backed by a corporate guarantee, they may not have the cash resources required by the producer in order to make a contribution to the film’s negative cost. The Facility will be in a position to address all of these issues. Because it will offer definitive, quick results for the most qualified properties – those able to attract the requisite collateral elements – we anticipate the Facility quickly will become a preferred choice for independent filmmakers of stature. We also anticipate that, for the independent producer, an expression of interest by the Facility to fund a Film Property will serve as a catalyst to magnetize other potential funding sources.

APPENDIX A
Conditions Precedent to Production

Our involvement with any proposed Film Property will depend upon the occurrence of several conditions precedent, which may not be met. We will not designate a Film Property to be produced using the Facility, unless and until that Film Property meets the Facility Criteria. We presently envision the Facility Criteria will be materially as follows:

1. The producer of the applicable Film Property must form a special-purpose entity (“SPE”). We may elect to become a Member or Shareholder of the SPE, or not, depending upon regulatory requirements associated with the jurisdiction of formation, or requirements to qualify for “soft money” funding contribution.

2. The SPE must have chain of title to the screenplay for the Film Property.

3. The SPE must have deal-memo agreements with the lead talent.

4. We must approve all material elements associated with the Film Property, including the screenplay, the budget, the shooting schedule, the producers, the director, and the cast.

5. The SPE must enter into a written representation agreement with a Foreign Sales Agent (“FSA”) which, on the basis of the screenplay and talent attachments, obtains bankable pre-sales of media rights in foreign territories equal to 10% to 50% of the Film Property’s final approved budget (or provides a standby letter of credit, or a bankable corporate guarantee convertible into a standby letter of credit, for that amount). The identity of the FSA, and the terms and conditions of the SPE’s agreement with it, will be subject to our approval, as will the identity of the pre-sold territories and the pre-sold amounts. The conceptual basis for this requirement is that, having obtained pre-sales from several major territories on the basis of the screenplay and the talent attachments, the producer of the Film Property will have validated its aesthetic judgment regarding the Film Property in light of the commercial and mercantile realities of the marketplace. This in turn will tend to maximize the likelihood of the Film Property’s commercial success.

6. The SPE must enter into a Loan Agreement and a Security Agreement with a lender to discount the pre-sale contracts obtained by the FSA and also provide “gap” financing equal to 20% to 35% of the Film Property’s final approved budget, secured by the minimum sales estimates (“MSE”) on the non-pre-sold foreign territories, on a non-recourse basis to the SPE (and to us). The FSA must certify that, based upon the screenplay and the attached elements, the MSE’s reasonably are believed to be accurate and realistic. The identity of the lender, and the terms and conditions of the SPE’s agreement with it, will be subject to our approval.

7. The SPE must obtain additional financing equal to approximately 50% of the Film Property’s final approved budget, which may come from any one or a combination of the following sources: (a) an advance or bankable commitment on a transaction for domestic rights; (b) a bankable commitment for tax-advantaged “soft-money” financing; or (c) additional funding commitment evidenced either by cash, an irrevocable, non-cancelable standby letter of credit, or a bankable corporate guarantee.

8. Other requirements will be set forth in a definitive written interparty agreement to be executed by the applicable SPE and us. These include, e.g., a completion guarantee (to insure the picture will be produced), laboratory access to the original film elements, and all appropriate insurances.

ENDNOTES

1. All film statistics are from the Motion Picture Ass’n of America (“MPAA”).

2. Especially since the studios owned the theaters, until the Supreme Court forced them to divest. De Vany, A. & Eckert, R. D., “Motion Picture Antitrust: The Paramount Cases Revisited,” 14 Research in Law and Economics 51 (1991); De Vany, A. & Walls, W. D., “Bose-Einstein Dynamics and Adaptive Contracting in the Motion Picture Industry,” 106 The Economic Journal 1493 (1996); Holt, J., “In Deregulation We Trust – The Synergy of Politics and Industry in Reagan-Era Hollywood,” 55 Film Quarterly 22 (2001); Pautz, M., “The Decline in Average Weekly Cinema Attendance: 1930 – 2000, 11 Issues in Political Economy (2002); Scott, A. J., “Hollywood and the world: the geography of motion-picture distribution and marketing,” 11 Review of International Political Economy 33 (2004); Friedrich, O., City of Nets 351 (1986).

3. 1,200 films were released in India in 2002; 1,013 in 2001; and 855 in 2000. Gomes, Janina, Internationalisation of the Indian Film Industry 2 (2003). India has approximately 12,500 screens, versus approximately 36,000 in the U.S. “With a population totaling more than 1 billion, 12,500 screens translates into a measly 13 screens per million of the population. This is far below global averages. India has witnessed a sharp decline in cinema attendance in the last 10-15 years due to three reasons, namely poor cinema content, poor film exhibition infrastructure and rampant piracy.” Ibid. 24.

4. For example, in its 2003 Annual Report, EMI Group PLC (one of the four major record companies) reported that 48% of its repertoire originated in the U.S. EMI Group PLC, 2003 Annual Report 44 (2003).

5. E.g. Bondebjerg, I., European Media, Cultural Integration and Globalisation 54 (2004); European Investment Bank, The European Audiovisual Industry: An Overview 38 (2001).

6. E.g. Weinberg, C. B., Profits Out of the Picture – Research Issues and Revenue Sources Beyond the North American Box Office (2003). Some recent examples of this trend: 8 Mile (2002), starring the rapper Eminem, earned $116.7 million at the box office and $130 million on DVD and cassette; Drumline (2002), $56.4 million and $84.7 million, respectively; Barbershop (2002), $75.8 million and $102 million; and One Hour Photo (2002), $31.6 million and $72.6 million. Nichols, P. M., “Video Revenue Is Still Rising,” New York Times (Jul. 25, 2003).

7. As set forth at www.the-numbers.com (2004):

8. Weinstein, M., “Profit-Sharing Contracts in Hollywood: Evolution and Analysis,” 27 Journal of Legal Studies 67 (1998).

9. During the filmmaking process, which takes approximately 12 to 24 months from the start of the development phase to theatrical release, a film progresses through several phases. In the development phase, a studio or the producer acquires the rights to a novel or story, and finances the writing of the screenplay. If the screenplay is approved for production, the project enters the pre-production phase. During pre-production, a director will be hired, principal cast will be committed, budgets developed, insurance placed and shooting schedules and locations planned.

In the production phase, principal photography is completed, usually in a period of seven to sixteen weeks. During post-production, the film is edited, director’s and producer’s cuts are made and the dialogue, sound track, special effects, music and motion picture are synchronized, resulting in the negative from which prints to be released to distributors are made. Primary responsibility for the overall planning, financing and production of the film generally rests with the producer. The actual creative filmmaking process, involving script consultation, casting, set and costume design, direction and photography, editing and cutting, is the primary responsibility of the director.

The principal revenue sources for films are domestic and foreign theatrical rentals, broadcast network television, syndicated domestic television, domestic pay and cable television, foreign television, home video and miscellaneous sources, such as music rights, airline exhibition and various merchandising rights. The timing of revenue received from the various sources varies from film to film.

Typically, domestic theatrical rentals are received approximately 90% in the first 12 months after a film first is exhibited and 10% in the second 12 months. Foreign theatrical rentals typically are received 40% in the first year, 50% in the second year and 10% in the third year. Home video royalties typically are received 90% in the first year and 10% in later years. Pay and cable license fees typically are received in the second and third years. Network television rentals typically are received 65% in the third year, 25% in the fourth year and 10% in the fifth year. Syndicated domestic television rentals typically are distributed evenly in the fourth and fifth years and beyond and other revenues typically are distributed evenly between the first and second years.

10. “If talent is revealed relatively quickly, then most of the active workforce may consist of ‘mediocre’ types who would exit the industry in the efficient solution. Instead, they stay in the industry, producing output that crowds out entry by novices. The industry as a whole has what is in effect an up-or-out rule, but this rule is unduly lenient.” Tervio, M., Mediocrity in Talent Markets 1 (2003).

11. Gilbert-Rolfe et al., op cit. 26.

12. Snyder, G., “God and plenty,” Daily Variety (Jan. 13, 2004).

13. Snyder, G., “And in the beginning: $27 mil B.O. for Mel,” Daily Variety (Feb. 26, 2004).

14. Snyder, G., “’Passion’ poised for heavenly B.O.,” Daily Variety (Feb. 9, 2004).

15. Which will make it interesting to see how General Electric, with its much-vaunted “Sigma Six” management process, will accommodate the somewhat different cultural environment of Universal Pictures, recently acquired from Vivendi. See, e.g., Flanigan, J., “GE’s Broad Vision May Transform Media,” Los Angeles Times (Sep. 7, 2003).

16. Hennig-Thurau, T., Houston, M. B. & Walsh, G. J., Determinants of Motion Picture Box Office and Profitability: An Interrelationship Approach 4 (2003).

17. This was the precise scenario when we produced and funded My Big Fat Greek Wedding, one of the most successful independently-produced pictures of all time.

18. Both of these were significantly different from the present offering in several respects: (1) They depended upon certain features of the Internal Revenue Code no longer in effect; (2) Participants were wholly at risk with no hedging mechanism, as opposed to the process of acquiring Film Collateral, which is entirely debt-driven, as set forth in this Prospectus; and (3) Because they were captive to a specific studio, they were subject to all of the studio’s business practices, which occasionally lead to an unsatisfactory economic result.

19. Goettler, R. L. & Leslie, P., Cofinancing to Manage Risk in the Motion Picture Industry (2003); Eller, C., “Battle of the Would-Be Blockbusters; As $100-million budgets abound, some studios trim lineups, seek partnerships,” Los Angeles Times (Nov. 1, 1996); Eller, C., “Movie Studios Learn Sharing Burden Can Be Risky Business; Splitting ownership of films can lessen the pain of box-office flops, but it also means having to split enormous rewards,” Los Angeles Times (Apr. 16, 2003).

20. From www.the-numbers.com (2004).

21. Madigan, N., “Titanic’s happy ending,” Daily Variety (Jan. 21, 1999).

22. Busch, A. M., “’Titanic’” sinks into the fourth quarter,” Daily Variety (May 19, 1997); “Long voyage home,” Daily Variety (Mar. 24, 1998).

23. Amdur, M., “Sharing pix is risky business,” Daily Variety (Nov. 16, 2003).