BEN MATTLIN
BLOOMBERG WEALTH MANAGER, July/August 2003
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Private Equity:

Who Oughta Be in Pictures?

Hollywood glitz and the potential to make a killing while making a movie are irresistible to some investors. But make sure interested clients understand the ins and outs

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Ben Mattlin

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THE FINANCIAL BACKERS OF THE FILM My Big Fat Greek Wedding looked ingeniously prescient last summer.  The movie, made for a mere $5 million, topped $110 million in box-office receipts between its April opening and September—a five-month period in which the Standard & Poor’s 500 stock index plunged more than 20 percent.

    Of course, box-office receipts don’t go straight to investors. Most of the intake is shared with distributors, who bear the above-budget costs of advertising and making copies, or prints, of the movie. Still, strong box-office receipts generally translate into plenty of cash in investors’ pockets. And there’s still the potential for video, DVD, airline, cable TV, network TV, and someday satellite or video-on-demand rights.

    True, success stories like Greek Wedding are few and far between, but Hollywood’s allure, combined with the possibility—no matter how remote—of bagging huge gains, can make film financing irresistible. And as long as there are even a few success stories, aspiring film impresarios as well as wealthy individuals seeking to diversify investments will no doubt continue to venture their capital. If your client falls into these categories, there are several things you need to know.

    Producers looking to fund a film begin by entering into a partnership with one or more investors. Typically, such a deal is structured as a pass-through entity like a limited liability corporation. This protects investors from personal liability for any problems or debts incurred by the partnership and exempts the partnership from being taxed as a separate entity. The investor agrees to provide a certain amount of money in return for which the producer agrees to make the film within a predetermined budget. Once the film is complete, the producer is obligated to try to sell it to a distributor. The distributor buys the rights to the film for a particular territory, medium (theatrical film or video, for example), and period of time, typically 15 to 25 years.

    If the production company either fails to deliver a completed film as contracted or completes the film but fails to sell it to a distributor, the investor may be able to take a tax deduction, depending on his or her circumstances. In some cases, the investor may be able to write off the forfeited investment as a total loss. However, “you can’t take the loss while the film is still in production,” unless the agreed-upon completion date has passed and it’s become clear that an acceptable film will not be made, says Douglas Burack, a partner at Lutz & Carr, a New York accounting firm perhaps best known as the vote-counters for the Tony Awards. “Until the film is finished and ready for distribution, you won’t be able to convince the Internal Revenue Service you made a disastrous film. You have to be able to show that you have a bomb on your hands.” Even so, films aren’t ideal tax shelters; losses from ongoing operations are deemed “passive activity” losses and can only be written off against passive activity income or gains from other partnership-related investments.

    If a distributor offers to buy the movie rights, your client is looking at a different set of circumstances. For example, the distributor might not be willing to pay enough to compensate backers fully for their initial investment. In that case, investors will still have expenses to write off against any future income. To figure the tax implications, "you have to work from the concept of income-stream forecasting," says Burack.

    To do this, it’s necessary to estimate how much income the film is likely to generate over its life. For example, suppose an investor contributes $1 million to make a film that’s estimated to bring in $3 million over its lifetime. If by the end of the first tax year it’s made nothing, none of the $1 million outlay may be written off. But then, in the second year, suppose the film earns $1 million from its initial distribution. That’s a third of its lifetime estimated income, so a third of the investment—in this example, $333,000—may be written off against the $1 million of income. And so forth. “The cost is picked up pro rata against the income,” Burack explains.

    Estimating a film’s lifetime income can be difficult and should be left to producers and other industry experts. “Look at how comparable films performed,” advises New York entertainment lawyer John Sloss. “Was there a big enough audience for similar movies? You have to be methodical and do your homework.”

    A qualified sales agent, who typically works for the distributor, can calculate a movie’s marketability and likely proceeds, too. “I wouldn’t go near a film project unless there’s a reputable sales agent attached, to give it legitimacy,” says Beverly Hills attorney Greg Bernstein. “It’s a good rule of thumb to set the film’s budget at no more than half of what the sales agent estimates it’ll take in.”

    One tax advantage of financing a film: None of the income is subject to Social Security or Medicare taxes, because it’s a distribution from profits and not a salary. Still, profits are taxable as regular income, not capital gains—unless the investor has taken a share of a production company, which is another sort of arrangement. But, revenue from the film isn’t taxable until the money is in hand, unlike with some other types of corporate entities.

    Preselling a film to a distributor—based on the strength of its script or the reputation of the producer, director, or actors involved—takes some uncertainty out of the equation. But such agreements often have a complex structure that make tax ramifications difficult to predict. For example, a company buying U.S. distribution rights might pay a relatively low flat fee at the outset—say, $1 million—with the understanding that after an agreed-upon time period, the distributor will turn over a percentage of box-office proceeds. “If the film fails at the box office, you still get $1 million,” Burack points out. “But then, when box office reaches perhaps $10 million as reported in Variety, you get an additional $100,000. At $12.5 million, you get, say, another $100,000.”

 

Before you can take a tax loss on a film, "You have to be able to show that you have a bomb on your hands"


   
This is a hypothetical example, but it illustrates the potential importance for tax purposes of box-office “bumps,” as these levels are called. In addition, film investors could receive still more revenue through ancillary distribution rights for other regions—like Europe or South America—and other media, such as DVDs or cable television, further complicating the tax picture. “Once these contracts are in place,” Burack observes, “it’s easier to estimate the film’s lifetime income. You know its minimum income, at least. And by the time the investor files a tax return, you might have an even better sense of how the film is received by audiences.”

    Of course, it’s always possible that a film written off as a total loss gains demand years later because, say, one of the actors has become a big star. Your client, thinking legitimately that the movie would never make a cent, has already taken a tax write-off. At that point, whatever profits that come in are fully taxable. If the movie is redistributed later, notes Burack, the investors will receive 100 percent of the income but have no costs to match up with those revenues.

    What if producers or distributors fail to deliver on their promises? The investor can sue for breach of contract, though it’s unlikely much of the investment can be recouped. Therefore, many entertainment attorneys insist on securing a completion bond before filming begins. Completion bonds are a sort of insurance policy that the movie will be made on time and on budget. If it isn’t, the bond issuer can take over the project and either pay off claims or finish the film, which saves the investor from being milked for additional funds by filmmakers. Some experts believe the investor should offer to pay for the completion bond himself or herself. “If you’re paying for a big budget movie already, what’s another $50,000?” asks Bernstein.

    Film producers seeking funds approach backers in a number of ways. Many will offer a prospectus or private-placement memorandum. The memorandum should spell out what the movie is about; who are the principals involved in its production; the number and size of shares, or investment units, available (for instance, 5,000 investment units in $1,000 increments); minimum and maximum investment size and number of investors; production budget; tentative production schedule; revenue payout schedule; and potential risks. As with all private placements, “the Securities and Exchange Commission generally limits the number of nonaccredited investors involved with a film to 35,” says Gill Holland, chief executive officer of CineBlast, an independent producer in New York. “Also, the producer can’t spend any money until there’s enough to make a sellable product.”

 

A good contract will specify how much each stage of production will cost

 

    Many film deals, however, involve only one or two investors. What’s more, many producers don’t have a private-placement document. These aren’t reasons to run away, but they are reasons to draw up a contract covering the same points that a private-placement document would. Make sure the producer signs the contract before any money changes hands. Any producer who refuses to sign such an agreement shouldn’t be trusted.

    Most producers and filmmakers will not welcome judgments from accountants or financial advisers about the artistic merits or likely success of a proposed film. Nevertheless, you should state any of your client’s preferences—such as no graphic violence or nudity—up front. And be sure to keep your eyes on certain numbers from the get-go. First, the contract or private-placement memorandum should specify the producer’s budget through completion of the film. That way, if for some reason the film isn’t finished as scheduled, your client will have legal recourse. Some questions will need to be answered. Can a film realistically be completed for the stated budget? Moreover, is the budget kept to a minimum so that there’s at least a chance that the backers will recoup their investment? Does the production company have general liability insurance? If so, are the premiums paid? Large expenditures or additions to the original budget must not be allowed without special permission.

    A good contract will specify that the budget covers four stages: preproduction, production, postproduction, and delivery of the film. It should break down how much each of those steps will cost individually. Preproduction should include the hiring of a director, the casting of roles, and the building of sets. Postproduction should explicitly cover picture and sound editing, music licensing, mixing, and the creation of posters or other print materials for publicity. Typically, the whole filmmaking process takes a year to 18 months. But some films can be made more quickly. “You could conceivably finance a movie in July, sell it at the Sundance Festival in January, and get some money coming in by February,” says Sloss. But that’s not likely.

    Second, the budget should include specifics about production costs. Many of these expenses, particularly cast and crew salaries, equipment rental, and laboratory costs can often be at least partially deferred until the film is finished, or “in the can.” But the total amount of deferments must be clear at the start. Check to see whether these fees have been negotiated at the going rate.

    Third, the contract or private-placement agreement must lay out a distribution sequence clarifying who gets paid when. For example, union members who deferred salaries must he paid first. The Screen Actors Guild is a powerful force. If any actors are due residuals, make sure the terms are clearly set and that the producer will handle these so the investor isn’t saddled with bills long after shooting stops.

    After deferred salaries—if there are any—are paid (which, again, should be specified up front as a separate budget item), investors should get some money back. If there’s more than one investor, each should receive a percentage of revenues in accordance with the relative size of his or her initial investment. Once the investment has been recouped, additional revenue is often split 50/50 between the investor(s) and the cast, crew, and creative team who deferred salaries. Once everyone has been paid a fair salary, any leftover revenue goes to the investors, who might share a portion of these profits with the producer who made the deal happen in the first place.

    Generally, film accounting is rendered quarterly, and investors receive distributions on a quarterly basis as the film realizes profits. If, that is, there are any profits. Because moneymaking movies are so rare, “it’s better to spread your risk,” says Holland. “Rather than putting a lot of money behind one film, your odds of success improve if you spread that money over several films.” This, of course, is the operating principle behind the big studios.

    Hollywood is notoriously full of charlatans who benefit from the virtually nonexistent oversight of filmmaking. But as Stuart Kleinman, a partner with entertainment-industry law firm Frankfurt Kurnit Klein & Selz in New York, observes, “Strangely enough, recent lack of confidence in the capital markets is almost making movies look like a wholesome business.”

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Ben Mattlin is a regular contributor to Institutional Investor and is working on a novel about Wall Street.

 

Bloomberg Wealth Manager, July/August 2003, pp. 33-36

 

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(Illustrations by Barry Blitt)