How Hollywood could benefit from 'Box Financing'

What Congress taketh away with the one hand it giveth with the other. The financial overhaul bill passed in June excluded box office futures from being traded on a publicly traded exchange as “commodities,” putting them in a rarified league with the only other prohibited item, namely onions, a relic of onion grower hysteria in the 1950s.

However, the same bill expanded the definition of permitted “swaps,” enough so that almost all film financing transactions fall within the new definition, including transactions where the return is tied to box-office results. Thus, film financing transactions based on box-office results (“Box Financings”) are likely to resurface as private “swaps.”

The goal of this article is to explain in plain English how Box Financings will work and the benefits to everyone in Hollywood from them.  First, some background: Many film companies want to reduce their risk on films, particularly larger-budget ones.  educing risk avoids the company going down for the count if the film flops, and it permits the company to spread precious cash over a wider number of films.

In the last ten years, a great way for film companies to hedge risk was to raise equity through private equity funds. But these transactions dried up in 2008 and do not look like they are coming back, mainly because these funds felt victimised by their perception (rightly or wrongly) of opaque Hollywood accounting. Just watch fund managers now shudder when you offer them a share of a film’s net profits. Eddie Murphy’s great quip – calling a share of net profits “monkey points” – best summarizes the current perception of what it means to invest in films. It is for this reason that the market for film financing from private equity funds is kaput.

Yes, there are still some equity investors out there, but they are few and far between, ranging from random rich star-struck investors to foreign distributors willing to contribute some equity, but it behooves film companies to come up with a solution that vastly increases supply, rather than muddling through looking for needles in haystacks. The strong film companies can, of course, raise debt financing, but debt does not shift risk. What is needed is equity financing.

An approach that might revitalise the market for equity investment in films is to end the accounting miasma, and tie the investor’s return directly to a percentage of the gross domestic box-office receipts to the theaters (“Domestic Box”) for the film. This approach raises the curtain of negativity and doubt that surrounds Hollywood accounting and leaves a spotlight on the glamour and thrill of “owning a piece” of a film.

Talk about transparent accounting – all the investor would have to do is open the trades. Accounting statements and audits would be history. The film company would pay the investor the specified percentage of Domestic Box, even though there is only an indirect link between Domestic Box and the film company’s ultimate net profits. From the film company’s perspective, Box Financing hedges risk, which is exactly what it wants to do. Box Financing is something everyone can understand, so it would open the investment door to the general public. It could be done across a slate of films or film-by-film, with investors investing in particular films of their choice.

A simple example may best illustrate this suggestion: Assume that a studio wants to produce a $100 million film, but it wants to limit its risk to $50 million. It raises $50 million of equity from an investor and agrees to pay the investor a payment equal to 50% of the Domestic Box. If the film flops and comes in with a Domestic Box of $10 million, the studio pays the investor $5 million, keeps the $45 million balance of the investment, and is happy.  If the film has a Domestic Box of $100 million, the studio pays the investor a break-even payment of $50 million, and the studio is happy because it will keep worldwide rights and profits to a successful film. If the film scores big and has a Domestic Box of $200 million, the studio will pay the investor $100 million, and the studio is still happy because it accepted that possibility as a tradeoff for reducing its risk.

More good news is the accounting and tax treatment of the transaction. For accounting purposes, any payment to the film company will be treated either (a) as a reduction in the cost of the film, with any payment owed to the investor being added to the cost of the film when accrued or (b) as equity, thus lowering the film company’s debt/equity ratio, which is an even better result than off-balance sheet financing, which has no impact on the company’s debt/equity ratio. For tax purposes, the investment should be treated as a tax-free equity contribution to an actual or deemed partnership. Any loss should be deductible to the investors as an ordinary loss, and any profit should be taxable as ordinary income, not capital gain.

In order for Box Financings to work, the investment must be refundable with interest if the film does not end up with the promised key cast and director or does not get a theatrical release on a minimum number of screens by a specified date. Because the film company will be required to make payments to the investor (whether due to the film not meeting the promised conditions or based on Domestic Box) regardless of actual net profits received, the film company will have to either (a) have a strong enough balance sheet to make the investor happy or (b) hold the investment in escrow until the Domestic Box results are in, precluding the investment from being used to cash flow production. Even if the investment is escrowed, the investor still will be relying on the film company to pay any amounts owed to the investor in excess of the investment if the Domestic Box is high enough. These factors militate toward making this transaction easier for the studios (the rich get richer), but it is not beyond the reach of well-heeled independents.

The main advantage of this approach is that it will bring billions of dollars to the table, and it will be sustainable. This new source of financing will benefit everyone, including studios, independents, talent, and crew.

The reason that Box Financing will achieve this result is obvious: It creates a transparent investment that allows investors to know the value of their investment by just opening the paper. This approach eliminates the perceived opaqueness (rightly or wrongly) of Hollywood accounting and leaves a spotlight on the glamour and thrill of “owning a piece” of a film. There would be a flood of capital available if investors could know the value of their investment by opening the paper, rather than waiting for months only to receive arcane accounting statements that they don’t understand. Private equity funds would come back to Hollywood in droves, and this would benefit everyone in Hollywood, since the more that the studios can hedge their risk, the more they can spend on a film and the more films they can make.

Another huge advantage to the studios is that Box Financing eliminates all audits and litigation, and this has become increasingly important given the string of losses that the studios have suffered in participation cases at the hands of juries lately. A plaintiff’s lawyer need only say “Hollywood accounting” to a jury, and they get the message. Box Financing ends all that.

Box Financing will not be publicly traded (at least at first), and this fact should eliminate all the sturm and drang that was caused by the prior proposal to have box office futures traded on an exchange.

So get ready for the next wave of financing – Box Financing is coming to a theater near you.

Schuyler M. Moore is a lawyer at Stroock and the author of The Biz, Taxation of the Entertainment Industry, and What They Don’t Teach You in Law School.  He is an adjunct professor at both the UCLA Law School and the UCLA Anderson School of Management.  He can be reached at smoore@stroock.com.