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The Basics of Film Finance

Financing of film projects often requires an elaborate patchwork of investors, banks, soft money tax credits and in-kind services, and some companies specialize in financing specific stages of production. One of the overall themes of the industry that can at times make obtaining financing hard is the risks involved in making films, many of which may have very little tangible value at the end of the process.

Financing of film projects often requires an elaborate patchwork of investors, banks, soft money tax credits and in-kind services, and some companies specialize in financing specific stages of production. One of the overall themes of the industry that can at times make obtaining financing hard is the risks involved in making films, many of which may have very little tangible value at the end of the process.

In broad terms, the "negative costs" of feature films is what it takes to pay for talent, labor, materials and effects, in order to produce the film "negative." Additional costs can be for prints, advertising, marketing and promotion. Film budgets are determined by what the market will bear to purchase the film once completed. In order to deliver a film within the budget, many costs may be deferred for payment at a later date, paid out of revenues generated Expert Witness: Kathryn Arnold
from the film once its distributed. Many times the producer must defer his/her own fee for producing the movie, in order to meet the budget. The hard costs of physically producing the film vary dramatically depending on the film, with low budget films ranging from $200,000 to $1 million, high budget films usually around $50-$75 million, and blockbusters − like the recent James Bond film "Casino Royal" − which was produced for $150 million.

The following excerpt from an industry document provides an overview of factors contributing to these "negative" costs and reveals that the risk associated with investing in these high budget A-films can be significant.

Marketing and promotional costs (combined with substantial fees paid to exhibitors, usually 40% to 65% of box office gross), distribution fees (usually 33%), overhead, interest and expenses (paid usually to studio distributors) and gross participations, greatly reduce the revenue stream flowing to the producer and net profit participants. According to the MPAA the average negative cost of a studio feature motion picture (which includes production cost, studio overhead and capitalized interest as of 2001 was $47.7 million. As of 2001 the average initial marketing costs (print and advertising) as of the feature is in excess of $20 million.… these statistics alone make the task of recouping production and marketing costs for MPAA pictures formidable. Low and medium budget pictures produced by the independents (typically for less than $1.5 million and $10 million, respectively), have less difficulty recouping, however low budget pictures often go direct to home video in lieu of a release in the theatrical market.

Typically the high-budget blockbusters, which are financed and/or released by the MPAA companies, generate the most money in the movie industry. In the example of Casino Royal, between its release on November 17th to December 3rd, box office ticket sales in North America were reported to be $115 million. As of April 2007, the movie had grossed over $593,352,994 globally.6 However because of the huge negative costs − in addition to marketing, promotion and advertising costs, company overhead etc, that they incur − these films do not necessarily generate the highest returns. While the big studios have traditionally dominated Hollywood, independent films have taken off over the last few years. Films such as Slumdog Millionaire and Saw are excellent examples of independently financed films that have generated high financial returns. This is simply a function of how the industry works, and many talented and successful producers must go outside the studio structure to make their films. Because of the risk involved and the desired return on investment, studios typically play it safe and stick to set genres of movies that have a proven track record of success at the box office. This is why studios love the summer blockbuster, the action movie and the romantic comedy – they perform time and time again and are based on an established formula of story + name actor + name director that often adds up to a box office winner.

Going the studio route to get the film made can be easier for the producer than seeking independent film financing because the studios are "one stop shopping" so to speak. They handle many of the arduous chores associated with getting the picture though production and distribution. However, in exchange for the studio’s money and the convenience of the process, the producer is forced to surrender much of the control to the studio when it comes to making the picture, including creative decisions, accounting, and whether the movie gets made at all. In the event the movie does not get made, and the producer wants to take the project elsewhere for financing, the producer may be responsible for repaying the studio the development costs accrued by the first studio, if they get financing from another studio or outside financing source. One particular movie has been through 4 studios over 10 years, and the option is set to expire shortly. If the current studio chooses to pursue making the film, then they must incorporate the monies owed the previous studios into the budget, which can often add up to several million dollars. Often times a film that has been in "Development Hell" will not get produced at all, because the "development costs" are so high, thus increasing the production budget to a level that no longer make the film a marketable project.

Much of a producer’s success or failure when producing a film independently hinges on obtaining funding from a bank or equity investor. Many producers have patchworked creative combinations of equity and debt finance with government grants and subsidies in order to cover the entire budget of the film. Many sophisticated financiers including hedge funds, ultra high net worth investors, tax credit buyers, buyer representatives, and private equity firms will supply the capital needed to finance films — this may happen at the development, pre-production or production stage. However, these individuals and groups will want a high rate of return on investment because of the risks associated with bringing the film through to production and actually seeing a return on investment once the film is distributed. For these investors, expenses may be immediately deductible for tax purposes, while taxes on profits may only have to be paid in the distant future. This is one way to maximize the value of tax deductions, to make the deal more attractive to the possible investor.8 More information can be found by researching the Tax Law 181 implemented by The American Job Creation Act of October 2004.

In addition to pursuing private investors to obtain the necessary money, the "negative pickup" deal is also a popular way to finance films. In this type of deal, a producer enters into a contract with a distribution entity and the distributor agrees to purchase the movie from the producer for a fixed sum on a given date. The producer is responsible for funding the film until that point and must pay any additional costs if the film goes over-budget. The producer will then take that contract to a bank for a traditional bank loan or to equity investors as collateral. While the terms of negative pick-up deals vary, the studio/distributor typically pays for all distribution, advertising and marketing costs once the film is delivered. The studio and producer will then share profits. Because the producer has taken the responsibility of financing production, he/she can usually negotiate a better definition of profits − on a net-profit basis or even gross profits if warranted − than if he/she made the film with studio financing.

Superman and Never Say Never are examples of negative pickups.9 One of the important facets of these deals is that once a negative pickup deal is signed, it is easier to obtain financing for the production since there is already a buyer for the film, and the "negative pick agreement" is often used as collateral for borrowing from a bank. However, as the studio commits money to the finished film they are going to demand that certain elements are attached to the project, in order to mitigate the risks of the film finding an audience.10 Many studios and distributors will attempt to mitigate the risk of the finished product by only offering a negative pickup contract to a production that has financiers, a script, and key creative personnel, most importantly the director and stars.

Various Levels of Financing
Banks and other financing entities will often provide gap/supergap financing as a form of mezzanine debt, where the producer completes the film finance package with a loan secured against the film's unsold territories and rights.11 However, banks will want to closely examine the collateral for the film because this type of lending is a very risky form of capital investment and accordingly the fees and interest charged reflect that level of risk. These loans are subordinate to the senior/bank production loan, but in turn, the gap/supergap loan will be senior to equity financing.

A gap loan becomes a supergap loan when it extends beyond 10-15% of the production loan required to shoot the film. This is because a bank is usually unwilling to bear the risk beyond 15% of the budget. Due to the high risk involved, many supergap companies have come and gone over the years, but a few established players have survived the ups and downs of the markets: Relativity Media, Screen Capital International, Grosvenor Park, Endgame Entertainment, Blue Rider, Newmarket Capital, Aramid Entertainment, MDG Entertainment Holdings, Limelight and 120dB are currently active in the debt financing space.

Another source of financing is through international sales companies that will facilitate the financing and distribution of the film for a fee. The fees charged depend on the sales company’s level of involvement during the various stages of development, financing, production and distribution. The more involved they are in each process, the larger piece of the pie they will demand. These companies sell the films at the many film markets and festivals around the world and charge their marketing costs against the film’s returns as well. So in this case, they charge a fee for financing, a fee for selling, and a fee for their marketing, which can add up. These are all factors that need to be considered by the producer when utilizing an international sales
agent to finance the film, as it will affect their ROI for as well as any equity investors that may be involved.

The bottom line with film financing in this constantly shifting, competitive marketplace, is that producers must come up with additional funding any way possible. In the last decade, many states and governments have seen the positive impact Hollywood has had on California’s economy, and now more jurisdictions want a piece of the action. For that reason many state and national governments have begun offering grants, subsidies and tax incentives in order to entice producers to shoot their films within their borders – which in turn brings in money to the local economy. Canada, The United Kingdom, Ireland, South Africa, Germany, Australia, and New Zealand among other countries, have film finance incentives that can be accessed to finance a number of film projects.

In addition to subsidies from foreign governments, there are a number of states that offer producers incentives to film in their local area. This makes it attractive for producers to shoot their movie in a state offering rebates or transferrable tax credits, which can then be passed onto their investors.
Louisiana, New York, New Mexico, and North Carolina among other states offer a variety of tax incentives that can reduce a portion of the budget that needs to be funded. Some of these incentives are paid up front by a "sale" of the tax credit, and other incentives are paid back to the production company once the "spend" in that state has occurred. As an example, if a $200,000.00 movie shoots in New Mexico and spends every penny in the state (or, through a pass through corporation that pays state taxes) the state of New Mexico will cut a $50,000.00 check for that motion picture. Many companies have existing relationships in their local areas, and create co-production arrangements with the producer to help obtain the various subsidies.

Considering that over 30 states in the U.S. now have some type of tax credit or rebate plan, many producers now seek to take advantage of these incentive programs. An AP survey found that states competing for film projects handed out $1.8 billion in tax breaks and other advantages to the entertainment industry from 2006 through 2008. If Michigan wants to help filmmakers make movies, then why not take advantage of that!
In addition to state incentives there are also federal tax benefits available as well. If the film is made in the United States, producers may further educate potential investors on how to utilize the tax code Section 181 to reduce their tax burden and hence reduce their risk in financing the project. Here are some of the highlights:13

75% of the motion picture must be shot in the US to qualify for Section 181

TV pilots, TV episodes (up to 44), short films, music videos and feature films all qualify for Section 181

Section 181 can be applied to regular income or capital gains

Depending on corporate structure and how the investors are involved with the company

Section 181 is retroactive

If this is done wrong your investors can end up with a major surprise when they turn in their taxes
In the end a producer must take all these variables of financing into account and figure out the best formula to get the movie produced, while still leaving a little bit for him or herself at the end of the day.

ABOUT THE AUTHOR: Kathryn Arnold
Kathryn Arnold, an award winning film producer and executive with over 15 years experience in film production, acquisition, distribution, international sales and gap financing. Extensive experience in development, casting, packaging and fund raising. She works with talent agents, production crew, distribution executives, investors, lawyers and graphic artists. Ms. Arnold has produced 6 feature films and directed a documentary on the iconic band Earth Wind & Fire. She has worked in Corporate Sponsorship, Commercials, Product Licensing, Corporate Relations and Product Placement.

Copyright Kathryn Arnold

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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