Do You Want to Invest In Films? Don’t Make These Mistakes
The story you are about to read is (mostly) true. The names have been changed to protect the innocent (and the not so innocent).
Meet Mark. Mark is a very successful litigation attorney. He specializes in handling class action lawsuits. Over the past twenty years or so, Mark’s firm has won over a billion dollars in judgments and settlements for his firm’s clients.
After all this time spent fighting the good fight, Mark has decided that the time has come for him to move on to the next phase of his life. Mark is retiring from the practice of law and is selling his interest in his law firm to his partners. Cashing out will bring Mark a very sizable return that should leave him set for the rest of his life. In addition to moving on from his law practice, Mark is about to be married to a new wife who is truly the love of his life. Things couldn’t be going much better for Mark.
Shortly after Mark announced his retirement, a friend of his introduced him to Jake. Jake is a film producer who, until recently, lived in a spacious beach house in Malibu. Jake had just moved to Mark’s state because it has a very generous film production incentive program. Jake believed that becoming a resident would qualify him to participate in the incentive program and use the money he got from the state to help finance his films.
Jake was every bit the slick Hollywood producer. He dressed well, drove an expensive, flashy car, lived in a fantastic house, and had a gorgeous young girlfriend. Jake was very smooth and very personable. Not surprisingly, Jake and Mark hit it off instantly. Mark saw Jake as the kind of person he aspired to be as he started this next phase of his life. Not long after they were introduced, Mark and Jake became fast friends and saw each other socially on a regular basis.
A few weeks after Mark and Jake first met, Mark finally closed on the sale of his interest in his firm. After hearing the good news, Mark and Jake made plans to have dinner to celebrate Mark’s good fortune.
During dinner, Jake told Mark about a new film project that he was working on. The new project would be an exciting action/adventure film, and Jake was convinced that he had managed to line up an A-list star actor (let’s just call him “the Star”) to play the lead. Things were starting to come together very quickly, and Jake was sure that this film would be a huge hit. There was just one small problem. Jake was having some difficulty raising all of the money he needed to make the film, including an investment of approximately $1 million to jump-start the production. Jake suggested to Mark that now that Mark had hit the big time, financially, maybe he would be interested in investing in Jake’s film.
Not surprisingly, Mark was a little hesitant at first. But Jake was a very good salesman. Jake told Mark that he had already secured most of the financing he needed and that he had a written commitment from an established film lender to loan him most of the money he would require to fully fund the budget. Part of Jake’s problem, however, was that the loan was going to take another month or two to close (paperwork, lawyers, red tape, etc.) and he needed at least $500,000 now to lock in the acting services of the Star.
Jake suggested to Mark that he could structure his investment in a way that greatly reduced Mark’s risk. The first $500,000 of the financing (the money that Jake urgently needed as soon as possible) could be structured as a loan to Jake’s production company, with the understanding that the loan would be repaid in full when the permanent loan from the senior lender closed. At most, this loan would be outstanding for about sixty days. The balance of the financing would be an equity investment in the film, which would earn Mark a 25% return on top of the amount of his investment. Mark definitely perked up when he heard that. A 25% return would be much better than what Mark could earn if he invested that money in the stock market. Jake also told Mark that in addition to getting interest on his short-term loan and the big return on his equity investment, Mark would get an executive producer credit on the film along with a producing fee of $250,000. Jake also told Mark that he should be able to secure acting roles in the film for Mark’s son and Mark’s bride-to-be.
At this point, Mark was beginning to think that this was too good an offer to pass up. Mark admitted to himself that he had absolutely no experience in the film industry. But Mark’s son (for whom Jake was going to get an acting role) had just graduated from film school, and Mark was certain he could look to him for advice to make up for his own lack of experience. Mark told Jake that he was intrigued with the proposal but that he needed a little time to think about it.
The day after their dinner, Jake sent Mark a copy of the film’s script, a summary of the project, a proposed financing plan, a copy of the film’s budget, projections from the film’s sales agent that showed how much the sales agent thought the film might earn from sales to foreign distributors, and a draft letter of intent for Mark’s financing. The budget showed that the cost to produce the film would be $10 million. However, the sales estimates were based on a budget of $6 million. Mark didn’t really pick up on that difference.
After he’d had a chance to look at the package that Jake had sent him, Mark set up meetings with Doug, the film’s director, and Paul, the loan officer who was handling this project for the senior lender. Doug reaffirmed everything that Jake had told Mark and also told him that the Star would be the perfect lead for this film. Paul confirmed to Mark that his company had in fact committed to make a loan to fund a portion of the cost of the film, but he also explained that his company would not have any obligation to advance any funds unless and until the loan actually closed. Mark and Paul did not discuss the concept of Mark’s initial loan being repaid out of the senior loan proceeds when that loan closed. They did, however, discuss the film’s proposed budget, and Paul told Mark that, as far as he knew, the budget was around $8.5 million.
After having a few more discussions with Jake, Mark decided to go ahead and make the investment. Jake immediately sent Mark a draft of a long form investment agreement, and just a week after the dinner when this first came up, Mark signed the investment agreement and sent Jake’s company $1 million. This is when things started to change.
Two months after Mark sent his million dollars to Jake’s company, Mark began to wonder when he would be getting back his $500,000 loan. Also, he had not heard anything further about the acting roles for his now wife and son. Mark went to the film’s set to visit with Jake to find out what was going on. This is when Jake dropped the bombshell.
It turned out that the film’s sales agent was not able to close as many foreign presales for the film as originally anticipated and the value of the sales that had closed was less than expected. Because the anticipated revenue from these presales was a key part of the collateral for the senior lender’s loan, the senior lender had to reduce the amount of its loan by an amount equal to the shortfall. This meant that there would be less money to make the film, and that meant Jake had to cut the budget to make up for the shortfall. However, cutting the budget meant that the amount of the anticipated production incentives for the film would also be reduced (the incentives were calculated based on how much money was being spent in the state). The production incentives were also part of the senior lender’s collateral, so this further reduced the amount of the loan.
To pare back the budget, Jake cut a few acting roles from the film (in particular, the ones that would have gone to Mark’s wife and son) and also cut back on many of the producing fees that were originally included in the budget (including Mark’s $250,000 fee, but not Jake’s own fee). So when the original sixty-day window came and went, instead of being repaid his initial loan and receiving his producing fee, Mark got nothing. From there it got worse.
While Jake ultimately did finish the film, it turned out not to be the smash hit that he told Mark he thought it would be. The reviews were brutal. No one liked this film. Consequently, the sales agent was not able to obtain any additional foreign sales, the film was never released theatrically in the United States, and the streaming sale they did make generated far less in license fees than originally anticipated. To make matters worse, the production company got into a dispute with the state over the production incentives (which were to be in the form of transferable tax credits), and, as of the writing of this article, the tax credits have still not been issued.
Because the sales were less than anticipated and the tax credits have not yet been issued, the senior lender has still not had its loan repaid in full. When it comes to the hierarchy of how financing on a film is recouped, a senior secured lender is always in first position, and no one else will see any money until that lender has been repaid in full. And since the senior loan is now in default and is accruing default interest and late payment fees, the likelihood that this loan will ever be repaid in full becomes slimmer and slimmer with each passing day.
As of today, Mark is closing in on the third anniversary of his fateful dinner with Jake and the funding of his investment in Jake’s film. In an effort to mitigate his damages, Mark has filed a lawsuit against Jake, Doug, the film’s production company, the senior lender, and others alleging, among other things, breach of contract and fraud. The likelihood of Mark’s lawsuit making it past a summary judgment motion is slim to none. The most likely outcome is that Mark will never see a dime from this film and his entire investment will be lost.
So, what mistakes did Mark make? Let’s start with how he handled the investment from the outset. When Mark got the package that Jake sent him, he looked it over, but he had no idea what he was looking at. Mark had never seen a film budget before, nor did he know how to determine whether the budget made sense given the nature of the film. Mark should have sought advice from an experienced film finance professional who could have evaluated the materials that Jake had sent him and let Mark know whether this looked like a good investment. For example, an experienced professional would have immediately picked up on the discrepancy between the amount of the budget that Jake sent Mark, the amount that was referenced in the sales estimates, and the amount that Paul told Mark was the film’s budget. Also, sales agents are notorious for inflating their sales estimates, so an experienced financier would have discounted the amount of the estimates before determining whether it looked like the film might generate enough revenue to fully recoup its costs.
The next big mistake that Mark made was not hiring an experienced film finance lawyer to review both the letter of intent and the investment agreement that Jake ultimately sent him. I suspect that Mark considered himself to be an experienced lawyer who, with a little input from his film school grad son, could review the investment agreement and make sure he was protected. Mark couldn’t have been more wrong. No matter how good your lawyer is at doing what they do on a daily basis, if your lawyer does not have extensive experience in handing film finance matters, then your lawyer will be in over their head. Mark was in way over his head.
Now you may be asking, what are the things that an experienced film finance lawyer could have done that Mark didn’t do? The list is long. First off, let’s start with the structure of the transaction itself. As Jake requested, the investment was split into two parts. The first part was intended to be a short-term loan to the production company, and the second part was a longer term equity investment in the film. The type of short-term loan that Mark made is typically referred to as a “bridge loan.” The purpose of a bridge loan is to provide the production with some immediate cash while it is waiting for the long-term financing to close. Bridge loans are, by their nature, among the riskiest types of film investments that one can make, and they really should be done by only experienced film investors. The reason they are so risky is that not all of the film’s financing is in place at the time the bridge loan is needed so there is always the possibility that the permanent financing might not materialize and the film might not get made. In that case, the bridge loan is usually a total loss.
While bridge loans are quite risky, a bridge lender can take certain steps to minimize the risk. First, the bridge lender should undertake an exhaustive review of the transactions that will comprise the permanent financing to ensure there is a good likelihood that the permanent financing will close and will be made available to the production. This would include reviewing drafts of the loan agreements for any anticipated production loans and reviewing all of the proposed equity investment agreements. In the case of Mark’s bridge loan, he was told by Jake that his loan would be repaid out of the proceeds of the senior production loan. Given this, Mark’s lawyer would want to review the senior lender’s loan documents to ensure that they included an express provision for the repayment of the bridge loan when the senior loan was funded.
Another key mistake that Mark made is that he didn’t take a security interest in the film and its underlying rights as security for the repayment of his bridge loan. If an investor is making a bridge loan, this is absolutely essential. If for some reason the anticipated financing falls apart and the producer can’t get the film made, at a minimum, the bridge lender can foreclose on its lien, which would give the bridge lender the opportunity to try to get the project produced somewhere else. Also, if the bridge lender has a first position security interest in the film, the senior lender will not be able to close its loan without coming to some sort of agreement with the bridge lender. The reason for this is that the senior lender will also insist on having a first position security interest in the film, and that won’t be able to happen unless either the bridge lender is paid off and terminates its security interest or it subordinates its lien to the senior lender’s lien. Either way, the bridge lender is in a much better position to ensure that it is taken care of when the senior loan closes.
In the case of Mark’s bridge loan, since he didn’t have a security interest in the film, the senior lender was basically able to ignore Mark’s loan and proceed to close its loan without regard for whether Mark’s bridge loan was paid off. With regard to the equity investment portion of Mark’s financing, the main reason that was never repaid was because the film didn’t generate enough revenue to repay the senior lender. Still an experienced film finance lawyer would have insisted certain requirements be included in Mark’s investment agreement that would have provided Mark with additional protections.
The investment contract that Jake sent Mark was a simple agreement stating that if and when the film earns any distribution revenues, some of that money would be used to pay back Mark’s equity investment plus his preferred return. That’s fine as far as it goes, but there are better ways to structure these types of transactions from the investor’s perspective. Also, this doesn’t take into account the production incentives that Jake tried to get. An experienced film finance lawyer would have insisted that all money that the film generates (not just the distribution revenues) goes to repay the investors before the producer gets any of that money. The senior lender was looking to the production incentives to be repaid. There’s no reason why the equity investors should not have recourse to any excess incentive revenues to recoup as well.
Jake mentioned that he had set up a special purpose company to produce the film. In all likelihood, this was a limited liability company (LLC). LLCs are owned by the members of the company. So the first thing a film finance lawyer could have done was insist that the equity portion of the transaction be structured with Mark buying a membership interest in the LLC, rather than just being a passive investor. This would have ensured that Mark would have been entitled to a share of all of the money that the LLC earned (like the excess proceeds from the production incentives). This would also mean that if the film were successful and Jake decided to produce sequels, Mark would be able to participate in the revenues from the sequels as well.
Another structural option that could have been explored would have been for Mark to negotiate with the senior lender to structure his equity investment more in the form of a secured loan rather than an unsecured investment. If, instead of giving his money directly to Jake’s company, Mark had purchased a participation in the senior lender’s secured loan, he would have had a much higher level of protection (and could even have potentially foreclosed on the film) if he was not repaid.
Leaving aside the secured lender option (which is not always available), the next thing that a film finance lawyer would have done is to require that Mark’s equity investment be placed in an escrow account where it could not be touched until the production had secured all of the financing necessary to fully fund the film’s budget. This would have ensured that if for some reason Jake wasn’t able to raise all of the money necessary to make the film, Mark would have at least gotten his equity investment back in full.
The next big mistake Mark made was not insisting on a completion guarantee from a reputable completion guarantor that secured the repayment of his equity investment if the film was not completed. A completion guarantee is a contract between a financier and the completion guarantor in which the guarantor agrees that the film will be completed and delivered to its distributors, failing which the guarantor will repay the financier’s investment in full. In addition, the guarantor also agrees to come out of pocket to fund any over-budget costs that may occur. In this case, while there was a completion guarantee that covered this film, Mark was not a beneficiary of the guarantee. So if the film was never completed, Mark would not have been repaid. I cannot overemphasize the importance of having a completion guarantee. Making an investment in a film without one is irresponsible at best.
The last thing that a film finance lawyer would have insisted on is the use of a third-party collection agent to collect all of the film’s distribution revenues (or at least all of the revenues that were paid after the senior lender was repaid in full) and pay them to the parties that are entitled to share in those revenues per an agreed-upon disbursement schedule. Having a collection agreement in place for this film would prevent any diversion of funds after the senior loan was repaid, since the production company itself would not have any control of the distribution revenues. Having a structure of this type in place is key to ensuring that an equity investor is at least being treated fairly.
These are some of the key areas where using an experienced film finance lawyer can be to your benefit. On top of this, the film finance lawyer will most likely have existing relationships with and access to important film industry banking and loan executives that can work to your benefit. Can using a film finance lawyer guarantee that you will be repaid in full and get your preferred return? No. No one can guarantee that, and Mark’s experience is a perfect example. Investing in films is inherently a risky venture. If the film performs well, you could end up making a substantial amount of money. If the film flops, you might lose your entire investment. But if you do use a film finance lawyer, at least you can ensure as much as possible that you won’t be ripped off. So the next time you’re thinking about investing in a film, call me first. I assure you that you won’t regret it.
Contact:
G. Raymond F. Gross
[email protected]
Phone.: 310-557-8807
Website: www.ghplaw.com