I'm back after a couple of weeks in Barcelona teaching a class and a little bit of family time. I hope everyone is having a great summer.
In the last installment, I talked about managing risk in film investments. Today I'd like to look at some of the typical structures that film investments take, putting them in approximate order from least risky to most risky. Of course, the more risk involved, the higher the return that is offered. However, I am not going to get into the specific amounts or nature of returns as the article would simply become too long. If you are interested in more details on any of these deal structures, please feel free to contact me and I'll be happy to discuss.
Many states and countries offer financial incentives to induce producers of film and television to come use their locations, facilities and personnel. This is a means of stimulating economic activity for their region, as well as promoting the area when it is featured in films and TV programs. Some of the most popular incentives are from the states of New Mexico, Louisiana, Georgia and New York, as well as various provinces in Canada. However, there are many other incentives available in the US and around the world.
If a producer wants to use these incentives as a part of the financing for the film, he or she must initially borrow funds from a lender who will then be repaid when the production is complete and the incentive is collected. The good thing for the lender is that the repayment and return on investment is not dependent on how the film does at the box office. The incentive is normally paid even if the film is not ultimately distributed. This means not only is the money repaid sooner (increasing the annualized ROI), but it is very predictable. And if there is a completion bond, then it is even safer because the completion of production is guaranteed.
Foreign Presale Loans.
Quite often, producers will retain the services of a foreign sales agent prior to producing the film. This agent will begin selling the right to distribute the film in various foreign territories. These foreign sale contracts then become collateral for loans which can be used as a part of the production budget for the film.
These senior (first position) loans are again, for the most part, not dependent on the box office performance of the film for repayment. The foreign sale contracts include a payment that will be made upon delivery of the film, and that amount forms the basis for calculating the loan. Therefore, so long as the film is delivered and the foreign distributor honors the contract, the lender is repaid with a profit.
The risk comes when a foreign distributor defaults on the contract, or the film is not completed (although a completion bond is normally a requirement for these types of deals). Also, some of these contracts are conditioned on a domestic (United States) release of the film. So, if the film does not get a domestic distributor or the distributor elects not to release the film in theaters, then some of the foreign contracts might not perform. These are all factors which need to be looked at and managed carefully in making these types of loans.
Foreign "Gap" Loans.
There is often some confusion among producers and some financiers as to what constitutes a "gap" loan. The name seems to indicate that it fills the "gap" in the financing structure. However, a traditional gap loan is a loan that is secured by unsold foreign territories. In other words, the gap lender is entitled to be repaid through the collection of proceeds of sales from territories in which no contract yet exists.
The obvious increased risk here is that there is no guarantee that those sales will occur or what amount will be paid in those territories. While there are some methods for assessing projected sales (primarily based on estimates from a qualified foreign sales agent), the repayment of gap loans can be significantly impacted by the ultimate quality of the film. This makes the investment more dependent on the performance of the filmmakers, and thus riskier than other senior debt.
Unsecured or Mezzanine Debt.
Although less common, some film financing structures include a second level of debt which sits behind the senior lenders in terms of repayment and security (the way a mezzanine floor sits below a main floor in a building). Because these mezzanine lenders are taking a junior position, not only do they typically receive a higher rate of interest, they also receive some portion of the profits from the film in the event it is commercially successful. Therefore, this type of investment is often viewed as a hybrid between debt and equity. In fact, it will sometimes be presented as a senior equity position rather than a junior debt position. However, at the end of the day, it is still occupying the same place in the waterfall when proceeds are distributed.
As with every business investment, the equity holders are the investors taking the biggest risk of the venture losing money, but also receiving the bulk of the rewards if the business is successful. In a film investment, equity participants can make a lot of money if the film is a box office hit. However, they are also at risk of losing most or all of their investment if the film fails to earn back the costs of production and distribution. This might be because of the ultimate quality of the film, a miscalculation in marketing, or simply because audiences decided to see something else instead.
As with any leveraged investment, the amount of debt in front of the equity can have a significant impact on whether the equity investors lose all of their money. However, the payoff for this leverage risk is the increased return on investment in the event a profit is realized, as less money can be invested in order to get the same returns thus increasing the annualized ROI percentage.
This is a very simplified discussion of the various structures typically used in film investing. Each of these deal types has dozens of nuances that can be negotiated and adjusted in order to further manage the risk and potential returns. Again I have to emphasize that investors really need the advice of someone experienced with these types of deals in order to make sure the best possible terms are included. In fact, even those of us with a lot of experience will sometimes get a second opinion from a colleague just to be sure we're seeing things clearly and not missing something that might make a significant difference in the deal.
Of course, if you'd like to discuss any of these deal structures in more detail, or if you have any questions at all about entertainment financing or related topics, please feel free to contact me. Entertainment finance is not merely my profession, but also my passion. I am always eager to discuss new deals or structures, or merely hear about what other people are doing in this space. It's how I stay informed and remain abreast of new developments.
Thanks for following this series.
I noticed an article this morning in the Hollywood Reporter about the purchase of HSN by QVC. This brings me back to my thoughts that it is perhaps easier to make money selling things through programming than it is to sell advertising for things through programming.
The reason QVC works is because they've brought the programming closer in space and time to the purchasing decision. And what gets even closer than QVC? Digital media, where one click starts the object of your desire on its journey to your mailbox (or front doorstep assuming you desire something that won't fit into your mailbox).
This is why I think Amazon is the big dog - quality original programming and selling lots of stuff. That's the winning combination. Entertain people and make money selling them stuff - not just motivating them to go buy stuff somewhere else.
There are other companies who have had this vision for a long time as well. Overstock.com talked about aggressively pursuing original programming over 2 years ago (not sure what happened there). And Joyus.com is a well-funded venture combining programs and commerce (although it feels like a lot of short infomercials to me). I even heard that Etsy wants to be in the programming game.
In truth, I think the real players in this space have yet to emerge. They probably have some little web series on YouTube that will suddenly (after years of trying) break out and start driving sales. The key is to make money off of the commerce that they're driving because people will continue to buy stuff, but they won't continue to pay much for programming.
And of course, the platform to focus on is mobile. That's where the Internet is moving and that's increasingly where digital programming and commerce will continue to grow.
Once you have determined that you have been presented with material and a team in which you'd consider investing, it is time to get down to the brass tacks - what is the deal that is being offered? Does it make sense? Does the potential upside justify the risk you are being asked to take? How can the deal be improved?
It is important to remember that your primary goal in film investing is to manage risk. We certainly want deals that give us the opportunity to make a lot of money, but do not be tricked into focusing on the potential returns. The producers will likely present you with a list of films that they claim are just like their movie and which made a lot of money. They will present that as the reason you should invest, but for the most part this argument is completely irrelevant. The success of those films offers no real indication that this film will have the same success.
Instead, you should look at the deal and ask what happens if things go badly. In a sense, you are asking not only about their plan for the film but also their Plan B - the back-up plan. What steps are they taking to mitigate the negative impact of the unexpected? Obviously they will have production insurance to cover casualties and calamities (if they don't, you should run away as quickly as possible), but you also have to look at whether there is a completion bond, whether they have any traction for potential distribution of the film once it is completed, whether they will have the cooperation of the stars in promoting the film. What is the distribution plan for the film and is it realistic, and perhaps more important, what could cause that plan to fail and what will they do if it does?
The other extremely important part of looking at Plan B is to consider the actual form of investment that is being offered to you. Are you getting a security interest in the film to protect your investment? Where do you sit in the priority of payouts - the so-called "waterfall?" Who is in front of you in the waterfall and how much are they getting back before you get your money? If you are being asked to assume a higher degree of risk, does your ultimate return in the event of success exceed that of lower-risk financiers, and by how much? Is it fair? More important, is it a risk-reward profile that you are willing to accept, or would you rather lower your risk in exchange for giving up some of your potential returns?
The only way this can be answered is with a realistic projection of how funds will be distributed under various scenarios ranging from worst case to likely case to best case. Frankly, most producers are not competent at creating these projections, and they have a built-in motivation to be more optimistic than what may be warranted. In order to prepare a projection of various scenarios with any degree of accuracy, there must be a fairly detailed understanding of the distribution process, collection accounts, residuals, and contracts. This requires a lot of experience and most of the people in the independent film space simply do not have that level of knowledge (although certainly many of them do).
So, if you are investing any amount of money that is a serious investment for you, you need to talk to other people with industry experience and get their take on the project. You should also get professional help from someone who has real experience with these types of investments and knowledge of the current market. As with any investment, knowledge is your friend and independent analysis of the claims being made is critical.
I'll continue with a discussion of various specific deal structures in the next installment.
I noticed an article in the Hollywood Reporter this afternoon about layoffs at New Form Digital - the digital media partnership between Discovery Networks and Imagine Entertainment. This followed another article about cutbacks at Heat Street, a digital media business owned by News Corp.
There are various reasons that businesses fail, but this got me thinking about the digital media industry in particular. While most participants still express enthusiasm for the potential of so-called "new media" (really not so "new" anymore - people have been trying to make money on the Internet for over 30 years already), it obviously is taking much longer than anticipated to become a fruitful industry. The obvious question is "Why?" The likely answer is that, as with so many pursuits, its biggest strength is also its biggest weakness.
Digital media would appear to have tremendous profit potential because digital distribution is so inexpensive, but therein lies the problem. Because it is so easy to publish digital media (through YouTube or any other of thousands of outlets), there is no barrier to entry. That creates an essentially infinite amount of content. Basic economic theory tells us that if there is an infinite amount of something, then it has no value.
This means that only the tiny fraction of content which attracts a very large audience has even the slightest chance of making money. And that means the real value is in making superior content and then marketing it in a way that causes it to rise above the endless sea of other programming. First-rate content producers and superior marketing are not inexpensive. So digital media is really a business where you need to spend the same kind of money as in traditional media, but then fight your way out of a limitless crowd of inferior competition. That's actually less attractive than traditional media where there are at least natural barriers to entry that keep most of the inferior competition off of the playing field.
The other problem is that in this endless barrage of messages and images that all of us confront every day, advertising becomes mostly ineffective. We simply see and hear too many things to pay any attention to most of it. We are tuned out most of the time. So ad-based models become less attractive as potential advertisers realize that they are not seeing a return on their investment most of the time because no one is really paying attention.
Personally, I think one possible solution is to tie media more closely to purchases that people are already inclined to make. This is at the heart of the Amazon vision and business. They make their money from selling things, not just from media and advertising. That's why Jeff Bezos is about to be the richest man in the world and that's where the media business should be looking for its inspiration. Media needs to be integrated into the normal chains of commerce. Attracting eyeballs to try to sell your ability to influence them in some way is becoming an increasingly difficult business, and that is not likely to change.
Comments? I'd love to hear your thoughts.
In the last installment of this series, I discussed how we evaluate the screenplay and story in a proposed film investment, both from a legal and creative standpoint. Once that hurdle has been cleared and you've decided that this might be a film you can support, the next step is to look at the team.
As every smart investor knows, the ability of management to execute and solve problems and pivot in response to the unexpected are the hallmarks of successful businesses. It is no different when making a film. It is impossible to make a good film from a bad script, but it is very possible to make a bad film from good material. If you are going to put your hard-earned money into a creative project, you need to have a high level of confidence that the filmmakers will make the best possible version of that story.
Let's look at the key players on the team.
Most people don't know what producers do. It is difficult to describe their job because they are responsible for such a wide range of functions. The producers of a film are like the heads of a company. The producers are in charge of both the business side and the creative side of the film making process. The producers generally have ultimate authority for how the money is spent and what ends up on the screen. Good producers know how to solve problems, control a budget, inspire the team, support the director, and maintain a positive, creative atmosphere and process. Get to know the producers of the proposed project - talk to them and see if they inspire confidence. You should feel that you can trust them and rely on them to protect your investment and make a great film.
The director of the film is responsible for everything that ends up on screen (subject to the approval of the producers). You should watch other films that the director has made and feel confident that he or she not only has a talent and facility for film making, but is also getting better with each new effort. You should look at the reputation of the director within the industry, with actors and with the public. In many countries, audiences go to films mainly based on who is directing. Even here in the U.S. many top directors have their own fan bases. You should feel that the director of the film in which you are investing is consistently getting a positive response to his or her work.
The Line Producer/Production Manager
While the film's producers are ultimately in charge, the Line Producer and/or Unit Production Manager are the people who are responsible for how every penny gets spent. These are the people who are truly guarding your investment and making sure that it all shows up on the screen and is not wasted. It is important to know that there are competent, experienced people in these roles. (You might also want to know about the Production Accountant - another important guardian of the funds.)
Of course, strong performances are at the heart of a successful film. While the actors are the most visible participants in the film making process, they are only one factor of many. It is of course critical to have talented actors in the film, and it is sometimes important to have popular actors in the film (and the most popular actors are often not the most talented). But if you have good producers and a good director, they will be sure to cast the film with solid performers and help those people to deliver their best performances. So, it is important that you feel confident in the cast, but don't place too much emphasis on those people just because they are names that you happen to know.
There are many, many other talented, hardworking people who participate in the creation of a film. Just sit through all of the end credits and that is obvious. As an investor, you can't investigate every crew position. You have to rely on the management team to get good people and manage them to their best work. However, I encourage you to know as much as possible about the people tasked with turning your investment into a work of art (and hopefully making a profit). Film making is very much a collaborative effort, and it is never a mistake to invest in people with great attitudes and a history of success.
This is the first installment in a multi-part series on evaluating and choosing film investments.
Feature films can be an attractive alternative investment vehicle if approached intelligently and carefully. A dispassionate and disciplined approach can help to control the risks, and the upside potential is extremely attractive. Of course, film investments will always be riskier than more predictable industries, but few industries provide the returns that can be achieved from a hit film. And there is the added benefit of using your money to bring important stories into our culture and thus impact the world in a small but significant way.
The first rule of film investing is to understand that it is all about controlling risk. It is tempting to think that you can predict whether a particular movie will be a hit, but you can't. None of us can. A film can have a great story, great director, great actors and good distributor, and audiences still might ignore it. All of those great elements might help to mitigate the risk of losing money, but they don't guarantee that you will make any. So when looking at a potential investment, always ask yourself "How do I reduce my chances of losing money?" If you do that, the profits will come.
When I am presented with a potential film investment, my initial focus is always on the material. Where did the story come from? Is it based on a book or other source material? Or a true story? If it's a true story, are the people in the story still alive? Are there any contracts for rights to the underlying story, either option-purchase agreements or life rights agreements? Does the producer who is presenting the opportunity actually have the rights to the underlying material and the screenplay? If you are being asked to invest in something that isn't really owned by the party seeking the money, then it will be a very short conversation.
Once ownership and/or control is established, then the focus turns to the story itself. A couple of key questions: What is it about? Who is the audience for this film? If the producer cannot tell you specifically for whom the film is being made, then the chances of losing money increase significantly. If the producer tells you that "everyone will love this movie" (or uses the term "four-quadrant film"), this means there is no clear audience focus.
There are very few films (if any) that everyone likes. In the independent film business (i.e., films financed by people like you rather than by studios), no one can afford to market a film to everyone. The key to success is to make a film for a very specific group and market directly to them. If the film expands to other audiences, that's great. But in the meantime, marketing money is not wasted trying to sell the film to people who don't want to see it. That is the easiest way to lose money on a film investment because marketing is expensive and it all has to be paid back before the investors ever see a dime.
If the audience focus is clear and the story sounds like something that audience would watch (based on the success of similar past films aimed at the same audience), then someone needs to read the screenplay. Most of the screenplays being marketed to investors are not good. It is not terribly hard to write a screenplay, but it is extremely hard to write a good screenplay. And it is impossible to make a good film from a bad screenplay. If the story, characters and dialogue are not good on the page, then they won't get better on the screen. A great actor saying dumb things still sounds dumb.
If you don't have the time or inclination to read the screenplay yourself, then have someone you trust read it for you. They don't have to be an experienced film maker, but they should have seen enough films and read enough stories to recognize if the screenplay has the potential to become an engaging film. And if your reader is a part of the target audience, that's even better.
If you have a good screenplay that the producer actually controls, and it is aimed at a viable targeted audience, then the investment has cleared the first hurdle. We'll pick it up from here next time.
I've told many of you before about a fortuitous conversation I had years ago with Regis McKenna, the original marketing guru who helped Steve Jobs shape the Apple brand. Although our chat lasted only 15 or 20 minutes (in the hallway outside a conference room at a Consumer Electronics Show back in the '90's), it still impacts me today. (I guess that's why I'm still talking about it.)
The most profound thing Reg emphasized to me is that the user experience is always the primary focus in successful product development and marketing. That philosophy is clear at Apple and at the heart of the company's success. What really matters is how the user feels about using your product.
This philosophy is developing to an even higher level today. In the entertainment business, it is no longer just about delivering a superior audience experience. We are steadily moving towards establishing partnerships with our audiences where we create their experience together. Some examples:
As always, I would love to know what you think.
Alibaba Pictures is the film division of Alibaba - the giant marketing and merchandising conglomerate owned by Chinese entrepreneur, Jack Ma. If you're not familiar with the company, it's somewhat like Amazon. The film division was formed in order to invest a part of the company's wealth in the motion picture industry.
After showing a loss of $139 million in 2016, Alibaba Pictures' CEO, Yu Yongfu, announced at the Shanghai International Film Festival that going forward, his company would focus on providing data for the entire Chinese film industry. He told the rest of the industry to think of Alibaba Pictures as a partner rather than as a competitor. We can all learn from this.
Money is fungible. Having money by itself does not create a sustainable competitive advantage. One person's money is no better than anyone else's. When you have money to invest, you have some bargaining power with the person who needs the money until another investor shows up. At that point, your advantage is substantially diminished. This means that, in the absence of any other factors, the most attractive investments will go to the investor who is willing to take the most risk and/or accept a lesser return on investment.
Alibaba Pictures is attempting to shift the playing field by using its own competitive advantage - data. Alibaba has over 500 million monthly users and the company knows a lot about the buying habits and behavior of those people. This allowed Alibaba to partner with Steven Spielberg's Amblin Pictures on the film A Dog's Life to raise the Chinese box office performance from around an expected $12 million to actual sales of $88 million. With this type of marketing power, Alibaba is in a position to participate in the best projects from every studio and distributor and make great returns on its investments, as well as being paid for its marketing services. A much better strategy than just funding its own films.
All of us are good at something - probably several things. We all have unique assets and qualities that we can use to help others succeed. If we bring real value, then we are in a position to get paid real money.
We do this in our law practice by using our knowledge and experience and contacts in the entertainment industry. When we represent an investor, we work with the producers to control risk, solve problems and create a better production. Everyone benefits from that. It also means that when our clients invest, the producers get more than just money - they get a partner and support to help the project succeed. That gives our clients a competitive advantage over other investors while controlling their own risk and increasing the possiblility for substantial returns.
What's your sustainable competitive advantage? How do you deliver extra value to the people and companies you serve? As always, we would love to hear your thoughts.
If you follow entertainment business news, you know that investments in Virtual Reality (VR) have been extremely popular for the past couple of years. However, when I talk to friends and clients in that sector about the business models for this new media platform, most of them admit that it is still somewhat unclear. Are VR investors going to make a lot of money? What is the pot of gold at the end of this rainbow? My clients count on me to have insight and ideas about their potential deals and investments, so I spend a fair amount of time thinking about this stuff.
This morning I was reading an interesting article in USA Today. It talks about a new venture between IMAX and AMC theaters that is putting VR "pods" in theater lobbies to allow consumers to play a game or have some other VR experience before or after their movie. This is a separate revenue stream for the theater (and potentially cross-promotion of the films being shown). So, it is basically just a high tech addition to their existing assortment of arcade games. Interesting idea, but is that what we're heading towards? Is the endgame for all of this investment simply better arcade games? Let's look deeper and try to understand this burgeoning media platform.
There are two important things to understand about VR. First, it is by definition, done in isolation from others. In order to create an immersive experience, the user must be separated from their physical environment. This means that the technology takes control of your senses by completely covering your eyes and ears. (I suppose true VR will eventually take control of your other three senses as well.)
However, much of our current entertainment experience includes a social component. We enjoy watching films and programs with family and friends. We ride on amusement park rides together. We sit in a theater full of people and the reaction of the crowd enhances our experience. Even when we play arcade games or video games at home, the people around us can participate as active spectators and root us on. We can throw each other looks and hear each other laugh. VR is the opposite of this.
The other important aspect of VR that we need to understand is that it is inherently a 3D environment. The user needs to be able to look up and down and around in order to have the sense of true immersion. Again this is the opposite of film and other programming where the view of the audience is carefully framed so that the experience can be crafted through a controlled series of images. VR does not allow the storyteller to have that kind of control.
VR truly is more like a multiplayer game. A 3D environment is created within which users create an individualized experience. It is World of Warcraft or Second Life with more of the noise filtered out so users feel that they are "really there." It does trick your mind to remove you from your physical environment and thus enhance the experience. But at the end of the day, it would seem that it is simply an incremental improvement to a model that has existed for years. It's perhaps not much different than closing the door and turning out the lights while you watch a movie. It is headphones for your eyes. It is a great experience, but is it really a whole new medium or just better technology for doing what we already do?
I want to explore this further, look at the business possibilities and share some of your ideas on VR in a Part II (and perhaps III and IV) of this post. I welcome your comments. What is the real future potential for this business where so much money is being invested? Let's figure this out together.
An article in today's Variety cites a PwC study that shows a slowing in revenue growth potential for the entertainment and media sectors. I'm not going to quibble with accountants about numbers - I know better, and I don't think they are necessarily wrong.
However, every industry faces cycles of expansion and contraction. These are not purely economic events, but mostly driven by technology and innovation (including the cultural impact of technology) - especially in today's environment. So, I view this not as a reason to hunker down, but more as a call to action.
As Spencer Johnson taught us in his landmark business fable, Who Moved My Cheese, change is happening every day. We can resist it, embrace it or drive it. It makes the most sense to be a source of positive change rather than to try to hang on to the last vestiges of a dying reality.
Every industry and profession faces the challenge of delivering something that customers will value. As consumers, we gather resources we can use to enhance our lives in some way that gratifies and fulfills us. Entertainment professionals are (presumably) skilled at delivering messages in ways that amuse and touch and impact people. So, if we apply that skill set in ways that enhance the lives of our customers, they will expend their resources to participate.
This doesn't mean we just need to make better movies (although that is always a goal). It means we need to look for better ways to apply our skills and talents in the context of the lives that our customers choose to live. That's positive innovation. We can do that.