|
FINANCING INDEPENDENT FILMS
Independent
films can be financed in a variety of ways. In addition to a filmmaker
using his own funds to make a movie, the most common methods are:
1)
loans
2) investor financing
3) borrowing against pre-sales (a loan against distribution contracts)
4) distributor-supplied financing.
LOANS
Loans can be secured or unsecured. A secured loan is supported or
backed by security or collateral. When one takes out a car or home
loan, the loan is secured by that property. If the person who borrows
money fails to repay the loan, the creditor may take legal action to
have the collateral sold and the proceeds applied to pay off the debt.
An
unsecured loan has no particular property backing it. Credit card debt
and loans from family or friends may be unsecured. If a debtor defaults
on an unsecured loan, the creditor can sue for repayment and force the
sale of the debtor’s assets to repay the loan. If the debtor has many
debts, however, the sale of his property may not be sufficient to
satisfy all creditors. In such a case, creditors may end up receiving
only a small portion of the money owed them.
A
secured creditor is in a stronger position to receive repayment. In the
event of a default, designated property (the secured property) will be
sold and all the proceeds will be applied first to repay the secured
creditor’s debt. Unsecured creditors will share in whatever is left, if
anything.
The
advantage of a loan, from a legal point of view, is that the
transaction can often be structured in a fairly simple and inexpensive
manner. A short promissory note can be used and the transaction often
is not subject to the complex security laws that govern many
investments. Thus, there is usually no need to prepare a private
placement memorandum (PPM). Keep in mind that if the agreement between
the parties is labeled a “loan,” but in reality it is an investment,
the courts will likely view the transaction as an investment. Giving a
creditor a “piece of the back-end,” or otherwise giving the creditor
equity in the project, makes the transaction look like an investment.
The
difference between a loan and an investment has to do with risk. With a
loan, the entity that borrows funds, the debtor, is obligated to repay
the loan and whatever interest is charged, regardless of whether the
film is a flop or a hit. The creditor earns interest but does not share
in the upside potential (i.e. profits) of a hit. Since the creditor is
entitled to be repaid even if the film is a flop, the creditor does not
share in the risk of the endeavor. Of course, there is some risk with a
loan because loans are not always repaid, especially unsecured loans
that don’t have any collateral backing them. That risk is minimal,
however, compared to the risk of an equity investment.
PRE-SALE
AGREEMENTS
In a pre-sale agreement, a buyer licenses or pre-buys movie
distribution rights for a territory before the film has been produced.
The deal works something like this: Filmmaker Henry approaches
Distributor Juan to sign a contract to buy the right to distribute
Henry’s next film. Henry gives Juan a copy of the script and tells him
the names of the principal cast members.
Juan
has distributed several of Henry’s films in the past. He paid $50,000
for the right to distribute Henry’s last film in Spain. The film did
reasonably well and Juan feels confident, based on Henry’s track
record, the script, and the proposed cast, that his next film should
also do well in Spain. Juan is willing to license Henry’s next film
sight unseen before it has been produced. By buying distribution rights
to the film now, Juan is obtaining an advantage over competitors who
might bid for it. Moreover, Juan may be able to negotiate a lower
license fee than what he would pay if the film were sold on the open
market. So Juan signs a contract agreeing to buy Spanish distribution
rights to the film. Juan does not have to pay (except if a deposit is
required) until completion and delivery of the film to him.
Henry
now takes this contract, and a dozen similar contracts with buyers to
the bank. Henry asks the bank to lend him money to make the movie with
the distribution contracts as collateral. Henry is “banking the paper.”
The bank will not lend Henry the full face value of the contracts, but
instead will discount the paper and lend a smaller sum. So if the contracts
provide for a cumulative total of $1,000,000 in license fees, the bank
might lend Henry $800,000. In some circumstances banks are willing lend
more than the face value of the contracts (so-called gap financing) and
charge higher fees.
Henry
uses this money to produce his film. When the movie is completed, he
delivers it to the companies that have already licensed it. They in
turn pay their license fees to Henry’s bank to retire Henry’s loan. The
bank receives repayment of its loan plus interest. The buyers receive
the right to distribute the film in their territory. Henry can now
license the film in territories that remain unsold. From these revenues
Henry makes his profit.
Juan’s
commitment to purchase the film must be unequivocal, and his company
financially secure, so that a bank is willing to lend Henry money on
the strength of Juan’s promise and ability to pay. If the contract
merely states that the buyer will review and consider purchasing the
film, this commitment is not strong enough to borrow against. Banks
want to be assured that the buyer will accept delivery of the film as
long as it meets certain technical standards, even if artistically the
film is a disappointment. The bank will also want to know that Juan’s
company is fiscally solid and likely to be in business when it comes
time for it to pay the license fee. If Juan’s company has been in
business for many years, and if the company has substantial assets on
its balance sheet, the bank will usually lend against the contract.
The
bank often insists on a completion bond to ensure that the filmmaker
has sufficient funds to finish the film. Banks are not willing to take
much risk. They know that Juan’s commitment to buy Henry’s film is
contingent on delivery of a completed film. But what if Henry goes over
budget and cannot finish the film? If Henry doesn’t deliver the film,
Juan is not obligated to pay for it, and the bank is not repaid its
loan.
To
avoid this risk, the bank wants an insurance company, the completion
guarantor, to agree to put up any money needed to complete the film
should it go over budget. Before issuing a policy, a completion
guarantor will carefully review the proposed budget and the track
record of key production personnel. Unless the completion guarantor is
confident that the film can be brought in on budget, no policy will
issue. These policies are called completion bonds.
First-time
filmmakers may find it difficult to finance their films through
pre-sales. With no track record of successful films to their credit,
they may not be able to persuade a distributor to pre-buy their work.
How does the distributor know that the filmmaker can produce something
their audiences will want to see? Of course, if the other elements are
strong, the distributor may be persuaded to take that risk. For
example, even though the filmmaker may be a first-timer, if the script
is from an acclaimed writer, and several big name actors will
participate, the overall package may be attractive.
The
terms of an agreement between the territory buyer (licensor) and the
international distributor can be quite complex. A sample license
agreement is presented at the end of this chapter.
Parties
may disagree about the meaning of terms used in their agreements. The
following terms are standard IFTA definitions, which are generally
accepted in the industry. They are used to interpret whatever document
they are attached to.
EQUITY
INVESTMENTS
An equity investment can be structured in a number of ways. For
example, an investor could be a stockholder in a corporation, a
non-managing member of a Limited Liability Company (LLC), or a limited
partner in a partnership.
An
investor shares in potential rewards as well as the risks of failure.
If a movie is a hit, the investor is entitled to receive his investment
back and share in proceeds as well. Of course, if the movie is a flop,
the investor may lose his entire investment. The producer is not
obligated to repay an investor his loss.
The
interests of individuals and companies that do not manage the
enterprise they invest in are known as securities. These investors may
be described using a variety of terms including silent partners,
limited partners, passive investors and stockholders. They are putting
money into a business that they are not managing (i.e., not running).
State and federal securities laws are designed to protect such
investors by ensuring that the people managing the business (e.g., the
general partners in a partnership or the officers and directors of a
corporation) do not defraud investors by giving them false or
misleading information, or by failing to disclose information that a
reasonably prudent investor would want to know.
In
a limited partnership agreement, for example, investors (limited
partners) put up the money needed to produce a film. Investors usually
desire limited liability. That is, they don’t want to be financially
responsible for any cost overruns or liability that might arise if, for
instance, a stunt person is injured. They want their potential loss
limited to their investment.
Because
limited partnership interests are considered securities, they are
subject to state and federal securities laws. These laws are complex
and have strict requirements. A single technical violation can subject
general partners to liability. Therefore, it is important that
filmmakers retain an attorney with experience in securities work and
familiarity with the entertainment industry. This is one area where
filmmakers should not attempt to do it themselves.
Registration
and Exemptions
The
federal agency charged with protecting investors is the U.S. Securities
and Exchange Commission (SEC). Various state and federal laws require
that most securities be registered with state and/or federal
governments. Registration for a public offering is time-consuming and
expensive, and not a realistic alternative for most low-budget
filmmakers. Filmmakers can avoid the expense of registration if they
qualify for one or more statutory exemptions. These exemptions are
generally restricted to private placements, which entail approaching
people one already knows (i.e., the parties have a pre-existing
relationship). Compare a private placement with a public offering where
offers can be made to strangers, such as soliciting the public at large
through advertising. Generally, a public offering can only be made
after the U.S. Securities and Exchange Commission (SEC) has reviewed
and approved it.
There
are a variety of exemptions to federal registration. For example, there
is an exemption for intrastate offerings limited to investors all of
whom reside within one state. To qualify for the intrastate offering
exemption, a company must: be incorporated in the state where it is
offering the securities, and it must carry out a significant amount of
its business in that state. There is no fixed limit on the size of the
offering or the number of purchasers. Relying solely on this exemption
can be risky, however, because if an offer is made to a single
non-resident the exemption could be lost.
Under
SEC Regulation D (Reg D) there are three exemptions from federal
registration. These can permit filmmakers to offer and sell their
securities without having to register the securities with the SEC.
These exemptions are under Rules 504, 505 and 506 of Regulation D.
While companies relying on a Reg D exemption do not have to register
their securities and usually do not have to file reports with the SEC,
they must file a document known as Form D when they first sell their
securities. This document gives notice of the names and addresses of
the company’s owners and promoters. State laws also apply and the offeror
will likely need to file a document with the appropriate state agency
for every state in which an investor resides.
Investors
considering an investment in an offering under Reg D can contact the
SEC’s Public Reference Branch at (202) 942-8090 or send an email to
publicinfo@sec.gov to determine whether a company has filed Form D, and
to obtain a copy. A potential investor may also want to check with
his/her state regulator to see if the offering has complied with state
regulations. State regulators can be contacted through the North
American Securities Administrators Association at (202) 737-0900 or by
visiting its website at
http://www.nasaa.org/nasaa/abtnasaa/find_regulator.html. Information
about the SEC’s registration requirements and exemptions is available
at: http://www.sec.gov/info/smallbus/qasbsec.htm
An
“offering” is usually comprised of several documents including a
private placement memorandum (PPM), a proposed limited partnership
agreement (or operating agreement for an LLC, or bylaws for a
corporation), and an investor questionnaire used to determine if the
investor is qualified to invest. A PPM contains the type of information
usually found in a business plan, and a whole lot more. It is used to
disclose the essential facts that a reasonable investor would want to
know before making an investment. The offeror may be liable if there
are any misrepresentations in the PPM, or any omissions of material
facts.
State
registration can be avoided by complying with the requirements for
limited offering exemptions under state law. These laws are often
referred to as “Blue Sky” laws. They were enacted after the stock
market crash that occurred during the Great Depression. They are
designed to protect investors from being duped into buying securities
that are worthless — backed by nothing more than the blue sky.
The
above-mentioned federal and state exemptions may restrict offerors in
several ways. Sales are typically limited to 35 non-accredited
investors, and the investors may need to have a pre-existing
relationship with the issuer (or investment sophistication adequate to
understand the transaction), the purchasers cannot purchase for resale,
and advertising or general solicitation is generally not permitted.
There is usually no numerical limit on the number of accredited
investors.
A
“pre-existing relationship” is defined as any relationship consisting
of personal or business contacts of a nature and duration such as would
enable a reasonably prudent purchaser to be aware of the character,
business acumen and general business and financial circumstances of the
person with whom the relationship exists.
Other
documents may need to be filed with federal and state governments. For
example, a Certificate of Limited Partnership may need to be filed with
the Secretary of State to establish a partnership. In California, a
notice of the transaction and consent to service of process is filed
with the Department of Corporations. If the transaction is subject to
federal law, Form D will need to be filed with the Securities and
Exchange Commission (SEC) soon after the first and last sales. Similar
forms may need to be filed in every state in which any investor resides.
In
the independent film business, PPMs are usually: a Rule 504 offering to
raise up to $1,000,000, or a Rule 505 offering which allows the
filmmaker to raise up to $5,000,000, or a Rule 506 offering which
doesn’t have a monetary cap on the amount of funds to be raised. A 506
offering also offers the advantage of preempting state laws under the
provisions of the National Securities Markets Improvement Act of 1996
(“NSMIA”).
504
Offering
Under
Rule 504, offerings may be exempt from registration for companies when
they offer and sell up to $1,000,000 of their securities in a 12-month
period.
A
company can use this exemption so long as it is not a so-called blank
check company, which is one that has no specific business plan or
purpose. The exemption generally does not allow companies to solicit or
advertise to the public, and purchasers receive restricted securities,
which they cannot sell to others without registration or an applicable
exemption.
Under
certain limited circumstances, Rule 504 does permit companies to make a
public offering of tradable securities. For example, if a company
registers the offering exclusively in states that require a publicly
filed registration statement and delivery of a substantive disclosure
document to investors; or if the company sells exclusively according to
state law exemptions that permit general solicitation, provided the
company sells only to accredited investors.
505
Offering
Under
a Rule 505 exemption, a company can offer and sell up to $5,000,000 of
its securities in any 12-month period. It may sell to an unlimited
number of “accredited investors” and up to 35 non-accredited investors
who do not need to satisfy the sophistication or wealth standards
associated with other exemptions. The company must inform investors that
they are receiving restricted securities that cannot be sold for at
least a year without registering them. General solicitation and
advertising is prohibited.
Rule
505 allows companies to decide what information to give to accredited
investors, so long as it does not violate the antifraud prohibitions of
federal securities laws. But companies must give non-accredited
investors disclosure documents that are comparable to those used in
registered offerings. If a company provides information to accredited investors,
it must provide the same information to non-accredited investors. The
offeror must also be available to answer questions from prospective
investors.
506
Offering
Under
Rule 506, one can raise an unlimited amount of capital. However, the
offeror cannot engage in any public solicitation or advertising. There
is no limit as to the number of accredited investors that can
participate. However, only 35 non-accredited investors can participate.
Accredited
investors include (among others) the following:
a.
any natural persons whose individual net worth, or joint net worth with
that person’s spouse, at the time of the purchase exceeds $1,000,000;
b.
any natural person with an individual income in the two prior years and
an estimated income in the current year in excess of $200,000 or joint
income with spouse of $300,000;
c.
any director, executive officer, or general partner of the issuer of
the securities being offered or sold, or any director, executive
officer or partner of a general partner of the issuer;
Under
Rule 506, each purchaser of units must be “sophisticated,” as that term
is defined under federal law. Note that an “accredited investor” is not
the same as “sophisticated” investor. The term “accredited investor” is
specifically defined by the federal securities laws, while the term
“sophisticated investor” has no precise legal definition. Both terms
generally refer to an investor who has a sufficiently high degree of
financial knowledge and expertise such that he/she does not need the
protections afforded by the SEC. An investor who is considered
“sophisticated,” might not meet the precise definition of an accredited
investor.
As
with Rule 505 offerings, it is up to the offeror to decide what
information is given to accredited investors, provided there is no
violation of the anti-fraud provisions. Non-accredited investors must
be given disclosure documents similar to those used in registered
offerings. If the offeror provides information to accredited investors,
the same information must be given to non-accredited investors. The
offeror must be available to answer questions by prospective
purchasers.
Under
Rule 506, each purchaser must represent that he or she is purchasing
the units for his or her own investment only and not with plans to sell
or otherwise distribute the units. The units purchased are “restricted”
and may not be resold by the investor except in certain circumstances.
Intrastate
Offering Exemption
Section
3(a)(11) of the Securities Act provides for an intrastate offering
exemption. This exemption is designed for the financing of local
businesses. To qualify for the intrastate offering exemption, a company
needs to be incorporated in the state where it is offering the
securities; carry out a significant amount of its business in that
state; and make offers and sales only to residents of that state.
There
is no fixed limit on the size of the offering or the number of
purchasers. The company needs to carefully determine the residence of
each purchaser. If any of the securities are offered or sold to even
one out-of-state person, the exemption may be lost. Moreover, if an
investor resells any of the securities to a person who resides out of
state within a short period of time after the company’s offering is
complete (the usual test is nine months), the entire transaction,
including the original sales, might violate the Securities Act.
Accredited
Investor Exemption
Section
4(6) of the Securities Act exempts from registration offers and sales
of securities to accredited investors when the total offering price is
less than $5,000,000.
The
definition of accredited investors is the same as that used under
Regulation D. Like the exemptions in Rule 505 and 506, this exemption
does not permit any public solicitation. There are no document delivery
requirements but the anti-fraud provisions mentioned below do apply.
California
Limited Offering Exemption
SEC
Rule 1001 exempts from registration offers and sales of securities, in
amounts of up to $5,000,000, which satisfies the conditions of
§25102(n) of the California Corporations Code. This California law
exempts from California state law registration offerings made by California
companies to “qualified purchasers” whose characteristics are similar
to, but not the same as, accredited investors under Regulation D. This
exemption allows some methods of general solicitation prior to sales.
ANTI-FRAUD
PROVISIONS
All
security offerings, even those exempt from registration under Reg. D,
are subject to the antifraud provisions of the federal securities laws,
and any applicable state anti-fraud provisions. Consequently, the
offeror will be responsible for any false or misleading statements,
whether oral or written. Those who violate the law can be pursued under
both criminally and civilly. Moreover, an investor who has purchased a
security on the basis of misleading information, or the omission of
relevant information, can rescind the investment agreement and obtain a
refund of his/her investment.
Excerpt
from Risky Business, Financing and Distributing Independent Films to be
published by Silman-James Press, Fall 2003.
|
