What They'll Never Tell You About the Music Business

by Peter M Thall

  In the past, a homemade piano and vocal tape could serve as a “hard copy” of an artist’s music. Times have changed. Over the last decade, it has become a necessity for artists to demo their songs for the record labels in such a highly sophisticated way that a normal person would be hard-pressed to distinguish the result from a full-priced Electric Lady master with all the trimmings. Musicians are able to make such demos because incredible innovations in recording equipment now allow them to build extremely effective home recording studios. This equipment, plus CD burners, MP3 file transfers via the Internet, YouTube, and other means of exploitation, is helping artists to find new and better ways to present themselves and to make access to their music more manageable. But the costs remain. These extend well beyond the cost of demos. They include all of the costs of beginning a career: from performing live, with the attendant costs of equipment, transportation, and mailings, to the cost of attending music conventions that cater to young artists, to the cost of legal and financial services, including the cost of creating the business entities that are necessary in order to function without unwanted liability to third parties, and, finally, to the cost of living—food and shelter for one’s very survival. And these costs are greater than ever before.

  OF INVESTORS AND INVESTMENT AGREEMENTS

  Enter the investor. There are as many variations of investors as there are forms of investor agreements. I am not talking about moneylenders who lend funds either in a lump sum or as needed up to a maximum amount—all in return for a promise to pay back the loan within a specific period of time, often in specific balanced installments, and always with an interest factor. Banks will usually lend money only to someone who has established good credit and has assets that can be designated as security to the bank in the event of default. A mortgage on a piece of real estate is the most common example of this model.

  Artists are not usually in a position to borrow from banks, not the least of the reasons being they cannot fulfill either of the requirements noted above. This does not mean that finding someone willing to invest in an artist’s career or demo recording is an impossible goal. Many people—often those with no music industry background—are willing to assist an artist in achieving the wherewithal to be seen and heard by a record company. Family members, friends, and strangers often combine to finance an artist’s needs. Like anyone seeking financial aid, artists must go through the process of developing a business plan. However, one of the most important parts of plans developed by entrepreneurs hoping to start up a small business, the forecast of earnings, is impossible to incorporate into an artist’s plan. The highly speculative nature of all music industry endeavors reduces the artist’s plan to a fairly simple agreement, one that states

  • the amount of the investment;

  • the purpose for which it will be used;

  • some kind of time frame in which the investment will be applied to the mutual goals of the artist and the investor—or returned;

  • terms affecting the manner in which the investment will be repaid (or not repaid).

  The most common forms of artist-investor agreements are partnerships, including the joint venture, where the partners are active participants in the venture covered by the agreement, and the various forms of incorporated businesses, including the S corporation, the C corporation, and the LLC (limited liability company). (In this chapter, and in chapters 6 and 16, I discuss these and other types of structures available to artists seeking investment capital.)

  FINDING THE MONEY

  It has not gone unnoticed by many fledgling artists, or their fairly sophisticated friends and relatives, that there is a widely held perception—much of it justified—that successes in the music business can make lots of money. Therefore, those with money are susceptible to being convinced to throw some of it into a pot to help an artist, or, more frequently, a record production company, a publishing company, a label, or even a management company, break into the business. Artists or their representatives trying to raise money for demos and tours (or careers) through one of the corporate forms—by selling financial interests to nonparticipating investors in their future profits—need to be aware that raising money this way is no different from selling securities. If they seek to raise money from passive investors (that is, those who are not active participants in the project being financed), they must comply with securities laws.

  Raising money is a difficult—and sometimes risky—enterprise. This goes not only for you, but also for your representative—no matter how well intentioned he or she may be. Just as you must exercise care in determining how best to raise money and on what terms you can pay it back, you must make yourself aware of how those who believe in you are seeking to raise the money as well; and if they intend to raise these funds from passive investors, then either they, or their lawyers, need to have a solid knowledge of securities law, as I will discuss in more detail below. Never forget, though, that most investors want the highest return, the highest liquidity (ability to turn their investment into cash easily and quickly), and safety. An honest advisor will tell them that is a rare combination indeed, but a dreamer won’t.

  Blue-Sky Laws

  In 1911, Kansas passed the first set of comprehensive laws in the United States designed to prevent the sale of interests in fraudulent schemes or schemes whose likelihood of success was highly speculative. It was said that the only thing that backed the securities sold in various fly-by-night enterprises being hawked to gullible Kansans was “so much blue sky,” and the Kansas laws were referred to as blue-sky laws. One judge referred to “vision” when describing the character of a particularly questionable venture. He wasn’t talking about creative vision; he was talking about fantasy, and “fantasy” ventures are what the state regulatory agencies in the United States under the umbrella of the federal Securities and Exchange Commission (SEC) seek to prevent by requiring those selling securities to comply with a complex set of filing regulations.

  Suppose, for example, you, or someone who believes in your talent decides to raise money from others in return for a promise to pay a percentage of profits at such time as the investment returns a profit. Say the original investor has contracted with you to provide $100,000, and subsequently decides to raise the entire amount or a portion of it from others. (In securities law lingo, he is said to be “offering” a piece of what he gets from you in return for a piece of the money he has promised to you.) That investor is, in effect, selling securities, and hence must comply with the securities laws of the states in which the various potential investors live—and possibly the securities laws of the United States as well. Note that whoever is making the offering must file—according to the specific state’s rules and regulations—in each state in which the investment is being solicited, even if the potential investor eventually declines the offer. And although many state registration requirements are relatively straightforward, there are nevertheless fees that must be paid to the agencies. And don’t forget the legal fees.

  The good news is that when relatively insignificant amounts of investment capital are sought by the person offering the “securities,” both the federal securities act and the blue-sky laws of each state offer a multitude of exemptions, thereby relieving the investor of most, but not all, of the costly and time-consuming filing and documentation procedures that would ordinarily be required for a larger investment. The bad news is that state regulations vary, and only someone thoroughly acquainted with securities law is in a position to sort them out. If an offering is made only in one state (that is, the offer would only be made to investors located in the same state as the person seeking the investment), the offering is not occurring “in interstate commerce” and therefore federal law does not apply. However, if an offering is made to potential investors located in more than one state, the offering becomes subject to both federal and state securities laws. There are generally two types of offerings: public and private. Due to the cost of registration and preparation for a public offering,
most small entertainment projects obtain financing through a private offering, which is exempt from the most burdensome requirements. Both the US Federal Securities Act of 1933 and all of the various states’ laws provide for private offerings.

  If a person seeking investment makes an offering involving interstate commerce, the most commonly used federal law is the private placement exemption offered under Regulation D of the 1933 act. However, although the offering is exempt, there are nevertheless specific rules, requirements, and filings that must be followed. By filing a simple form—Form D—with the SEC, a small company (Friends of and Investors in Superartist?) can sell up to $1 million of security interests (that is, equity in the artist or in a production company) in a twelve-month period.* A word of warning: Don’t forget that, in addition to compliance with federal regulations, the person seeking investment capital must also comply with each state’s security laws. (Rules change frequently, so be careful!)

  There is also an exemption within Regulation D that permits offerings without regard to dollar amount provided that there are no more than, or the offering party believes that there are no more than, thirty-five purchasers of securities from the offering party. Rule 501 makes it clear, however, that one does not have to count among the thirty-five those people who are considered under the law to be accredited investors. “Accredited investors” are those that are either experts in the securities field or well off financially. A definition of such investors supplied by the SEC in Rule 501 can be found at 17C.F.R. Section 230.501.

  Typically, Regulation D forbids advertising or general solicitation of investors. It also stipulates that an offering document, such as a private placement memorandum, must be prepared and given to each prospective investor before he or she actually makes the investment. This document sets out the details of the investment and its potential risks.

  Penalties for Failure to File

  When anyone seeking to obtain passive investment to finance a demo, an album, or a career fails to file the proper documents with the applicable securities agencies, any one of the following may occur:

  • having to pay fines

  • having to pay punitive damages

  • facing future restrictions on seeking investment for other projects—up to and including being barred for life from doing so

  • having to file retroactively at considerable cost

  • having to return the investment money with interest

  • having to cite the violation in future private placement memoranda that he or she, either alone or in association with others, wants to use to solicit investments

  It is likely that if the investor is a family member or a close friend, the securities agencies will never receive a complaint; if they do, they will usually drop the issue entirely. There are provisions in the securities laws in which the disclosure requirements are treated differently when investors are a small number of “friends and family.” However, securities law compliance is more likely to become an issue when a disgruntled investor—not necessarily, but usually, a stranger—feels slighted (and when, of course, the investment has gone south). Did you forget to invite your investor to the CD listening party? Did you fail to return his telephone calls? Have you incorrectly credited or failed to credit him on the CD jacket or wherever else credit was expected or promised? Even when you have failed to follow the laws designed to protect investors, if everyone makes a profit, you are not likely to have a problem. But angry investors who have also lost money will be looking for reasons to file a complaint (the SEC provides preprinted forms for easy complaining), and they may well find them. And, once a complaint is filed by an investor who claims to have been misled by you, the securities agencies will have no choice but to investigate. Further, certain illegal actions are more visible than others, and may be noticed even when none of your investors has complained. For example, if you advertise for investors, which, as noted above, you cannot do except as part of a formal public offering, federal or state securities departments may, in the course of their routine watch policies, see the advertisements, at which point they may well decide to knock on your door and pursue you. Talk about a career bummer!

  INTERNET-SPECIFIC OFFERINGS

  It used to be difficult enough to identify the particular states in which a blue-sky registration had to be filed. Some were easy: the state in which you lived, the state in which your potential investor lived. Some were less easy. With the advent of the Internet, offering semianonymity and a very broad reach, things became even more complicated—and opportunities for fraudulent investment schemes multiplied. But in this country, no technological advancement can gain a footing for long before a law or rule is adopted which will regulate it.

  Organized in 1919, the North American Securities Administrators Association (NASAA) is the oldest international organization devoted to investor protection. It lists on its website, www.​nasaa.​org, an enormous number of organizations that protect the (potentially) defrauded investor. NASAA has recognized that the Internet has become an alternative distribution channel for people who may defraud others. Reaching people via email is more efficient than the old-fashioned telemarketing method, and as this new method spread around the world, both the NASAA and the SEC had to address the issue, both to protect legitimate offerings and to identify illegitimate ones. In addition, over half the states in the United States have established Internet surveillance programs that watch for fraud. Take heed. The Internet is probably so much a part of your daily life that it would seem natural to use its long reach to interest potential supporters. But utilize a chat room, or encourage a well-heeled “fan” to donate money, and you may be headed for trouble. If you mess up once, you may be looking at jail time. If your “fairy godmother” investor decides to solicit investment funds from others and she messes up, you can be held responsible also.

  THE SAFE HARBOR DISCLAIMER

  Legislation and/or policies designed to protect people from certain risks and uncertainties that they might otherwise be subject to are called safe harbors. NASAA has created a safe harbor disclaimer whereby you (or your investor) can indicate either on your home page or via other methods those states to which you are directing your offer of investments, and you (or your investor) can then follow the blue-sky rules and regulations of those states, a move that substantially insulates you from the charge that you (or your investor) have been making offerings in states in which you have failed to register or chosen not to register.

  Following NASAA’s guidelines does not protect people seeking investments from others from charges of fraud if they violate any rules or regulations of the state or federal securities laws, but complying with these guidelines—which is evidence that you are really trying to do the right thing—can at least shift to state authorities the burden of proving violations of the law. Over half of the states have adopted this safe harbor disclaimer exemption. Hopefully, the rest will follow suit.

  GETTING THE RIGHT ADVICE

  As you have seen, this process is very dangerous. It’s cliché time. The securities departments of the various states and the federal government were not “born yesterday.” “There is nothing new under the sun.” “It’s all been done before.” “The securities police can “see you coming.” I am not suggesting that raising money by selling interests in a company is a bad idea. In fact, it can be a very good idea. If Microsoft can do it, why not you? If an off-Broadway show can raise a million dollars in an environment where the odds of losing it all are similar to the odds in the record business, why not your career, your record company, or your newly discovered artist?

  There are plenty of lawyers who specialize in securities law. The problem is that most music industry attorneys do not. Some music lawyers are members of law firms that have securities divisions, but the majority of the boutique firms offer legal services predominantly in the area of facilitating music business transactions. So before you start raising money left and right, it’s a good idea to first consult with a secur
ities lawyer. Just as the laws are there to protect the “little old ladies” who might otherwise be taken advantage of, they are structured to assist you in doing it right. It will be money and time well spent. And besides, perhaps the securities lawyer knows a couple of people who have money, instead of CDs, to burn.

  PAYING IT BACK

  In return for a budgeted amount that will serve their needs for a given period, artists will agree to pay back their investors in one of the following ways, or variations of one or more of these ways. Polyphonic, a new medium for financing fledgling artists, is a special newcomer in this arena and I discuss it in some detail later in this chapter.

  First Monies Plus a Percentage

  The artist can agree to pay investors out of the very first cash he or she receives from a contractual relationship with a record company or a music publishing company (known as “first monies”), and, subsequently, by paying an identical amount out of, for example, 50% of the next monies received. Say an investor has invested $1,000. Under this payback method, the investor would receive the first $1,000 of money not otherwise committed for recording, and half of the next $2,000 of similarly designated money—not a bad return on a risky investment.

  Straight Percentage