Key Considerations in Film Finance

Written and researched by Colin Brown
​@filmonomics

Revised April 2015

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Identifying Bad Actors and other Occupational Hazards

We are constantly reminded of why the film industry can seem so habitually perilous. Nightmare scenarios appear to erupt regardless of film success or failure. “Birdman” won four Oscars this year, including Best Picture, and sold more than $103 million worth of tickets worldwide. But that didn’t stop one of the film’s financiers, Worldview Entertainment, from being ensnared in suits and countersuits that rage on in court to this day. Whatever the eventual truth behind all the legal mudslinging, Worldview’s infighting demonstrates how even those well steeped in business acumen and film investment culture are not immune to meltdowns. This was, after all, a prolific production-funding outfit hailed by industry insiders just two years ago for being both forthright and quick to act. "They make smart decisions and have the capital," gushed John Lesher, a producer on “Birdman,” during that honeymoon period before the claws came out. Now this once high-flying hero on the indie financing scene is in danger of being as washed up as Michael Keaton’s character.

In a business built on relationships, nasty divorces can sometimes result. But so too can enduring love affairs: just because Sarah Johnson, the film financing daughter of a multi-billionaire, has alleged all manner of managerial tricks and derelictions of duty in her $70 million lawsuit against Worldview Entertainment, doesn’t mean that she herself has soured on the movie business. In fact, she recently co-founded yet another financing and production company called Green Hummingbird Entertainment. For good and bad, hope springs eternal in cinema.

Filmmaking is a business clearly driven by passion – and occasionally blinded by it too. We all want to believe the deals are real. Just ask lawyer-producer Steven G. Kaplan. He spent the last four years fighting a legal battle over a bogus $300 million film financing deal that was offered to him by a non-existent company to enable ten feature films to be produced. The instigators behind that fake deal were first introduced to him in 2008 by the former president of the Benfica professional soccer club in Portugal. Had Kaplan dug deeper into those credentials he might have discovered that the initiating businessman had himself been convicted of embezzlement from the club six years prior – a red flag if ever there was. “I wasn’t aware of any of that,” Kaplan told The Hollywood Reporter shortly after his $27 million damages award was affirmed by a Californian appellate court in March. “I wouldn’t have done the deal if I’d known.”

In theory, the ‘bad actor’ rules that now govern all capital raising by private companies and private funds in the US would weed out such wrongdoers. As required by the 2010 Dodd-Frank Act, the Securities & Exchange Commission (SEC) specifically bans those with criminal convictions and court orders involving securities violations from participating in the more lightly regulated capital-raising tools. Those mechanisms include both investment crowdfunding and private offerings. However, the due diligence onus is placed squarely on the fundraisers’ shoulders. They are the ones who must exercise “reasonable care” – a phrase that presumably means more than just a Google name search - to discover whether their private offerings involve those with any history of ‘bad acts.’

Background checks of publicly available records will certainly help identify convicted felons and anyone cast out of the fully regulated sectors of the financial community. But are such willful miscreants really the source of most film litigations? The complexity inherent in film funding - typified by smoke-and-mirror accounting and “waterfall” recoupment schedules that seem to punish those taking the greatest risks – means cinema is always prone to borderline behavior and bare-knuckle negotiating tactics from all quarters. That celebrated cloak of mystery allows the film industry to walk the fine line between deception and salesmanship without necessarily stepping over into outright fraud and illegality. This ethical fog is not just characteristic of cinema. As GroupM chairman, Irwin Gotlieb, noted in April about his own “Mad Men” world of advertising: “Complexity and lack of understanding are often confused with opaqueness. Just because you don't understand it, don't assume the other guy is a crook."

As murky as the film industry can be for seasoned practitioners, imagine what perils await those wading in for the first time without a clue about when and how films make their money – let alone what questions to ask. A total of $103 million was reportedly solicited from private investors for“Legends of Oz: Dorothy’s Return” a proposed computer-animated sequel to “The Wizard Of Oz” featuring a smattering of A-list voice actors. In more ways than one, this is a movie we have all seen before. In their roadshow slide deck to potential investors, the fundraisers projected anywhere from $720 million to $2.04 billion gross revenue on film content. Even at the low-end, these are outsized Disney-scale numbers that no independently released animation feature film has ever come close to matching. Court documents examined by TheWrap.com show that at least one investor received profit projections forecasting a minimum return on investment of 162 percent, and also received suggestive materials featuring the DVD covers of Pixar smashes such as “Toy Story,” “Finding Nemo” and “The Incredibles.” Not too surprisingly, there were no such pots of gold at the end of this particular rainbow. “Dorothy’s Return” grossed less than $19 million from worldwide theaters.

Much like the Scarecrow, some of those investors must be now wishing they had more of a film business brain. They are not alone. Judging by our own monthly FILMONOMICS TALKS, whose insights are peppered throughout this refresh of the third installment of the White Paper, there is pent-up demand across the professional filmmaking community for greater illumination and more rigorous examination. This goes beyond just matters of business scruples and fraudulence. Structural changes are also needed in order for the film business to transition out of financing models that made sense during the flush days of the videocassette and foreign pre-sales but now look antiquated and unfathomable in the face of current market realities. Such imbalance practically invites abuse.

The history of cinema can be seen as a succession of “new waves” that have transformed the way stories are told on screen. German Expressionists, Soviet Formalists, Italian Neorealists, France’s Nouvelle Vague, Brazil’s Cinema Novo, Hollywood’s Movie Brats, and even the so-called No Wave filmmakers, have all left their filmmaking imprints. The same can be said for film financing. The movie business has found itself constantly adapting to a similar ebb and flow of new financing waves.

With each financing cycle, the industry’s deal-making geography has changed too, particularly when it comes to independent film finance. During the 1980s, the Dutch division of Credit Lyonnais became the lending linchpin for the independent studios that grew up with the videocassette boom. In the ’90s, it was the turn of Germany and the dozens of tax-sheltered film funding vehicles listed on its Neuer Markt exchange that underwrote the world’s movie productions. At other times, British sale-and-leaseback schemes have been in vogue, so too U.S. insurance companies, Wall Street hedge funds, private equity firms, and sovereign wealth funds. Right now, it seems that the focus is turning towards wealth created in both the tech industry and the world’s emerging consumer markets.

While cinematic fashions have changed, the core principles of storytelling have not. New Wave filmmaker Jean-Luc Godard distilled this perfectly when he observed: every film should have a beginning, a middle and an end - but not necessarily in that order. The same can be said for film financing: the instruments may change and the geographical axes may shift, but the fundamentals of smart investments remain true. It still boils down to entering into well-structured deals with vetted teams that demonstrate integrity. The right people matter as much as the right business plans. Since filmmaking requires so much daily firefighting, knowing how people will behave under conditions of constant stress is important. So too is a firm grasp on how a particular project fits the needs of the commercial marketplace.

“You have to have complete confidence in the people that are going to be taking control of this cash and this project and deciding where the storytelling goes. You have to have complete confidence that they've done this before, that they know what they're doing. They're probably going to run into every single problem that every producer runs into, every director runs into. Hopefully, they've had those problems before and know how to solve them.”

“If you are a producer at the earlier side of your career, you want everyone around you to be smarter and more experienced than you are.”

“The producer is the most important thing when you’re investing in a movie because you want someone who knows what the hell they’re doing and who can take care of your money. There are only about two-dozen producers who I would trust to really make a one-to two-million-dollar movie. There just needs to be a lot more business discipline introduced into the film world. If you go to our FAQ page, the last question actually stipulates exactly what materials we ask for. We have a very thorough vetting process where we ask for budget, schedule, estimate, script, look book, financial recruitment structure, sales and distribution plan. That’s the stuff all investors need to ask for before deciding to sign a check over. So many producers send over a script with nothing.”

“You have to be really, really careful about who you're getting into business with. It’s critical that you meet people and do your due diligence. What type of person are they? How have they managed similar projects in the past? As an equity investor, you want to be taking on performance risk: evaluating whether the pieces stack up so that it’s going to monetize to an amount greater than it costs. What you don’t want to be taking on is delivery risk, which is whether the damn thing gets done. If the film doesn’t get finished, there's nothing to exploit. Some people have a lot of credits. They’ve done a lot of stuff, you assume. What I'm saying is be careful to assume.”

“One of the biggest issues that equity crowdfunding faces is that I don’t think producers do nearly enough due diligence. I tell even some of my favorite, closest, smartest producers who I’ve ever worked with that they did not do enough due diligence on me. It worked out with them but I would have asked myself a lot more questions than they did of me.”

As a film investor, learning how to recognize the right signals comes with experience. But a good place to start is to follow these three eminently sensible operating rules paraphrased from Kevin Frakes, co-founder and co-CEO of the film production and financing outfit PalmStar:

Investors have been known to act against their better judgments, of course. In his chapter for the book Film And Risk, prominent Los Angeles-based entertainment lawyer Bill Grantham recalls coming across projects that were so obviously flawed he begged clients not to get involved with them, sometimes providing detailed written explanations of exactly how they were going to lose all their money. They did it anyway – evidence of a psychological component to film investing that stretches beyond steely business calculation.

Even the most coldly detached investor still needs to guard against common pitfalls. A film might be a roaring success, but because some investors chose to invest in the overhead and development costs of the production company in a "first-in, last-out” position, they may have lost out on windfall profits. Alternatively, investors may find themselves too far down the revenue sharing waterfall in a film whose budget over-runs have led its producers to stack new senior financing tranches on top of investors’ equity claims. With all this in mind, Part III of this Slated White Paper offers up a quick survey of how films are commonly financed in the hope of illuminating what is essentially an elaboration on more commonplace capital structures.

New business models will inevitably emerge as they always do, perhaps this time bringing some much needed simplicity and greater transparency to the money-raising process. In that same book, Grantham ends his chapter by asking what a rational model for film financing would look like. His answer is one that combines a “hard-nosed appraisal of the risk timeline” with a reduction in the complexity of film financing transactions. Such a reduction will “arguably restore clarity to the process of risk assessment.” Reading the following overview of film financing, investors new to film might well come away with the same conclusion and push for that new paradigm. But until that reboot happens, investors would be wise to understand the basic workings of the current operating system, its various permutations and moving parts.

Films get financed because their producers have assembled a good “package,” that industry catchword for all the different elements that must combine to create a desirable project in the eyes of the industry. In the past, such packages were straightforward in concept, if not in execution. Secure the rights to a great movie concept, tease out a script that tantalizes in the first ten pages, attract a successful director and “attach” at least one “bankable” star: a male or female lead actor charismatic enough to ensure that the film will be distributed and attract a paying audience. Bingo – potential financiers, sales agents and distributors come knocking.

Determining who such “A-list” actors are at any given time is a favorite media sport. Back in 2011, at the height of “Twilight” mania, Forbes magazine declared Kristen Stewart as the world’s most “bankable” star based on the fact that her films earned $55.63 for every $1 that she was paid. The following year, it was Natalie Portman who topped that list generating $42.70 for every studio dollar paid. The two most recent lists were both topped by Emma Stone, whose movies return an average of $61.45 – nearly twice that of Dwayne Johnson, who came in second. The fact that women dominate these ROI indices is continuing evidence of the gender disparity in salaries.

More recently, Vulture.com teamed up with a guest statistician from FiveThirtyEight.com to determine that yet another actress, Jennifer Lawrence, was Hollywood’s most valuable movie star of 2014. By almost every metric, J-Law came out on top. She was rated the top Action Star, top Drama Star and top Comedy Star – and also pulled off the rare feat of being both cinema’s number one tabloid magnet as well as its most respected star. She was also the top-grossing actor of 2014. Only when it came to International Stars did Lawrence have to settle for third place, slipping behind both Leonardo DiCaprio and global superhero Robert Downey Jr, reputedly the industry’s highest paid actor. Such lists are inevitably skewed towards the U.S. No Hollywood actor can actually claim to be the most popular movie star on the planet, a distinction that still goes to India’s Shah Rukh Khan according to many global news services such as the BBC and CNN. Chances are that his mantle will be taken over next by a performer from China.

Quantifying such popularity is an increasingly complex business. Stars’ names certainly increase investor confidence and also serve as magnets for attracting other actors to a particular project, but they are now just one part of a larger matrix of packaging elements that sum to a film’s marketability. Other considerations now enter the equation, most particularly a solid business plan that lays out how financiers get their money back based on the film’s capital structure and a realistic assessment of audience demand. Such plans should show how the producing team’s relationships, skills, and market intelligence would maximize their project’s industry appeal. Proper production budgets, reasonably priced talent, proven crew members, and a compelling marketing and distribution plan all lend further credibility. So too will details about ancillary opportunities, social media assets, committed marketing partners, built-in fan bases, and alluring artwork.

Those marketability ingredients are in a state of constant flux. Actors are still primarily assessed on their international appeal since, as “Hunger Games”producer Nina Jacobson noted recently at the Milken Institute Global Conference, “only a very, very inexpensive movie can afford not to travel now.”But other factors are coming in to play too in an effort to keep up with audience dynamics. Casting agents privately acknowledge that followings on Twitter, Facebook, Instagram and Snapchat can now make the difference when deciding between which of two professional actors to hire. It’s a social-sharing universe that comes with its own cast system. Based on their official page followings, there are three names that appear on the top ten actors lists for both Facebook and Twitter and all three are better known for their music: Justin Timberlake, Jennifer Lopez and Selena Gomez. The same trio is currently killing it on Instagram – and so too is Kevin Hart, with his 10 million plus followers there to add to his nearly 19 million Twitter fans. In a world where Millennials appear to have abandoned traditional television, still the medium of choice for movie advertising, that viral reach into their laptops and mobile devices can help create awareness. And at very little cost. Already Kevin Hart’s films do more advance ticket sale business from cell phones than anyone else’s films, making him a one-man marketing machine.

Exactly how many actors can consistently predetermine a film’s financial success is open for debate. Kevin Hart may be one of Hollywood’s more reliable moneymakers, but the same is certainly not true for Selena Gomez, at least for roles that require more than just her voice. And for all their evident star-power and previous chemistry together, Jennifer Lawrence and Bradley Cooper (who topped Slated’s own rankings at the time of going to press) were unable to save “Serena” from box office ignominy this year. Indeed, when it comes to Hollywood superstars - particularly ones who are clearly miscast – that expensive top tier may actually prove a liability. They are difficult to replace, for one thing. Agents will often insist on “pay-or-play” deals for their star clients, basically a guarantee that they will be paid their large fee even if they are not used in the production. This is not quite so cut-and-dried as it first appears since the guarantee only kicks in when the film’s financing closes - which is not the case with many indie film projects. As Jeff Steele explains: “If you don’t secure your financing, you don’t have to pay, because you, the producer, also never got to play. This is one of several Conditions Precedent (CP) that are part of a pay-or-play offer, which protect producers”. But for those films that do succeed in closing their funding on the back of those names, that salary overhang will makes it that much harder for a film to earn back its budget, especially if those actors have also negotiated “back-end” participation in the film’s net profits. So be careful who you wish for.

This is all assuming, of course, that your projects are able to land such star names in the first place. For most producers and investors, they remain out of reach. While talent representatives will tell you that their clients are driven by the material presented to them, the reality is that those industry gatekeepers also need assurances that the filmmaking teams know what they are doing. Their antennae are on full alert for signs of inexperience. One red flag might be an ill-advised distribution deal. Perhaps it was a deal that was struck in haste during a vulnerable period in the film’s development history, or maybe it was a case of giving away exclusive rights to the first online distribution platform that wooed them; either way, these are telltale sign of amateurism on the part of the producing team. So is the absence of a top-notch entertainment lawyer. For all such reasons, a thorough finance plan that comes fully represented asserts far greater marketability these days than any name actor can; in fact, you won’t be able to land those stars without that professional underpinning. Just listen to what film financing expert Jeff Steele wrote in the very first blog post for his entertainment consulting firm, Film Closings:

“It doesn’t take much for me or any other funder to tell the professionals from the amateurs. One look at a producer’s finance plan (as well as their choice of attorney) tells me right away what kind of closing I’m in for. Being that a film finance closing can last anywhere from 4-12 weeks, this can be a relatively clean, straightforward experience, or three months of hell. Simply put, a finance plan is the best indicator of a producer’s financial I.Q. We need to know that you know how much money you really need and where you’re going to get it from.”

As he says, if you going to do business with CAA, WME, ICM, Gersh, UTA, or any of the other packaging agencies or management companies, you’d better come in swinging with a major law-firm or attorney that has a verifiable track record of closing talent deals with the bigger agencies. These are so often the real marks of “bankability.”

While it is widely accepted that there are no set rules for independent film finance, certain structures and risk-mitigation strategies have taken root. Here is a run-through of the most common ones.

In the heady days of the home entertainment boom, pre-sales evolved as a way for producers to raise financing for films in development. Working usually through a sales agent, the financing for production budgets is pieced together by selling rights to that project in various “windows” (theatrical, DVD, video-on-demand, pay-television, etc.) to distribution companies who can then exploit these rights in their respective markets: Scandinavia, Benelux, Latin America, Asia, German-speaking territories, and so on.

The payment is usually termed a “minimum guarantee,” an advance on royalty income from that particular window in that particular territory. In theory, should a film earn more than that “MG” then net profits (“overages”) are also paid to the producer. Typically, upon signing a pre-sale contract, the prospective distributor pays a 20% deposit to the film’s account, with the balance due once the completed film has been properly “delivered.” Producers use the combined value of those distribution contracts as collateral for a bank loan to finance the film’s production. The exact amount of that loan is based on the bank’s assessment of the distributors’ creditworthiness.

There are costs involved in putting such deals together. Packagers can take anywhere from 5%-15% of every sale. Sales agents’ fees vary between 10%-25% for obtaining distribution contracts only – and as much as 30%-35% should they secure a cash advance or bank contract.

“With sales agents it’s that awful Catch-22 dance. You want a sales agent to participate in the conversation about casting, about who's going to direct it, about where you're going to film it, because they know what's selling everywhere, right? But they don't want to get involved until you have a project that's got some attachments to it – that real currency in the rest of the world - because they make their living from big fees.”

“Three, four years ago you would do incredibly well with a $20 million Jason Statham movie. Something that isn't really that smart but keeps the story going and is full of action, car chases and what have you. This is widely referred to as a ‘programmer:’ if the movie was great, it would do well theatrically; if it wasn't so great, you could always recoup on TV or DVD. Well, DVD now is pretty much vanished. Now it is less obvious what distributors will buy. They will focus on things that make the most noise. What are those? Well, movies that win awards that have cast in them, that people are interested in reading about. All of a sudden, your Jason Statham action movie doesn't look so attractive any more. The ground is shifting and the most important thing is to focus on what is working and ask questions. The one thing that has proven to work really well is the prestige picture - films like "Dallas Buyers Club.”

“The problem now is that there is a mad rush for everybody to make unique sort of off-center films, and probably in a year or two after everything kind of settles out, everybody will be like a school of fish and go in another direction.”

“We had John Travolta and Salma Hayek in a movie that we really wanted to make for six or seven million dollars. But there are no guns and there's no sex, and it's drama, and it's really more Salma's movie and we went to a film market and got a lesson. It was very, very hard to pre-sell.”

As mentioned earlier, pre-sales are really just pieces of paper that producers take to the bank to convert into the cash used in the film’s production. In the case of certain territories or individual distributors with poor track records, letters of credit are needed before any sums are advanced. If the film is budgeted above $2 million, the bank will also demand that there is a completion bond in place to ensure that the film is completed and delivered to the foreign distributors with all the elements (such as stars, artwork, marketing materials, etc.) specified in the contracts. In return for providing this insurance policy, the completion bond company charges a premium that is usually a percentage of the film’s cost. Based on its risk assessment, these premiums run from 3% to 6% of the budget. If the film overruns its schedule or budget, the bond company also has the right to take over its production and supervise its completion.

While pre-sales remain one of the backbones of the independent film business, foreign distributors have become noticeably more cautious about the films that they choose to commit to ahead of actual production. Where once it was very possible to obtain all the financing for a film based only on a script, director, and a couple of stars, now there are shortfalls between what a film will cost to produce and what it is able to accumulate in minimum guarantees. “Gap financing” emerged to bridge that difference.

With gap financing, banks provide a loan of between 10%-30% of a film’s budget against the value of all the distribution markets that remain unsold. An experienced sales agent is engaged to provide an estimate of what those territories could cumulatively be worth. The bank will typically lend half of that projected total and demand that at least two pre-sales are already in place as a measure of a project’s viability. In return for its financing, the bank will be senior in the capital structure, receiving all income until its principal and accrued interest are fully recovered.

As the pre-sales market continued to soften, the gap has widened further. So-called “super-gap” financing has recently emerged, essentially a riskier form of mezzanine-style financing in which more (up to 35%) of a film’s budget is borrowed against future revenue projections. In return for financing more of the budget, super-gap lenders demand higher interest rates.

When this White Paper was first written in 2012, the industry was seeing a gradual decline in the number of banks willing to engage in such “last-in, first-out” lending, replaced by a handful of specialist boutiques. This trend towards specialist or private capital could be seen across the spectrum of film financing, perhaps reflecting the impact of capital constraints on traditional (e.g. bank) financing, and the realization that focused expertise can greatly improve the risk/return profile in film investment.

Today, the picture is rather different. In an article last November that talked about a new “golden age of film finance,” Variety observed that banks are back in force and even taking on more risk. National Bank of Canada is moving into mezzanine/supergap, as well as bridging deals; Union Bank has also moved into mezzanine financing, along with offering more liberal rates on pre-sales and gap. Similarly, boutique lenders such as 120db Films are raising their own gap ceilings, a competitive reaction to a world where more and more money is now chasing fewer and fewer projects. “Instead of 20%-25% maximum” noted 120dB principal Peter Graham, “we’ll do 25%-30% maximum.”

As budget shortfalls started to widen, producers looked to public funds – dubbed “soft” money – to make up the difference. Pioneered by the likes of Canada, France, and Australia as a magnet for drawing overseas film shoots to their countries, soft money started around 2002 to become an important part of U.S. independent film financing as states offered incentives of their own. A total of 43 different states granted at least $3.5 billion worth of subsidies to films, TV shows, and commercials between 2005 and 2010, according to a Tax Foundation calculation done for Bloomberg Businessweek. At the last reckoning, 39 states as well as Puerto Rico have film production incentives on their books.

Such production incentives come in many flavors. There are refundable tax credits, transferable tax credits, cash rebates, grants, sales tax immunities, lodging exemptions, and fee-free locations. Producers who qualify for these incentives are offered an average subsidy of 25 cents for every dollar of allowable production expense, a figure that has risen to more than 40 cents on the dollar for shoots in Alaska and Michigan.

This is not the same as free money, of course. Unlike grants, you can’t spend a tax credit or rebate. Producers still have to raise equity or borrow money to cover the full cost of the film. A $5 million movie might get $1.25 million in rebates, say, but producers have to spend that $1.25 million in order to get that rebate, so the money has come from somewhere. In some cases, states allow for tax credits to be traded at a discount to rich people or entities looking to offset their own profits, in which case a percentage of the money is available to the production upfront. Whatever the system is, the attraction of such incentives is obvious: the more that soft money is able to reduce the budget, the quicker the film becomes profitable and the sooner equity holders get to share in that profit stream.“Anyone who makes a film in the US without a tax rebate is a de facto idiot,”proclaimed “Boyhood” producer John Sloss at Winston Baker’s TV & Film Financing Forum East earlier this month.

How long such enticements can keep going in the face of budget shortfalls is subject to constant political debate in America. Last year, Maryland found that the state only generated 10 cents in revenue for every $1 in film production tax credits awarded. A 2014 report by Massachusetts revenue department said its 25% production rebate cost the state a net $356.7 million in the six years leading up to 2012. Its newly installed Governor, elected in the face of a $1.8 billion deficit, now wants to replace those incentives with low-income tax credits. Over the past few years, notes the National Conference of States Legislatures, the likes of Arizona, Idaho, Indiana, Iowa, Kansas, Missouri and Wisconsin have ended their incentive programs, or have not included funding for the programs in upcoming budgets. Connecticut suspended its incentives for film production, but maintains tax credits for other types of media. And just recently Michigan’s House of Representatives voted this month to end its uncapped rebates that were among the most generous in the U.S. states.

But while some states are threatening to kill or pare back their incentives packages, others such as Hawaii and California have increased their allocations. And then there is Europe. E.U. states inject an estimated 3 billion Euros ($3.36 billion) per year in film support, of which two thirds comes in the form of grants and soft loans (i.e. at below-market rates of interest), and the rest in tax incentives. Under the rules agreed in 2013 by the European Commission as part of its new Communication Cinema policy, producers can raise up to 50% of their film budgets from these subsidies. For smaller-budgeted films that figure can be as high as 80%. Better still, such subsidies no longer cover just production costs, but also expenses related to script-writing, development, film distribution and film promotion at film festivals.

Germany, which channels $330 million each year in “soft money” contributions towards the development and production of films and TV of all nationalities, remains a favored location for international co-production thanks to those generous film subsidies and top-notch studio facilities.

Much of this German soft money comes via big regional funds that only need to be paid back if and when the film is deemed sufficiently successful: their recoupment is entirely performance contingent. Combine this with federal and E.U. subsidies, take advantage of co-production treaties, negotiate pre-sales to neighboring Austria and Switzerland, and producers can cover their entire production budget by choosing to shoot and edit their films in Germany. Film projects are assessed on the basis of script, cast, talent package, budget, financing plan, local spend, chain of rights, distributors, international sales company, etc. While German cultural or historical content is seen as a plus, it is not a deal-breaker when it comes to approval – allowing films of all nationalities and subject matters to benefit.

Co-producing with other countries is often challenging, as anyone who has tried to tap into China’s burgeoning film market can testify. Even Europe, where there is a more reliable framework for collaboration, can be difficult. “The language problems and the different legal systems must not be underestimated,” advises international producer Thierry Potok, the former head of Berlin’s Studio Babelsberg who has since been in charge of a large Cologne-based production studio. “If you have 2 or more different co-producers, the problems are compounded, and you'd better foresee a comfortable budget for the lawyers and tax advisors. In any case, the most vital point is to select your local partners very carefully in order to find people who are experienced, who have a good reputation and do not end up constantly fighting it out in the courts.” Once again, it pays to reap the benefits of a professional’s inside track.

“One mistake that producers make a lot is that they over-collateralize loans that they take from these various sources. You might have a situation, say, where a reputable sales agent tells you the value of your film in the unsold territories is worth $10 million. You know that a bank will lend you up to 50%, so the biggest loan that a bank would give you is $5 million. That's the most cash they'll give you, but they'll cap out at 30% of the budget. If your budget is $5 million you don't need to use the rest of the world as collateral for a $2 million loan, right? Producers make this mistake all the time because they don't know enough to say to the bank, ‘No, that's overreaching.’ You may find that when you're done with this film and you screen it for taste makers, for friends, for family, everybody says the same thing: ‘Oh my God, he shouldn't have kissed her,’ or ‘He should have killed her." So now you need $1 million for re-shoots. You should be able go back and borrow against those other unsold territories to re-do the murder scene.”

“I have never bonded a single film of mine. I think for films that are, let’s say, under $3 million, the bond for me is a really good line producer and production accountant. That’s my bond. I made a movie that was $1.3 million that I was looking into bonding and I met with some financiers and we went through the budget line by line and they literally doubled every item. They kept saying ‘How can you do that for so little’ and I reply ‘I’ve done it before. I’ve made $50,000 films. I know I can do this.’ Bond companies just don’t operate in this sphere. They don’t understand how micro-budget films get made.”

“One of the things to keep in mind is the turnaround time on getting the tax credit for the rebate. New York, for example has been very backed up. I think it's a 16 to 18 month waiting period on a tax rebate. I think as investors that's something that you need to account for in terms of recoupment.”

“Every time you invest in a project, lawyers are going to tell you to set up an LLC. Now sometimes that's the right thing to do but other times it's wrong, depending on the tax incentive you are chasing. I would say the biggest piece of advice when these productions are being set up is to talk to a CPA or a tax credit expert in harmony with a lawyer. You really need tax advice at the same time you're getting legal advice, otherwise, the tax credit could actually end up getting trapped in the LLC.”

What happens when your combination of presold minimum guarantees, gap financing, and soft money is still insufficient to cover the financing of a particular project? The answer has been to turn to some kind of private financing. This might be in the form of direct loans from individuals and institutions that are made at higher interest rates than those charged by commercial banks. Or it might be straightforward equity in return for a substantial ownership position in the film and a privileged recoupment position. Some structures provide a blend of both.

The challenge with this late-stage private financing is two-fold. The producer is lumbered with high transaction fees, on top of all the bank charges, agency commissions, pre-paid interest, deferrals, and other contingencies that have already taken a bite out of the budget. The investor is also buying into a movie in which all the saleable foreign markets have been disposed of already. As Edward Jay Epstein points out persuasively in The Hollywood Economist, the only real asset that remains is the 20% tier of the foreign contracts and subsidy contracts which is not covered by the bank loan. This is also the riskiest tier. If the producer manages to bring the movie in on budget, some of that equity investment can be paid back from the contingency funds released by the completion bond company. Beyond that, the investor must hope that the unsold American rights will find a distribution home.

Fortunately, this precarious arithmetic has also led to some positive changes in dynamics of independent film financing, at least from an investment point-of-view. For one thing, budgets are dropping. Films that might have been made for $10 million a few years ago are now being shot for half that amount, sometimes even less. Equity investors are coming into the financing picture far earlier in the process, allowing them greater potential control over their asset. “Most of what we’re seeing this year are movies 100% financed by equity,”Myles Nestel, CEO of Solution Entertainment Group told Variety ahead of last year’s American Film Market. “Certain equity partners would rather own the whole film than pay expensive debt costs.”

The presence of these 100% equity players over the past couple of years has helped solve a cashflow problem that had been looming in the pre-sales marketplace. Since not all movies that are sold end up being made, distributors have started to avoid making any down payments until the film starts shooting, removing the up-front cash component that often serves as collateral. In addition, talent agents are getting wise to sales agents who launch projects to the market before they are properly packaged and financed. As has been noted by film financier Maggie Montieth: “Agents want to be reassured on their client's behalf that the money is actually there, before their clients are used to shop the projects." The involvement of equity financiers during the packaging process provides validation that they are market-ready. So much so that there is talk of a misalignment of supply and demand: there is actually more money right now than investment opportunities. “From a financing perspective, it’s never been better,” observed Nestel in November. “But it’s not about the money; it’s about the talent. The challenge right now in the independent market is getting talent to commit and stay committed.”

Entrepreneurial by nature, such equity financiers are also willing to turn to new forms of film financing. These include partnering with service-providers such as production facilities, raising financing from ancillary income flows from music and publishing rights, and turning to sponsorships. Using brands to stretch advertising dollars during a film’s release cycle may be nothing new, particularly for Hollywood movies. Think James Bond. But what is new - and potentially far-reaching - is how brands are now starting to dabble in film production itself. A new version of Shakespeare’s Romeo and Juliet, adapted for the screen by Oscar-winner Julian Fellowes and released in 2013, received a substantial slice of its $17 million budget from Swarovski Entertainment, the new film division of the $3.8 billion Austrian jewelry maker. It is unlikely to be the last such experiment, particularly in the cause-driven world of documentary features.

The industry is also waking up to the possibilities of crowdfunding. We are not just talking here about rewards-based donations that are funneled through platforms such as Kickstarter and Indiegogo, but also equity crowdfunding, online syndicates and peer-to-peer lending enabled by online marketplaces such as Slated. “I happen to think that crowdfunding is the sleeping giant of film finance,” said Cinetic Media chief John Sloss, speaking just a couple of weeks after the SEC had opened the door wider on online investments by fans.

In the old days of cinema, feature-length reels of celluloid acetate had to be trucked around in huge cans that were delivered to theaters and unspooled to audiences. Tickets sold at the box office – an income stream that is split between distributor and exhibitor – remained the primary revenue stream for movies until the 1977 release of “Star Wars” demonstrated the considerable merchandising and other ancillary revenues that can come from a popular “franchise” that has captured the zeitgeist.

It is worth noting too that “Star Wars” only dethroned “Jaws” as the all-time box office champion a full seven months into its first-run in U.S. movie-houses. These days, even successful films are only seen in theaters for three months before they are made available for exclusive periods of time (known as “windows”) in various distribution channels following that initial release. Such channels encompass everything from DVDs and airlines to the various TV windows: pay-per-view, pay-television, and free over-the-air broadcast.

The fact that those movies can now be delivered digitally, rather than in physical form, has opened the door to new possibilities. Not only can films be piped directly into theaters, allowing for greater programming flexibility, they can also be summoned “on-demand” for viewing across all manner of TV, computer, and mobile screens.

Broadly speaking, there are four types of online movie services. Transactional video-on-demand (TVOD), essentially movie rentals chosen a la carte, is the natural outgrowth of the pay-per-view business. Electronic Sell-Through (EST) refers to the purchase of video content that is then downloaded and stored by the consumer. There are also two kinds of all-you-can-eat movie menus: those that are offered as a monthly subscription package (SVOD) and those that are streamed for free but preceded or surrounded by advertising (AVOD).

Of all of these, the Netflix brand of SVOD is seen as having the highest growth potential around the world – and is consequently the most disruptive to the carefully orchestrated procession of distribution windows that has come to define established film business economics. The fact that Netflix offers a flat fee for the independent films they license, regardless of how often those films are watched on their service, has been a source of growing concern. There is no real data yet on what works with video-on-demand audiences, across any of the viewing platforms, which makes financial projections that much more difficult.

Also disruptive are the new hybrid forms of distribution that are opening up. Independent films are being given simultaneous VOD and theatrical releases by distributors that have access to both platforms. Despite the fear that such hybrid distribution strategies would lead to cannibalization of demand, the results have been seen as beneficial to producers and their investors. As far as we can tell from a VOD business that has been loathe so far to share numbers, not only do the films benefit from the exposure that comes with a cinema release (a promotional shop-window that reverberates throughout a film’s distribution lifespan), but they also enjoy an accelerated revenue stream as customers from potentially 100 million North American homes order their film at various price-points. This applies even to relatively obscure titles such as the April 2011 documentary “American: The Bill Hicks Story” that Magnolia released simultaneously “day-and-date” in a limited theatrical run, and to cable viewers. Made for very little money and released on a miniscule budget of five hundred dollars, the producers actually broke-even on the theatrical release, where the film earned $90,000. They stand to make a handsome profit from the $600,000 that they and Magnolia have officially estimated as their cumulative three-year VOD revenue.

Finding the optimal cost/benefit balance between a theatre and video-on-demand release is something that distributors are still grappling with. TWC-Radius made waves last year by releasing its “Snowpiercer” on VOD just two weeks after it showed in just eight movie houses in the US. The hope was to avoid the hefty marketing costs that come with releasing a film widely and keeping it in theatres, before then having to pay for a second marketing campaign to mobilize small screen viewers. The strategy may have backfired. While the film grossed $4.6 million theatrically and generated roughly $6.5 million on VOD, industry observers believe that “Snowpiercer” may well have grossed $45 million had it followed a traditional windowing pattern that preserves a three-month separation between theatres and home viewing. Wary perhaps of leaving money on the table again, TWC-Radius reversed tactics on its latest horror release. Just four days before “It Follows” was due to premiere on VOD after a limited release in four theatres, TWC-Radius announced it was keeping the film in theatrical play and expanding wide to 1000 screens. “It Follows” has generated $14 million not to mention the kind of buzz that will ensure an extended afterlife in the on-demand world.

From the onset, it is important to note that there are multiple exit strategies for film investors looking to get back their equity capital. Some don’t even involve waiting until a film is released in theaters or watched on a small screen. Every year, at least one major film festival can point to an independent feature film whose distribution rights are sold on the spot for a multiple of its production budget. A great example is “The Way, Way Back,” a $5 million project that was listed on Slated before selling to Fox Searchlight for $9.75 million at the 2013 Sundance Film Festival. Depending on how that film’s financing was structured, those who invested in that film could have theoretically doubled their money before the film had even begun its commercial life.

This immediate return of capital eliminates the investor’s exposure to performance risk - the ideal outcome for an investor, unless they are keen to play the long game and participate in the upside alongside the distributor. Such was the case with several breakouts at this year’s Sundance including the idiosyncratic drama that won both the Grand Jury Prize and Audience Award,“Me & Earl & The Dying Girl.” Although bidding for the film reached a record $12 million, the equity financier on the film, Indian Paintbrush, opted for a lower upfront sum of $4.7 million in return for a greater slice of any eventual profits and a lower distribution fee from Fox Searchlight. The worldwide distribution deal was described as a partnership between Indian Paintbrush and Fox in which the studio became an investor in the film, rather than buying it outright.

More often than not, a film has to start generating an income stream from its distribution before investors begin to see meaningful returns. In some cases, investors might negotiate a fixed ROI on the capital they supplied – repaid after a set target has been met. In other cases, they might agree to a minimum ROI and arrange to receive a series of repayments over a film’s lifecycle.

To illustrate how this all works in practice, let’s look at a scenario involving a film that has secured theatrical distribution across North America and has performed well at the box office. Under typical circumstances, the exhibitor that operates the movie theaters, will retain about 60% of all ticket sales revenue. Before any financiers get to share in that remaining 40%, however, the distribution company will collect a distribution fee and also recoup its P&A expenses (i.e. the money spent to both market the movie and to produce copies of the film, physical or virtual, to play in those theaters). Depending on what “back-end” agreements were struck with performers, residual payments and talent participations might also kick in, usually within sixty days of the film’s release.

Now comes the point that financiers and investors start to receive their money back. As a general rule, the first monies received from net distribution revenues are ring-fenced and automatically prioritized to repay all investments and debts incurred in creating the film. Once that production budget and any preceding overheads and development costs are “recouped,” the film is said to have reached its break-even point. This then triggers a profit-sharing arrangement between the producer and investors. The film’s stars, writers, and director tend to be paid from the producer’s profit.

Although producers often have substantial profit participations in their movies – assuming they didn’t have to give it all up in order to raise financing – the truth is, says Bill Grantham, that most producers make their money out of fees.“They're making good fees from getting their movies, and they're hoping for that win for one movie that’s really, really successful, which is going to pay for their retirement, and their yacht, and all of this. Mainly though, the producer business is not a profit-driven business. It’s a fee-driven business.”

The contractual order in which financial contributors to a film’s production are repaid is known as the “waterfall.” Tax obligations and any bank debt are repaid first, followed by equity investors according to pre-negotiated terms, and finally the producers. This is a simplified picture. As with all industry-specific corporate financing, there are many structures which can significantly increase the complexity of the returns waterfall. This is why a well-structured business plan is so important, balancing the competing claims on any film in a hopefully fair and equitable manner. While investors tend to concern themselves with limiting their downside exposure, going so far as to insist on significant fees within the film’s budget to help hedge their risk, it’s often the allocation of the upside that can cause greater problems. Another key consideration is timing. One of the reasons why investors like to keep budgets low is that this accelerates the break-even point and improves the internal rate of return on that investment. Too big a budget, especially in these times of diminishing pre-sales, and your capital is stuck.

As producer Ted Hope once noted:

“There is no structure or mechanism to increase liquidity of film investments, either through clear exit strategies, or secondary capital markets. The dirty secret of film investment is that it is a long recoupment cycle with little planning for an exit strategy. Without a way to get out, fewer people choose to get in. Who really wants to lock up an investment for four years? Not investors, only patrons…”

“My sweet spot is making movies for a million dollars and under. I prefer to structure them as all equity - and I’m very vocal about this - in the sense that as an investor I would be much happier giving you a dollar knowing you can at least guarantee me 50 cents back from tax incentives and foreign sales. We’re not going to be carving out debt positions. We’re not going to be bringing in institutional financing to back that. We’re going to use everything as revenue and that’s more enticing to me because I at least know something is going to be returned and on the off-chance that this is a wild success, I now have more skin in the game and control more of the upside. The decision-making that needs to happen with the film also tends to be entirely aligned. You’re not going to have to worry about some debt investor saying, ‘No, I’d rather do this and because I’m in first position, this is what we’re going to do.’”

“If you're talking about a two, three, four million dollar movie then I'd say your best bet probably is to raise the whole thing in equity. It's probably the safest thing to do. It's probably the most manageable thing to do. Traditionally, however, if you are willing to give away part of the upside, you're betting against the movie because what you're doing is you're sharing the risk. A loan just has to be paid back. You never have to give them another dollar after they repay the loan. So then it becomes this maths problem. What do I need to do in order to satisfy the loan? The message you're actually sending when you take on debt is that you believe in your project.”

“The equity is customarily at the bottom of the revenue-sharing waterfall. As equity, you're standing there waiting for it to cascade but in reality it’s this terrible little drizzle down there. You're just hoping that you're going to get your money after everybody else has got theirs. In other words, it’s not just a pie, which is chopped up and everybody gets a piece of it in proportion to what they put in. Instead, there are people who are in favorable positions, who get in line ahead of you. The game is finding a way of getting your money out soon. It’s a strange psychological thing. What I have discovered in this business is that if you simply call something, ‘debt’, then pretty much everybody says, ‘Yeah, well, you obviously come out ahead of the equity.’ Even if it’s just really basically a piece of hidden equity.”

“We are now trying to get involved earlier in the process so that we can get more aggressive with the deal terms, with the financial structure, and get a better handle on our position in the waterfall. Whether it's putting up some sort of debt or mezzanine position against the foreign sales or bankable tax rebate, we want to really mitigate our risk and say: ‘Well, we recouped 75% of our capital from the rebate, 20% of our capital from foreign distribution and now we can totally just ride the upside.’”

Who wouldn’t want a slice of Hollywood’s big budget action, particularly those “tentpole” franchises such as “The Avengers” or “The Dark Knight Rises” that rake in nine- and ten-figure sums at the worldwide box office?

The six conglomerates that make up the studio system attract the top talent, compete for the choicest projects, enjoy access to capital, are in a strong position to control costs by extracting terms from suppliers and clients, and spread their production risks across a vertically integrated empire with a firm grip on every distribution medium and global market. Above all, with a broad portfolio of films these studios can subsidize the less successful pictures with their blockbusters’ profits. Such in-built advantages help explain why investing in studio production output remains out of reach for most private individuals. Studios have the resources to finance their own movies, so why would they let others in? The answer, surely, is when the expected cost of outside capital is less than what the studios currently pay on their own funds. In other words, the studio’s business relationship with the outside world is inherently asymmetrical.

That said, Hollywood investment channels are not completely closed off. Studios such as Warner Bros. and Universal Pictures turn to investment vehicles like Village Roadshow and Legendary Pictures as their regular co-financiers in order to shift their capital burden off their own balance sheet. In turn, these funds raise their own combination of debt, mezzanine, and equity capital from large institutional investors and banks.

But getting in on such funds for even the most sophisticated, well-connected investor is never straightforward, as film finance advisor Laura Fazio learned. During the last several years, she structured financings for Legendary, Village Roadshow, and a host of other giant Hollywood film deals totaling more than $4.5 billion while spearheading the entertainment practices of Dresdner Kleinwort and then Deutsche Bank. “It is tough for an accredited investor to invest directly in these tentpoles," she acknowledges. "We wrestled with this a bit at Deutsche and tried to use the high net worth guys as potential equity. But the regulations are very onerous. The best means to invest right now is, unfortunately, only via the public markets. One could invest via the institutional pools, but that is spotty. It is absolutely something we are aware of but have not yet been able to resolve."

Those that do manage to get through Hollywood’s door had better hope for greater transparency and a better alignment of investor and studio interests than has so often been the case. There are a number of problems for the unwary private investor to look out for when seeking a piece of major Hollywood films. Here are five identified by Bill Grantham:

from Bill Grantham's book Film And Risk

“Can you get into the good projects? Hollywood has been stingy about letting outsiders into the most lucrative films, and while there are some privileged entrants, this is a permanent worry. For 30 years or more, there’s always been a risk that the outside money finances the dregs.”

“Can you be sure that your money ends up on the screen? Many big Hollywood films are seriously over-budgeted, and investors need an experienced and forensic eye to scrutinize the numbers. The devil – in terms of cost and return – is usually in the detail and private investors need to commit the time and work to limit downside risk.”

“Even if it can obtain a relatively favorable recoupment position (e.g., ahead of deferrals) and a premium, a lot of money is paid out ahead of the investor. Too many investment propositions, if weighed carefully (see previous point) don’t have realistic chances for payback out of first cycle revenues (see next point).”

“The great appeal of the old presales model was the fast pace at which money came back: Distributors paid on delivery, which was typically 12-18 months from the time the money went in. This is more difficult today, requiring investors to have a more realistic expectation as to the true rate of return that their money may obtain.”

“Investors and their advisers often simply lose their heads when offered film deals - and these are people who in other business activities are hard-headed realists.”

While a couple of these issues also apply to independent film financing, they are magnified by Hollywood’s often maligned but misunderstood accounting methods. The widespread belief that the studio’s bookkeeping methods do not correspond to general accounting practices keeps rearing its head in high-profile lawsuits. Melrose Investors 2, a New York-based financing entity that co-financed 29 films with Paramount Pictures in 2006, has questioned how $375 million invested in movies such as “Dreamgirls,” “Mission: Impossible III,” and “Transformers” that grossed $7 billion between them can still not amount to a dollar in profits.

The disparity certainly reinforces Hollywood’s reputation for opaqueness, and the allegations about concealed payments and secret agreements with third parties make for good copy. But lost in all the rhetoric is the reality that Melrose 2 actually made a decent ROI. “Vine Alternative Investments and the other investors in Melrose 2 are attempting to inappropriately parlay a successful motion picture investment into a windfall. Based on the performance of the films in which it invested, Melrose 2 is expected to make a double-digit return on its investment,” countered Paramount.

The flipside to this is that double-digit returns seem to represent the ceiling on what is possible through Hollywood partnerships. In the UK, more than two thousand investors including celebrities such as David Beckham, Bob Geldof, Peter Gabriel and inventor Sir James Dyson contributed an average of £100,000 each to a film financing partnership created by London’s Ingenious Media. The average £50,000 in profit that they reportedly pocketed from that investment seems like an attractive return until you realize that Ingenious Film Partners 2 LLP owns a 25% chunk of “Avatar,” having put up $75 million of that film’s budget. “Avatar” is still the most successful film of all time when measured in the crude terms of "absolute box office profit", grossing nearly twelve times its production cost at cinemas worldwide for a profit of $1.15 billion from theatrical markets alone. If an outlier such as “Avatar” gives investors a putative ROI of no more than 50%, imagine the yield across a more typical Hollywood release slate.

If you are truly looking for blockbuster returns, the better play surely is to avoid the tentpoles altogether and focus your energies instead on the tadpoles – those independent films that stem from the nascent imaginations of tomorrow's generation of blockbuster filmmakers. Dig into the filmmaking origins of Chris Nolan and Bryan Singer, to cite just two of today's most consistently successful franchise filmmakers, and you’ll see once-experimental directors who quickly graduated to Sundance film festival breakouts that offered eye-catching returns. Nolan’s “Memento” made eight times its budget at the global box office; Singer’s “The Usual Suspects” made nearly six. These indie sensations are also the very kind of films that enjoy long afterlives from on-demand revenue streams.

These are not isolated success stories. A wide range of independently financed hits – everything from “Winter’s Bone” to “The Hunger Games,” to cite the films that star another Sundance discovery, Jennifer Lawrence – have served as proof of concept that financial indie success is still very much possible in a fluctuating marketplace. After striking rich with “Black Swan,” a massive global hit, you might think that the group of Texas and Louisiana oil and gas tycoons that financed it would count their blessings and move on. After all, they put up $6.8 million on that film and realized a return of $54 million, larger than their entire film fund of $40 million.

Instead, brothers Timmy, Tommy, Todd, Tyler, and Bobby Thompson have come back for more. Much more. “We took the same investors from fund one, sunsetted it early, and they all came in at ten times their investment” says Brian Oliver, the president of Cross Creek Pictures after closing the new $300 million fund. Since then the company has put money into “The Ides Of March,” “The Woman In Black,” “Rush,” “A Walk Among The Tombstones” and the upcoming films “Everest” and “Pride And Prejudice And Zombies.”

All of which goes to show that if money is treated well, and transactions are conducted openly, investors will want to come back for more. The need for greater transparency, effective due diligence and more equitable and liquid capital structures keep coming up in our Filmonomics discussions at Soho House. Improve on all three fronts and the film industry can finally look forward to a returning and sustainable investor class.

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