How to recoup on Film finance Investment

Your daughter’s best friend just wrote the next Hangover, only it’s about a bachelorette party instead of a bachelor party, and the script is hilarious. Even better, your daughter will get to star in the movie if her highly reputable (and flush) father helps finance the movie. Great…for your daughter and her aspiring filmmaker bestie. But for you dad, just how exactly are you going to get your money back if you finance the project? Allow me to introduce you to the film distribution waterfall.

What to do Before you Invest

Before you pony up a penny, the filmmaker must be able to show a clear path to recoupment. This is why you need to see a clearly thought out, well-researched, realistic finance and business plan. If the filmmaker knows what she is doing, she will have already thought about how the movie will be marketed and distributed. This is important because this is how you recoup. If there is no plan in place, then you might as well call the investment a gift, because you’re not recovering a single cent. As a father myself, I’d just buy her the mini coup your precocious teen wanted instead. At least you know you’re buying a depreciating asset there. But to finance a film project, the project needs to have buyers, and those buyers need to be anticipated BEFORE the movie goes into production. This realization often distinguishes the pros from the amateurs.

Now let’s pretend the film has a business plan. Okay we’ve jumped over one hurdle, but we are nowhere near done with the race. Does the business plan have a realistic recoupment schedule?  What is the distribution strategy? In our hypothetical bachelorette’s Hangover movie which for simplicity’s sake I will call “The Bachelorette’s Hangover”, we have a comedy, probably which will star 3 to 5 females. From an investor’s perspective, you should be on alert if the business plan relies on foreign sales for recoupment. I don’t know if you’ve ever watched a foreign comedy on a plane before, but I have. Humor is not like horror. I can be scared with subtitles, but it’s harder to get the joke. In other words, a distribution model that relies on foreign sales for recoupment is better suited for a Horror film, but not so much for a comedy. This is why it is important to not only demand a business plan, but to know how to analyze whether the plan makes sense based on the genre, story-type, the level of director and cast, etc. that the plan revolves around. Hence, the recoupment schedule must be unique and tailor-made for the particular type of film or TV program to be produced. An experienced entertainment attorney will help you analyze these deal points and can assess risk vs. reward before you commit.

I already invested. I just want to know when I can recoup…

If you read this blog post too late (or if you read the post and decided that The Bachelorette’s Hangover really is the next Hangover franchise and committed investment dollars anyways) the next question becomes – how do I recoup? This depends. The process of structuring the recoupment schedule is done when the producer/filmmaker or their attorney negotiates the agreements between the production company and the talent, investors and distributor(s).  Therefore, the order in which the monies are paid out – and to whom – will vary from one project to another. For example, a film shot in New Orleans may be entitled to Louisiana tax credits. Are these funds allocated to you, the investor who put first money in? Or will these funds be used by the production company to cash flow production? This needs to be negotiated in your film financing agreement BEFORE you commit funds. Absent a film finance agreement, most likely the filmmaker will keep the tax credits and apply it to production costs, or if all costs have been paid for, maybe they use the funds to buy that mini-coup! Of course I’m kidding, but only partly — that’s why detailed contracts at every stage are crucial in order to guarantee timely, first priority recoupment (if available).

Note that priority of recoupment is a negotiable item that can change over time. For example, say you are first to invest in The Bachelorette Hangover but the movie doesn’t get made unless Anna Kendrick plays the lead — and Anna wants to be named as producer with first position for distribution! Because you loved Anna in Pitch Perfect you agree to modify your film finance agreement so that Anna can take first position once distribution proceeds are recouped. This happens all the time, but it is an outcome often overlooked by new film financiers. Just because you are first in line when project starts, that doesn’t mean you are first in line to recoup by the time all parties attach to the project. Bear this in mind when you are evaluating the business plan — is the main star already attached? Is anyone else first in line to recoup ahead of you? Can this be negotiated?

Another question impacting your recoupment — how was the remainder of the film’s budget financed? There are many financing structures available, from slate deals to split rights, negative pick-ups, and a host of other structures your attorney should help you analyze, if applicable, each of which can increase the complexity of the recoupment schedule. A well-structured business plan will detail all financing necessary to complete the film’s budget and will also detail before you invest how each financier is to be paid, and in what priority, prior to the rolling of a single camera. If you didn’t guess already, this is again where I recommend having an experienced entertainment attorney in your corner before you take the plunge.

Time to Collect — Film Tax Credits

Film incentives/tax credits/government subsidies all play crucial roles in facilitating the development and production of various film projects. These incentives help to mitigate the risk of investing in motion pictures, which in turn encourages investors like you to get involved with a film finance venture in the first place. So if, for example, The Bachelorette’s Hangover has a big Mardi Gras sequence and production is set to take place in New Orleans, you as an investor should evaluate the state’s then available tax incentives. This is your first opportunity to recoup. Just note these incentives vary by location and are always subject to change, so stay diligent.

In general, a production can get back up to 80% of their budgets from government subsidies, tax shelters and tax schemes, grants and film funds. Therefore, if the production company takes advantage of a particular country or state’s film incentives, tax credits or rebates, and if thereafter the film is actually made to completion, the investor should expect to begin to see a return of some or all of their investment, even before the film is sold, thanks to these incentives.

Note however as we discussed earlier — if the production qualifies for tax credits, you may want to ensure that the funds are not used to cash flow the production. Instead, the tax credit can be used to secure the financing in debt or production loan, by either a bank or investors lending against the tax credits. The drawback here however is that this strategy usually involves interest and finance charges, and usually puts the lender in first position for repayment of the loan and interest. In addition, usually the lender will finance no more than 80% of the face value of the tax credit: they will discount it by a certain percentage to account for risk. Furthermore, as a prerequisite for a production loan, a bank or production lender will require the production company to obtain a completion bond (completion guarantee), which can further impact the recoupment schedule.

Therefore, if you’re able to qualify for Government subsidies, that doesn’t necessarily mean the filmmaker has to increase the films’ budget incrementally. The filmmaker may use the tax credits or rebates to pay you back, rather than scaling up the budget because of it. In this scenario, up to 80% of your investment can be secured by subsidies. These government subsidies can act as a partial safety net for your investment, which will be especially useful if the movie flops at the box office and/or on VOD.

It is important to note, however, that the bigger the budget, the greater the risk for investors. Therefore, as budgets get bigger (budgets $3 million and up) it is generally much harder to secure all of the budget in equity, and thereby the need to cash flow the production with the tax credits and foreign pre-sales.

Recoupment stream #2 — Pre-sales

Foreign pre-sales are a key source of revenue for independent films, and can serve as a primary source of collateral for a production loan since the project may not be able to get a cash advance (up-front money) to pay for production and post-production expenses or to pay back the early equity investors like yourself.

But pre-sales are not attractive to all investors. While it is common to see the financing plans for projects with budgets $3 million and up consisting of foreign pre-sales, it is not so common below $3 million. In addition to the lack of a pre-sellable talent for smaller budget movies (as most foreign markets require at least B-list talent attached to even consider a pre-sale engagement), the added fees and finance costs and any discounting that will take place for a foreign pre-sale deal often makes the deal impractical for lower budget films.

Very few independent films are pre-sold for a multiple of its production budget. Therefore, very few films will see the investor recoup from a sale at the script stage or the initial sale at a major film festival premiere or film market, such as Sundance, TIFF and AFM, unless the project has recognizable stars attached to the project at time of pre-sale.

In addition, typically, you as an equity investor do not receive recoupment from the territories and markets that are subject to pre-sale financing, especially if the Minimum Guarantee (MG) was used to secure a production loan. Therefore, be careful whenever a business plan mentions foreign pre-sales in its distribution model. In most cases, no matter how well a film performs in a given territory, market or medium, the only money the producer will recoup to pay you back is the MG.

Distribution — Your Upside

For a film to actually generate revenue, it needs to be distributed. Whether or not this means theatrical distribution, utilization of streaming services or direct-to-digital release, you as an investor should know, based on the business plan, how the film’s release-type will affect your recoupment schedule.

Unless the project will be self-distributed (e.g., Reelhouse, Tugg and VHX), having a good sales agent will be crucial to successfully distributing the project. A film sales agent will be able to provide the filmmaker with some sense of the estimated value of the film before she brings it to the film market and festival circuit. Having a sales agent attached early on thus is crucial, since the agent can assess the market value of your film before you finalize your film budget. As an investor, you should be asking whether the sales agent has been engaged. After all, what good is it to put $20M into the Bachelorette’s Hangover if the movie is only estimated to gross $12M worldwide? Some filmmakers, especially experienced ones, will act as their own sales agents, which is fine. But their business plan will use comps (comparable film outcomes) to project low and high-end sales outcomes for their project. But be careful how you as an investor analyze box office comps as an indicator of another film’s potential success, as investors usually make their money back off territory sales once the film is completed, not box office sales.

The film went digital — but is anyone watching it?

Digital distribution is quite popular — but just because you can search and find The Bachelorette’s Hangover on Hulu, that doesn’t mean you’ve earned your money back. if you as the investor plan to finance a direct-to-DVD or straight to VOD film, the filmmaker can’t just throw the movie out there and expect it to make money. Unless the producer is willing to do a full-on marketing campaign and mini theatrical release, deployment of this distribution model is unlikely to generate recoupment of investment in and of itself. This model needs eyeballs, and a lot of them, to recoup. For it’s not just about getting the film on Netflix, Amazon, Hulu, etc., It’s about getting people to watch the film on Netflix, Amazon and Hulu. To do that, a good business plan budgets for marketing expenditures on either a small theatrical run and/or publicity campaign to drive sales. Absent these numbers, a plan predicated on digital distribution is doomed to fail.

What if we made the movie into a TV series?

Not a bad idea, but note the recoupment schedule is quite different if you’re making a TV series rather than a feature film. Television rights are currently the largest source of income for feature films, far more money than theatrical, DVD, VOD and streaming. However, each film will have a different income pattern, and some will earn more on other platforms than they do from television. If your content is suitable for TV adaptation and there is a plan for such adaptation, you as an investor want to make sure you participate in this derivative source of income before the rights are sold.

Private Equity/Debt/Co-financingS

State and federal securities laws require filmmakers to provide potential investors with accurate information so that they can make informed investment decisions. Investments garnering more than $500K should be accompanied by a PPM (private placement memorandum) disclosing all material terms of the investment, from principals involved, disclosure of other investment participants, project details, and numerous other elements that an experienced securities and entertainment attorney can provide.

Recoupment problems can occur when there are too many investors and/or the filmmaker gives away too much of the equity to initial investors, stake holders and collaborators, without leaving much room for others to come onboard the project later. Under the terms of most co-financing deals, the new investors are often the last in line to get back their investment.

Another problem pertains to seeking additional investmetn for P&A (print and advertising). P&A investment are generally riskier than production investment: The P&A investor comes in last (although some deals can be structured so that the P&A financing is “last in and first out”), and if the movie is a flop at the box office, the P&A investor loses all their investment.

As an early stage investor, be mindful if the business plan does not leave room for late-stage investment, as your terms may be renegotiated if, for example, P&A financier requires a last-in, first-out deal to participate.

To avoid or limit recoupment problems when there are too many investors, the investment should be structured using a single equity source (an individual or institutional investor, equity fund or venture capital firm) or a co-financing with a distributor.

Deferred Compensation

Deferred compensation is a production expense that covers income earned but not paid to talent. For example, if a producer chose to invest or defer his/her fee in the movie (called deferred producer’s fees), you as early stage investor should be aware of how these deferred payments affect your recoupment position in the revenue waterfall.

Deferred compensation can be paid out of gross revenues, net receipts, or paid before, with or after equity investors. The filmmaker will need to address these issues regarding the timing of payment of all deferments, answering at outset whether they to be paid out of first dollar participation, adjusted gross, net profits or producer net profits.

Profit Participations or Contingent Compensation

Profit participation (also called contingent compensation) is payment in the form of a share of the “profits” to talent, financiers, sales agent, and other stake holders and collaborators, based upon a percentage of “gross receipts” or “net profits” from a motion picture. Profit participation was designed to enable producers, writers, directors, actors, music composers, equity investors and others to participate in the financial success of a motion picture.

A-list talent sometimes work at scale (at lower fixed compensation levels) – if the project is right – in exchange for a higher back-end (profit participation). As such, a filmmaker may use contingent compensation as an important tool to attach name talent and experienced cast. Then, if the movie turns out to be a hit, a relatively small percentage of the profits can yield a tremendous return for a participant.

However, due to the malleable nature of the definition of “gross receipts”, whenever talent says they want profit participation on gross receipts, the producer or their attorney needs to ask, “which gross receipts?”

Types of Profit Participations:

There are two basic types of profit participations: gross profit participations and net profit participations.

1. Gross Participations

• First Dollar Participations – This is gross participations based on the gross receipts (including discounts and rebates) earned and actually received by the distributor from all markets, territory and media (before any deductions for distribution fees or distribution expenses, production costs (negative costs), before equity investors and private lenders recoup their equity investments or loans, respectively, and deductions for deferred compensation and participations for talent and financiers).
• Deductions “Off the Top”– This is gross participations that is not a “first dollar” participation. It includes certain “off the top” deductions, including certain distribution expenses, such as sales taxes; guild payments (residuals); trade association fees and industry assessments; conversion/transmission costs; collection costs; checking costs; and advances not earned. P&A costs (sometimes referred to as “releasing costs”) typically are not included in “off the top” deductions.
• The “Adjusted Gross” Participation – This is gross participations on gross receipts after deducting the “off the top” deductions plus distribution fees (such as P&A costs) and any advance/MG paid by distributor. The size of the distribution fee generally increases with the amount of the MG, since the distributor’s risk of not recouping the advance is greater. These are the sums the production company receives from the distributor and are usually referred to as the “adjusted gross”. These gross receipts are usually called the production company’s gross receipts.

2. Net Profit Participations

• Net Profits – Net profit participations are usually based on the gross receipts remaining after deducting the distribution fees, distribution expenses, negative cost (this is how much it costs to produce and shoot the film), interest on negative cost (this is usually interest on the investment), production company overhead, deferments and gross participations, and adding back tax incentives and rebates.

Note that there are a thousand or more ways that gross proceeds can be measured or defined. As a result, the above is a simplified version of determining “gross profit participations,” “net profit participations,” “gross receipts,” “net profits,” “net receipts” or the timing of participations. A more in-depth analysis is beyond the scope of this article. The bottom line is that there are a dozen different ways to structure an investment agreement, and it will be crucial to have a good attorney to work through the process with you.

Payment of Residuals to Unions and Guilds

If it is a guild/union picture, applicable collective bargaining agreement usually requires the production company to pay residuals (aftermarket payments) to the respective guilds or labor unions, such as the American Federation of Musicians (AF of M or AFM), Directors Guild of America (DGA), Screen Actors Guild‐American Federation of Television and Radio Artists (SAG-AFTRA), Writers Guild of America (WGA) and International Alliance of Theatrical Stage Employees (IATSE). As mentioned above, these residuals that are due to any talent or other persons employed in the production of the picture are usually deductible “off the top” as a distribution expense. These “off the top” deductions are typically from pay television, cable, home video (DVD, Blu-ray, videocassette) and free TV exploitation. Although no residuals are due for worldwide theatrical exploitation, these can amount to substantial payments to the talent guilds. The production company is responsible for these residual payments. However, the guilds or labor unions may require the production company to have the distributor sign an assumption agreement requiring the distributor to pay the residuals directly to the guild or union.

Sharing Revenues Amongst Co-producers

Co-productions may be based on the collaboration between two or more producers from the same or different countries for the creation of a film or television program, for example, a project that is an official treaty co-production amongst two or more countries under a bilateral agreement.

A co-production may include a reduction in the cash needs of the production budget and reduction in the recoupable cost of production. A co-producer may have put equity in the project or may have otherwise contributed to the project (eg. by securing distribution in particular territory or attaching talent or other valued production asset). Another example — a foreign co-producer may pre-buy the film in exchange for a license fee or MG (in cash) plus goods, services and facilities (i.e. equipment, use of the studio or station’s production staff and access to sound stages, edit suites, etc.) and it may allow producers access to soft money, such as tax incentives, grants, soft loans and equity investments.

Each co-producer may recover their recoupable cost of production, first from their country, and secondly from a share of revenues from the rest of the world. Each co-producer may also be entitled to receive deferred producer fees from the revenues and may also participate in the net profits.

Timing of the Recoupment schedule

The following are, in general, some of the things your investors will need to account for in terms of recoupment:

• It may take 18-24 months from completion of the film through to the film’s sale and start of any positive cash flow.
• Some equity funds try to recover P&A principal and interest within 12 months of placement of principal funds.
• The timing for VOD revenue greatly depends on any adherence to the theatrical windowing model, before VOD release or streaming them for Netflix, Hulu or Amazon Prime subscribers.
• Depending on whether it is a union/guild picture and what back-end agreements were struck with talent, residual payments and talent participations might kick in, usually within 60 days of the film’s release.
• In some states, the turnaround time for getting the tax credit is generally 30 to 60 days of submitting the final application for a Tax Credit Certificate. However, during high queue seasons, it can take as long as 16 to 18 months after completion of production to get the tax credit, and it can take years for a film to file all the paperwork necessary to get the (up to) 30% reimbursement for production costs.
• Once the production budget and any preceding overheads and development costs are recouped, the film is said to have reached its point of profitability or break-even point. This then triggers net profit participations, and only then. But, since interest continues to accrue until production costs are fully recouped, interest (together with distribution fees and expenses which are also recouped first), repayment may forestall net profit participations until repaid in full.
• So as an investor, lower budget projects may be attractive the lower the budget, the sooner the project is likely to reach a break-even point — in turn improving the internal rate of return on the investment.