The Hollywood Economist 2.0

by Edward Jay Epstein

  Since the cash flows from indie films tends to be erratic, these smaller distributors had come to rely on advance output deals with three pay-TV channels—HBO, Showtime, and Starz—to pay their overhead. In return, the pay channels got the exclusive rights to show their new movies. In 2008, for example, the $80 million that New Line Cinema received from HBO paid its annual overhead and development costs. Bob Weinstein, the co-chairman of the Weinstein Company, not only described output deals as “the bedrock of the business,” but said in 2008 “not one company in this business could survive and succeed without one.”

  His words soon proved prophetic. When the pay-channels found they needed fewer movie titles to retain subscribers, and began cutting back on their output deals in 2008, the “bedrock” crumbled within a matter of months. By 2010, most of these indie distributors and mini-majors were effectively out of business including New Line Cinema, Fine Line Features, Picturehouse, Warner Independent, Fox Atomic, and Paramount Vantage. Miramax, the linchpin of indie distribution for nearly two decades, closed down its main office in New York in 2008, and in 2010 its owner, Walt Disney, sold the company and its library to Filmyard Holdings for more than $660 million. Almost all remaining players have drastically changed their acquisition strategy. Sony Pictures Classics does not buy any film that costs over $2 million, Focus Features is putting its resources mainly in co-production deals in Asia, and Lionsgate is investing in horror sequels like Saw VII. With the prospect of American distribution rapidly fading, indie producers are now finding pre-sale financing almost impossible. “It’s a dead business model,” a former Miramax executive said.

  If so how can Indie producers continue to make movies? They might be able to find wealthy individuals entranced enough with a movie fantasy to put up the money, but they still need to devise a new way in this digital age to distribute them to an audience willing to see something more than the movie versions of amusement park rides.

  HOW TO FINANCE AN INDIE FILM

  The first reality an indie producer must come to grips with is that it is almost impossible to get meaningful US distribution for a movie before it is made, even if the producer has a great script, cast, and director. This means that for all practical purposes the value of the US market for financing a movie is virtually zero.

  As a result, a producer has to depend almost entirely on the foreign markets for financing. To be sure, foreign distributors, no longer confident that indie films would have the publicity and hype that goes with an American release, have greatly reduced the amount they are willing to commit, and three of the top seven markets, Japan, Spain, and Italy, have sharply cut back on their pre-sales deals, but even so, it is possible to raise the additional funds through government subsidies and tax shelters (which can provide 30 percent of the budget). Assume that the producer has lined up all the ingredients necessary for international sales, including script, director, and stars, and now needs $10 million to make the movie. Here is what must be done.

  STEP I: FOREIGN PRE-SALES

  The producer first must retain a foreign sales agent to sell the foreign territories. This agent, who gets between 10 and 20 percent of these sales, makes an assessment of what these markets are worth, then negotiates contracts in which each foreign distributor agrees to pay the producer an agreed upon sum once the movie is actually delivered. In return, he gets all theatrical, DVD, electronic, and television rights to the territory until receipts exceed this sum. The best a producer can hope for these days from the foreign markets is 80 percent of budget, so, if all goes well, the producer of this $10 million film gets $8 million in contracts for foreign sales.

  STEP II: SUBSIDIES

  The producer arranges to shoot the film in a state or country that provides “soft money” in the form of subsidies and tax credits for about 30 percent of budget, which, in this case, will yield another $3 million. To get this money, however, he or she has to complete the movie. Even though on paper, the producer now has $11 million to make a $10 million movie, he or she needs to convert it to cash. This requires finding a bank willing to accept these pieces of paper as collateral. But no bank will do so without another piece of paper, called a completion bond. The completion bond guarantees that the movie, come hell or high water, will be completed and delivered with all the elements, such as stars, specified in the contracts.

  STEP III: COMPLETION BOND

  The producer buys a completion bond from an issuer such as Film Finance. The company, to reduce its risk, insists on certain conditions. Typically, it requires a producer put aside 10 percent of the budget for unexpected contingencies as well the money necessary for so-called “deliverables,” such as the dupe negatives for foreign distributors. In the case of this $10 million film, the completion bond company takes a 2.6 percent fee, or $260,000, and requires $1 million for the “contingencies” and $200,000 for the “deliverables” be held in an escrow account, once the bank delivers the loan.

  STEP IV: BANK FINANCING

  Banks, even with a completion bond, will lend no more than 80 percent of the face value of the collateral. In this case, the producer borrows 80 percent on the $11 million in contracts and soft money, or $8.8 million. But from that sum, the bank deducted its own fee, which is 3 percent, or $264,000. In addition, it also requires that the producer set aside in an escrow account the interest on the loan for 18 months. At a blended rate of five percent, this amounts to $660,000. So what the producer actually gets is only $7,876.000.

  Now, once the loan is delivered, the producer must pay the foreign sales agent. Assume the agent gets a 15 percent fee of the $8 million in pre-sales, or $1,200,000. The producer now has only $6,676,00. Then, after paying completion bond company, and putting the requisite money aside for contingencies and deliverables, he or she has $5,216,000 left from the loan, barely half the money needed to shoot the $10 million movie.

  STEP V: FINANCING THE GAP

  Filling a nearly $5 million gap is no easy matter. If the producer reduces the budget by cutting out any of the stars or other specified production values, he will violate the terms of the pre-sales and subsidy contracts. So unless he wants to re-negotiate with everyone, he has to stick to the budget. Nor can he borrow more money against the bankable collateral since he has mortgaged his production to the hilt.

  This leaves the producer only one way to fill the gap: finding an equity investor to buy part of a movie that has not yet made. To make such a “gap” investment feasible, the producer can offer the investor repayment from the 20 percent tier of the foreign contracts and subsidy contracts not covered by the bank loan. In this case, that 20 percent tier will yield $2,200,000 after the film is delivered in all the foreign markets. But that still leaves an unsecured risk of some $3 million. If the producer manages to bring the movie in on budget, the $1 million fund held for contingencies can also be used to further repay the equity investor. But the investor still has $2 million at risk. To get back this money, and make a profit, he must gamble that the unsold American rights will be sold after the movie is completed. Since of the thousands of movies submitted to film festivals each year, only a few dozen find meaningful distribution, this is no small risk. But resourceful producers can find investors willing to take it.

  PART VII

  THE POLITICS OF STREAMING

  THE QUEST FOR THE DIGITALIZED COUCH POTATO

  The numbers—or at least the secret studio revenue numbers in the May 2008 All Media Revenue Report—tell the story. As late as 1980, movie theaters provided the studios with 55 percent of their total revenues; in 2007, movie theaters provided only 20 percent of their total revenue (over half of which came from overseas). The other 80 percent now came from the ubiquitous couch potato who was viewing his movies at home via DVDs, Blu-rays, pay-per-view, a digital recorder, cable channels, or even network television. A studio’s task in this new environment, as Sony Chairman Howard Stringer explained to me, “is to optimally leverage our product across all these [new] platforms.” The way studios ac
hieve this “optimal leverage” is to give each of these platforms a discrete time frame, or window in which it could exploit the home audience.

  A brief history is in order. Since the 1980s, the studios have managed their revenue by employing a system of “windows” to release their products to different markets. First, movies play in theaters, then, six months later, the video window opens, followed by the opening of the pay-TV and then free television window.

  Then at the turn of the millennium the prospect of mass sales of DVDs in retail stores began opening cracks in the entire system. Warner Bros. led the way. To win critical shelf space in Wal-Marts, they needed to release their summer blockbusters such as Harry Potter and Batman on DVD during the hottest sales periods, Thanksgiving to Christmas, instead of waiting for an artificial window to open up later. So they shortened their window. Other studios followed suit with a vengeance, shrinking the window to four, or in some cases even three, months. Then thanks to the Internet, studios began to announce an upcoming DVD while the movie was still playing in theaters. As a top studio executive explained to me, “It was a voluntary decision made for purely financial reasons by the major players … to satisfy quarterly profit goals, nothing more, nothing less.” To avoid losing audiences, multiplex chains, which need to maximize their popcorn sales to stay in business, cut the run of such movies. The consequence was a spiral that fed on itself: the shorter the run, the less money from the box office. This decrease, in turn, further increased pressure from the young Turks in the studios’s home-entertainment divisions to further collapse the window. The main resistance to this change came from the old-guard studio executives who fear that undercutting the movie-theater business will—even if it improves DVD sales—unravel the very foundations of Hollywood. They argued that the theatrical platform, to which most of the PR hoopla, magazine covers, TV talk shows, and the rest of the celebrity-worshiping culture is geared, is crucial to generate worldwide DVD sales.

  Amidst this battle to devise a strategy for the DVD window, the entire window system began to disintegrate as digital downloading and other new forms of delivery threatened to make irrelevant the artificial boundaries between pay-TV, network television and cable television. The $64 billion question for the studios is now: Does any barrier, no less a fragile window, make sense in the quest for the couch potato in an increasingly digital age?

  THE SAMURAI EMBRACE

  The momentous shift from theaters to homes proceeded from a series of decisions made not in Hollywood or New York, but in Tokyo and Osaka.

  This reinvention of the film business began in the 1970s with the engineering by Sony and Matsushita of an affordable videocassette recorder. Through a process of ingenious compromises, Sony made its Betamax small enough to fit on top of a TV set and foolproof enough to be operated by a child. The Hollywood studios led by Universal fought for seven years in the courts to prevent it from reaching the market.

  If they had prevailed over Sony, the video rental market may never have developed, but, fortunately for the studios, they lost their case in the Supreme Court in 1984. (It was a bittersweet victory for Sony who, in the interim, lost the format war to the even more user-friendly VHS format developed by Matsushita.)

  The VCR soon became a ubiquitous household appliance, video stores became a part of the urban landscape and the newfound flow of money from video rentals proved to be financial salvation for the very studios that had so bitterly fought the new technology. As a consequence, in deciding what films to make, studios approved projects that had greater potential for huge video rentals. These proved to be special-effects laden disaster and fantasy films that appealed to children and teenagers. Films that did not fit the requisites of video buyers were given a lower priority and, as it turned out, these included dramas, comedies and political exposés intended for an older, more diverse, and less predictable audience.

  Next, in the mid-1990s, Toshiba and Sony changed the Hollywood equation even more radically by substituting a digital platform, the “DVD” for the videocassette. As with the VCR, this digital future was resisted by most of the Hollywood studios who were concerned that it might kill the video business that had become their golden goose. But now Sony, which owned the Columbia Tristar studio, and Toshiba, which was a part owner (and strategic partner) of the Warner Bros. studio, had marshaled enough power in Hollywood to ensure that enough titles would be available for the DVD launch. The combined libraries of these two studios included over 24,000 titles. So, in August 1995, in a conference in Hawaii, Sony and Toshiba (and all the other Japanese manufacturers) agreed on a single format.

  Even though most of the other major studios did not participate, the DVD roll-out succeeded in transforming films into a retail product. DVDs could be played not only on DVD players, but on personal computers, game consoles, iPods, and other digital devices. By 2000, Wal-Mart had become Hollywood’s single biggest customer, selling about a third of all DVDs, occasioning top studio executives to journey to Bentonville, Arkansas, to find out what ratings, stars, genres, and other attributes would help them win strategic placement in Wal-Mart stores.

  Throughout the 1990s studios had been cutting back on the number of titles they released since the popcorn culture at the multiplexes did not require much diversity. But now retailers such as Wal-Mart, Target, and Borders allocated valuable shelf space according to the numbers of titles a studio could deliver. As shelf space became the new name of the game, studios sought to increase their leverage, or throw weight, by buying up independent distributors (and later “mini-majors”) to get more titles. As a result, six companies—Time Warner, Sony, Fox, Viacom, Disney, and Universal—came to dominate not only all the major releases but the entire universe of so-called indie releases. The DVD, with its random access and easy navigation, also opened up for these companies a rich new market: boxed sets of TV series. Not only could they tap their huge TV libraries, but they could invest in original series, such as The Sopranos, Mad Men, Big Love, The Wire, Rome, Dexter, Sex and the City, and 24, which often proved more profitable than films that opened in theaters.

  For the growing home audience, the DVD also made films a more interactive experience. Couch potatoes could now change the language of a film, its aspect ratio, rating, or ending; watch additional scenes (which in some cases are shot for the DVD), or listen to commentaries by directors, writers, and actors, or play a game, music video, or gag reel. With these bonus features driving a large part of DVD sales—one-third of polled DVD buyers said that they first played the bonus feature—Hollywood’s films became part of a package.

  The next move by the Japanese electronic giants came in 2005: the high-definition disc. Pioneered by Japanese television in the late 1970s, high definition makes the home the equivalent of a theater by furnishing film-like images on a large screen. There were two versions, Toshiba’s HD-DVD and Sony’s Blu-ray.

  Since both render a similar quality image, the battle between Sony and Toshiba turned on who could enroll Hollywood studios in support of their format. And, as the Japanese manufacturers knew from their past format wars, this would require bribes in the form of “replication deals.” Sony had an advantage in that it owned one of the major studios, Sony Pictures. It then bought control of MGM—almost exclusively for the purpose of locking its library into the Blu-ray formula. And it made secret deals with Disney and Fox, giving it four studios with about half of Hollywood’s desirable titles. Toshiba fought back by spending over a quarter of billion dollars in cash replication deals, getting for its money Paramount, Universal, and Dreamworks to commit to exclusively put their titles on Toshiba’s HD-DVD format. The format war was then decided by Warner Bros., which sold almost 40 percent of all DVDs. Its new CEO, Jeff Bewkes, decided its interest lay in establishing a single format, and opted for Blu-ray.

  Meanwhile, Sony launched PlayStation 3, which despite its juvenile sounding name, is a state-of-the-art computer that can connect wirelessly to TV sets, computers, printers, and the Internet, an
d simultaneously run up to nine different kinds of consumer electronics, play and record high-definition films, download movies from the Internet and (with a card) cable television, and, as far as games go, render characters in frighteningly realistic ways. The result is further convergence of Hollywood’s dream factory with the digital domain.

  The hand of Tokyo may not always be visible in the dazzling glitter of Hollywood, but it has enabled it to reinvent itself. It is not that the Japanese set out to change the way the world sees movies, it is that Hollywood failed to see its own digital destiny.

  THE RISE OF THE TUBE MOGULS

  In the new millennium, Robert Iger, former head of ABC television, got Michael Eisner’s spot at Disney. Brad Grey, the former head of a television production company, Brillstein Grey Entertainment, became the studio head at Paramount. Howard Stringer, a former president of CBS Television, became the first non-Japanese chairman of Sony. Peter Chernin, a former president of Fox broadcasting, became chairman of the Fox Entertainment Group, which includes the Twentieth-Century Fox studio. Robert C. Wright, the former head of NBC television, became head of NBC Universal, which owns the Universal studio. And Jeff Bewkes, the head of HBO, became chairman of Time Warner. That all of Hollywood’s new moguls have come from the realm of television reflects a singular if dismal reality: in 2009, only about 2 percent of Americans went to the movies on a given day, whereas more than 90 percent of them watched something on television at home.