By Jon M. Garon
Gallagher, Callahan & Gartrell, PC
Unlike other industries, the motion picture business presents a second type of financing sale in addition to the typical model of equity financing. It involves selling the film’s distribution rights. In this form of financing, the company sells its assets in exchange for a present or guaranteed payment. For example, if the film company sells its rights to European distribution in exchange for $50,000, then its future revenue will exclude any monies made in the countries identified as Europe, whether those markets generate $5,000, $50,000, or $500,000. This arrangement reduces the potential for future income, but also serves to reduce the risk of loss.
From the filmmaker’s standpoint, cash for the production is the most critical requirement of any financing structure; no number of future promises will cover rental fees or payroll. Unfortunately, the business realities for presale agreements often require that the completed film be delivered prior to any payment. To actually produce the film, the filmmaker must borrow from a lender, using the presale agreement as collateral. Under this structure, the interest costs are not avoided, and the filmmaker may still shoulder the residual risk that presale fees will not materialize. Nonetheless, since a presale agreement allows the filmmaker to finance a project without risking personal funds, it remains a very attractive option.
Presale and distribution deals may vary significantly. Some of the more common structures are briefly described below.
1. Cash Deals
Only in the rarest of situations or with the lowest of budgets will a filmmaker will be able to fund the production with a cash advance on a guaranteed distribution. There was a time when companies such as Cannon Films would create one-sheets (theatrical advertising posters) that the company would exhibit at the international film markets. If it was successful selling enough territories based on the poster, Cannon would contact the named talent and begin the process of producing the film. If a film didn’t attract enough interest, the remaining posters would be discarded and those projects never started. Today, modest cash advances may sometimes be available, but this is the exception to the rule.
2. Negative Pick-Up
Although the details can vary greatly, the term negative pick-up means that a film studio or distributor pays for the cost of the film to be finished to the point that a completed negative is ready to use. Generally, the filmmaker sells the film to a studio in exchange for reimbursement of production expenses and some form of profit sharing from the eventual proceeds of the film. For example, if a filmmaker had a budget of $1 million for a film project, she would “sell” the film by promising to deliver a completed motion picture substantially the same as that described in the screenplay in exchange for a payment of $1 million. Once the negative was delivered, the film studio would then have the obligation to finish the prints for the film, pay for its marketing and distribution, and split profits, if any, with the filmmaker on the agreed-upon percentage basis. The negative pick-up is the filmmaker’s “field of dreams”—if she shoots it, the money will come.
The negative pick-up arrangement often operates very similarly to studio financing. Each major decision may be subject to review by the distributor. The distributor will require that the script be followed, the agreed-upon casting not be changed, the length of the film be acceptable, and the film be eligible for a particular MPAA rating, typically a PG-13 or R. Any major deviations must be approved by the financier or the filmmaker risks the company stopping payments or claiming that she has breached the agreement.
The amount paid for a negative pick-up need not be the same as the production cost of the film, although the distributor will often seek to cap the payment at this amount. If so, the filmmaker must be sure to include budget items for herself and others who have invested sweat equity as the basis for negotiations with the studio. To add these items later in the negotiations will result in little or no personal payments.
The actual payment structure can vary from arrangement to arrangement. In most cases, the purchasing studio will provide funds on a weekly basis as necessary for the film company to meets its regular obligations, but only after the filmmaker demonstrates that the project remains on budget and on schedule. In other cases the funds will be paid on delivery of the final product, so the filmmaker must use the negative pick-up agreement to obtain commercial loans to cover production expenses.
3. Distribution Guarantee
Closely related to the negative pick-up arrangement is the distribution guarantee agreement. In this case, the distributor agrees to purchase the completed film’s full distribution rights in exchange for a fee and an agreed-upon royalty or gross participation amount. A distribution guarantee does not eliminate the risks to the filmmaker, because the funds are generally not made available until the filmmaker has completed the film.
Since the sale of distribution rights does not immediately result in cash to the filmmaker, she must use the sales agreement as a form of collateral against which the film company can borrow money from a bank or other lender. Under the distribution guarantee agreement, the film’s distributor serves as guarantor of the loan. Since the lender is entitled to repayment regardless of the film’s revenue, the distributor’s guarantee may put the lender in a position of much greater security than if the filmmaker is solely responsible for the loan. If the distributor is a stable, well-established company, lenders are generally willing to finance this type of arrangement.
Invariably, the lender will require that the film company furnish a completion bond, which serves as insurance against the film not being completed as required by the purchasing distributor. Together, the loan interest and the premium cost of the completion bond could add 20 percent to the cost of completing the film. Short-term financing may further increase this cost substantially.
4. Foreign Distributors, Markets, and Territories
Foreign distribution has grown to become the single largest category of film distribution income, exceeding both domestic theatrical exhibition and video sales for revenue. Despite its importance, however, foreign distribution is risky territory for independent films, because the language, currency, and legal enforcement barriers often make it difficult to collect royalties or enforce contract rights. If a filmmaker seeks an advance and a royalty payment in exchange for foreign distribution rights, she must face the vagaries of currency exchange and the unfortunate but all-too-common practice by which foreign distributors refuse to distribute royalty income.
Even if royalty payments are forthcoming, the difficulties of auditing foreign receipts and dealing with clever accounting practices make this income source highly volatile. For an independent filmmaker without the leverage of an ongoing relationship, the cost of collecting small royalties from a foreign distributor in a small territory can be larger than the amount of payment being sought. Where possible, the filmmaker is best served by selling the rights to a foreign territory outright instead. More modest prepayments will result in greater cash in hand for the filmmaker and should be the preferred strategy with all but the most reputable of distributors.
Nonetheless, independent filmmakers have been increasingly successful selling the rights to foreign territories in exchange for advance payments and using these payments to finance all or most of the film’s budget. These transactions can be conducted through direct cash payments or through letters of credit that are deemed sufficiently sound by the U.S. lenders.
Often the strategy in these sales follows that of Cannon Films: invest early in the poster art so that the purchaser knows what it is marketing. Few people have the skill necessary to read a screenplay (or even view a rough cut) and successfully visualize the final film. On the other hand, most people have attended at least one film solely on the basis of the poster. Perhaps this form of financing seems artistically impure, but commercial success for a film requires commercial techniques.
During the independent film boom of the 1980s, the combination of new marketing opportunities and healthy tax regulations led to an infusion of foreign capital. This financial resource, if it ever truly existed, disappeared as a result of changing economic conditions and substantially more restrictive tax regulations. When the dot-com securities market collapsed, a flurry of venture capital sought independent film opportunities, but that money has also disappeared as the next generation of investors learned the risks of independent film distribution.
But a new international market continues to expand: independent U.S. filmmakers may find opportunities to collaborate or coproduce with production companies outside of the United States. Occasionally these coproduction arrangements will provide financing to the U.S. company, but more often the foreign company enjoys subsidies for its local production and will provide services in exchange for the co-ownership of the project. While such an arrangement entails a number of unique risks, it may also afford the independent filmmaker some attractive side benefits: opportunities to travel and to benefit from the coproducers’ expertise.
The traditional Hollywood studios manufactured motion pictures. They purchased the raw materials—stories and talent—and produced finished films that they exhibited in theaters throughout the world. Over time, the production activities separated from the distribution activities, so that the studios would distribute and promote films produced by other film companies, reducing the studios’ risk if a film was never made.
Today, the major motion picture studios are primarily distributors rather than film production companies. Instead of directly purchasing stories or scripts, the studios work through existing relationships with established production companies. These production companies package the script, develop the budget, and manage the production. The budget will include a negotiated fee for the producer’s own expenses and income. The agreement between the producer and studio will also determine the producer’s participation in the film’s revenue. The studio will finance the project on an incremental basis, providing the necessary funding for each step of the process. In exchange, the studio has primary control over the project and the ability to terminate it at any point in its development.
This incremental approach, known as a production and distribution deal, allows the studio to maximize its control while minimizing its risk. The producer will typically receive a small fee for early preproduction activities. Although the costs of script and budget preparation often exceed this payment, the producer rather than the studio covers this risk. If the studio is interested in developing the project further, it will release funds to the producer to pay for selected key aspects of preproduction. Locations will be scouted, the script rewritten or polished, and key personnel identified. Throughout this process, the producer will receive little or no additional pay.
Eventually, however, the studio may commit to the project. It “greenlights” the film and commits to principal actors, director, and designers. (For some directors and actors, the studio will be obligated to pay them whether or not the production is ever filmed.) During this phase of preproduction, the studio will typically distribute a small portion of the producer’s fee. The bulk of the producer’s fee will be paid during principal photography, with small payments withheld until the delivery of the first rough cut of the picture and the delivery of the final picture.1
For the independent filmmaker, making a picture under a studio-financed production deal is both a blessing and a curse. A well-made studio film has the potential to greatly exceed the success of any independent film. The studio’s marketing budgets and promotional savvy can make a household name out of anyone, opening the door for tremendous professional control on subsequent projects.
The curse is that the independent filmmaker gives up control immediately. Rarely do studio screenplays resemble the writer’s first drafts, and novice directors will be second-guessed at every turn—if the filmmaker is allowed to remain attached to the picture at all. Still, that is where the money is. For most artists it is commercial success that buys them the luxury of later artistic control.
This is part of a series of book excerpts from Independent Filmmaking, The Law & Business Guide for Financing, Shooting & Distributing Independent & Digital Films designed as an introduction to the many legal issues involved in the filmmaking process.