The future of film financing, an essay by Adam P Davies

If it is clear that the producer wants the product on as many websites as possible, would market forces really create competition amongst filmsites or encourage them to scramble to pay money upfront in return for the "privilege" to sell the movie?"

If you thought the biggest threat facing the international film business was piracy, think again. The creation of a single global market on the Internet for distribution also challenges the pre-sales model where film rights are sold on a territory by territory basis. The majority of independent films intended for theatrical release often raise a third or more of their budget through pre-selling rights: in a world where distribution is day-and-date across territories and platforms this doesn't make so much sense, as a producer you would probably not want to favour one country over another any more than there would be a point in releasing through only one download/streaming service.

Adam P Davies, one of the top film finance and tax brains in the business, and adviser on several hundred features, including Warzone, Nil by Mouth, Gods and Monsters and Sexy Beast, has written a detailed explanation and exploration of this little discussed but genuine problem. The threat of piracy is still tough to quantify: however the loss of some 30% or more possible production funding is far more immediate - it is as if all sources of public finance were to vanish suddenly. The article first appeared earlier this year in the Film Finance Handbook - World Edition which we wrote together, launching in Europe at Cannes in May and hopefully debuting in North America at Sundance next year.

The Future of the Mainstream Financing Model by Adam P Davies, taken from the Film Finance Handbook: How To Fund Your Film (Netribution, 2007).

The Tangling of the Web

No discussion about the future of the film financing "model" is complete - or should even start - without serious thought being given to the impending changes from the growing impact of the internet. Not just from the perspective of the end-user's experience, but also the implications for distribution methods, real-time transfer of money, sources of production finance, piracy and so-on. It is true that no-one can unequivocally proclaim through a crystal ball exactly how the business will be run in ten years time. But what is clear is that the various "possibilities" thrown up by the internet that everyone was hypothesising about five years ago have now been replaced by "probabilities". At the numerous over-priced seminars regularly addressed by top-brass industry executives discussing forthcoming issues, the phrase "This is how things could change" has finally switched to "This is what we are currently planning and testing"...

 


Chapter 4 (free download) provides a full discussion of the impact of the web on filmmaking, financing, marketing and distribution. For now, though, we will look specifically at how the finance models discussed earlier in this Chapter might be affected by developments over the next few years. Of course, nothing in this section should be read as gospel as no-one knows for sure precisely how things will turn out. But there are some serious issues being raised right now that need to be addressed imminently if independent films are to continue being funded at the budget levels we are currently witnessing.

The key question to be addressed is: If, today, an independent film is typically funded predominantly from soft money, equity, pre-sales and gap, how is that likely to change? The answer simply depends on the extent to which these elements are sensitive to current developments in technology and, in particular, internet use.
First, soft money tends to be linked to the location in which the production finance is spent, so its availability is not directly affected by technological advancement. Equity is invested with a view to profit, ie. the excess of income over the repayable costs of production. In principle, an investor will not mind how this income is received (via new technologies or otherwise), so long as there is a surplus in which to share. If s/he believes that, commercially, the project is likely to turn a profit, s/he will invest, period. Gap finance is based on the risk that sales income will reach certain minimum levels so, if the structure of film sales doesn't change, neither will gap financing (all other things being equal). Which leaves us with the sales themselves.

As illustrated earlier, sales are territorial acquisitions of distribution rights, and (in the form of pre-sales) can typically provide between 10% and 60% of a budget. And this, in our view, is where the current financing model faces a serious potential clash with the future. If a film can be financed without the need for territorial pre-sales, either through alternative traditional means or via new technologies (see, for example, Chapter 4 below), then there isn't necessarily a problem, as the finance plan will not be affected by any changes to the way pre-sales work. However, for those films that will continue to require pre-sales as part of their production financing (remember, a bank, fund or other financier might want to see pre-sales in place to demonstrate the project's commerciality), there are some pretty harsh realities hiding just around the corner relating to the established territorial pre-sale structure.

The key word here is "territorial". A distributor puts up a certain amount of money based on how much it thinks it can make in its own territory. The internet, by its very nature, is not categorised on a territory-by-territory basis. So if the future is all about the web, it is likely to have a huge impact on a) the structure of distribution deals, b) thereby, the value of sales advances (MGs), and c) in turn, the contribution of pre-sales to the budget. The web is potentially a severe spanner in the works.

MGs today are calculated with reference to anticipated earnings, primarily from theatrical, TV, and DVD (video) exploitation. Distributors can forecast how much they think they will make during their licence period from TV broadcasts, video rentals and sell-through, cinema exhibition and the like, and decide how much they are willing to advance against it. But if these formats (or some of them) are to undergo wholesale change, then so will the income derived from them. Which leads us to the question: What formats will be available for the distributor to sell in its territory, how much will it get for them, and how (and when) will it get paid. But before speculating about how much income the distributor will get from where, we should consider how the end-user will in fact be viewing the product, and where s/he will get it from, and how much (and when) s/he is likely to pay for it.

Split Screens - only two valuable formats?

Taking the film industry as a whole, the current school of thought gaining ground the quickest is based on a 2-format model. The idea is that in future, the general public will think of film-watching in one of only two ways, being on a large screen, or on a little screen. Conceptually, they will distinguish between, on the one hand, watching a film in public with dozens (or hundreds) of other people laughing, crying, and screaming alongside them and, on the other hand, watching it in private, either alone or in the presence of a few family members or friends. The former could be called the "big screen experience" with an "event" feel to it, and the latter the "small screen experience".

Commentators argue that the big screen, or cinematic, experience is here to stay, despite (or even because of) technological advances, and the statistics, at least so far, seem to back this up. On the whole, cinema attendances seem to be fairly stable, notwithstanding a few countries bucking the trend by experiencing significant short- or medium-term drops or rises. But there appears to be no wholesale desertion of the movie theaters, and no earth-shattering worldwide increase either. And this pattern looks to remain fairly steady, at least under current forecasts.

The cinema's robustness as an entertainment option might, in Economics terms, be part-explained by the fact that a trip to the cinema can display certain "Geffen good" characteristics. This means that, for some people, should their income drop, they are actually more likely to go to the movies instead of, perhaps an expensive meal out or a visit to the live theatre. Conversely, spending on a "normal" (rather than Geffen) good would tend to fall as income decreases, but the cinema (like the humble potato) bucks this trend, certainly for those who are fairly well-off to start. On the other hand, for those in lower income brackets, a rise (rather than fall) in earnings will increase the chances of a trip to the movies, as the cinema becomes a more affordable option, when they might otherwise stay in to watch a video or participate in other low-cost entertainment activities.

The cinema thereby behaves more like a "normal" good for them. These two phenomena, when combined, make cinema-going a fairly tough animal with higher than normal chances of survival in most economic circumstances.

In non-Economics terms, people simply enjoy going out to the movies, and supposedly always will. It's a different experience to watching live theatre, and there are not many new technological inventions which are likely to compete with the atmosphere and tradition of the "big screen experience".

On the other hand, the viewing of films on other formats seems to have a very different future. At present, the choices are watching on television (whether paid for or free, scheduled or on-demand), on DVD / video (rented or owned), on the internet (downloading or live streaming), on mobile phones and, increasingly, on handheld gaming consoles (HGCs). It seems widely accepted that all these formats will, over the next few years, "converge" - probably eventually into just one, single format. Conceptually, a viewer will not distinguish between watching a movie through any of the above means. The suggestion is that s/he will download a movie on-demand via the internet, and then decide whether to watch it on a fixed screen or on the move, either immediately or at a later date. This assumes that films will not spontaneously combust after a period of time (to replicate the current "rental market"), although with technological advancement, that option shouldn't be totally ruled out. So after purchasing a film one morning, say, the viewer should - at the press of a button - be able to switch from viewing it over breakfast on a home entertainment system (the large screen in the dining/living room) to some form of mobile device (a hybrid of today's mobile phone, PDA, MP3 player and HGC) whilst travelling to work. Then, on reaching the office, a flick of another switch and the film "jumps" to the computer screen so s/he can watch the ending during lunch-break. In the viewer's mind, all of these are the same "small-screen experience", and a single price should be paid for the right to watch - perhaps for only a limited period of time - on any or all of these devices. The purchase itself would take place either wirelessly (perhaps through a mobile network) or via an internet download, but the viewer will not distinguish between these options when it comes to paying the purchase price and then viewing the movie. All this technology is already with us ("Blue-tooth" being one example of a method wireless switching from one device to another); it's just a question of rolling out the products to the consumer market at sensible speeds and prices, and that should take just a few years to achieve. To summarise, a 2-format theory would suggest that, conceptually, people will consider the right to watch a movie anywhere in private - as opposed to on the big screen - as a single product, and will therefore pay a single price.

The important thing to note here is that at no stage did the viewer watch a "TV channel" (paid or free), or hire or buy a hard copy of the film, such as a video or DVD. This means that, if the entire public does end up watching movies in this way, there will be no market for TV or DVD sales as we know it, and distributors buying film rights in the way they do today will not be able to make local sub-sales of those rights. It follows that format-to-format "holdback windows" would become instantly confined to history. In fact, if you take the 2-format approach to its logical conclusion, as the big-screen and small-screen experiences themselves are considered different products, they do not actually compete with each other, and so "day-and-date" (ie. simultaneous) releasing across both formats could become the norm.

The only "territorial" rights a distributor would buy would therefore be theatrical and so, if internet rights (ie. the right to transmit content online, through the web) are not acquired by these distributors because they cannot be split territorially, the value of MGs will drastically decrease. Where film rights are sold on a pre-sale basis, as an element of the production financing, this would clearly leave a huge hole in the budget as MGs plummet.

The Need to Sell Internet Rights

It follows that, in order for rights pre-sales to maintain their current levels of contribution towards production finance (and assuming theatrical receipts don't miraculously increase so much that they cover the deficit from loss of TV and DVD revenues), either more theatrical-only presales need to be made - to make up for the loss in the TV and DVD element - or some element of internet rights might also have to be pre-sold. Pre-selling more of the world theatrically is not necessarily a huge problem if recoupment for other financiers - and a decent profit - can be expected from income resulting from subsequent sales of internet rights. Of course, returning to large-scale "soap"-type sponsorship is another option (see section on Sponsorship, above), but for now we will concentrate on the internet issue.

Note that the licensing of internet rights is a fundamental legal requirement for the purchase of films to be made online. The problem is that internet rights, by their very nature, are not territorial, and so cannot be sold to territory-based distributors in the traditional way. That said, for many existing films, internet rights have in fact been sold to distributors, but on condition that they may only be exploited when sufficient, reliable and industry-acceptable geographical safeguards are in place, so as to ensure each distributor cannot sell to an end-user outside its granted territory. Despite inordinate amounts of money being thrown at creating this type of technology, in truth the internet is no closer now to having hack-free geographical safeguards as it was when these contractual clauses first started appearing in the late ‘90s. And if territorial exclusivity is not a realistic option (although some still argue it is only a matter of time before the technology will arrive), a traditional territorial distributor is unlikely to be the purchaser of internet rights in the future.

This throws up a few more questions. Does it mean that internet rights can only be sold in one go on a worldwide basis? If so, who would buy them? Could a pre-sale of internet rights be possible, to help finance the film? In order to address these issues, it's necessary to consider how a buyer itself would make money. If it buys these internet rights, it needs to know that it can recoup the purchase price, and turn a profit. It must therefore understand how - in practice - it can exploit these rights once it purchases them. To consider this, we need to start by looking at the other end of the supply chain, and working our way up to the Producer see how the business model might work.

Websites as the End-User's Point-of-Sale

First and foremost, we have to presume that the future model relies on consumers legally purchasing films online, as the alternative would look like a pretty grim prospect indeed. In this regard, a quick comparison with the music industry over the last few years should present a stark warning. For now, though, we won't address how the industry - through encryption software or otherwise - will prevent a similar collapse in revenues from illegal acquisition of content (again, see Chapter 4, below). But to provide any financial model for the future, the assumption has to be that there will be a consumer market for acquiring films at a price. Besides, a Producer, having spent substantial sums in getting his/her film made, cannot receive income to repay the financiers and make a profit unless the public ultimately forks out cash to watch the film. It's all well and good saying "But I can get my film to millions of viewers through Google Video", but if they're not paying to watch it, and they are effectively replacing your TV and DVD revenues, how are you going to fund your $10m film in the first place, or repay any financiers who were mad enough to give you the cash?

So we assume that the end-user, the consumer, will be prepared to pay a certain amount to buy the film for his/her small-screen experience. Unless mobile phone networks' bandwidth increases dramatically, and the associated costs to users reduced even more significantly, the initial download of a movie is likely to be via the internet rather than straight to mobile. In other words, films will be bought online. This also means, of course, that they must be priced in such a way so that the prospective viewer isn't enticed to obtain an illegal copy for free instead. Current research suggests that the average net user in Europe and North America would choose to pay approximately $2 online for a music album rather than download it illegally, but at any higher price, s/he is more likely to download it for free from an illegal site. Accordingly, the price of mainstream albums has continued to fall towards these levels, and it appears that an equilibrium is not far off. According to some reports, by the end of 2005, for the first time, more albums (not yet singles!) were being downloaded from the net legally for a price than illegally for free.

Let's suggest, for argument's sake, that the "natural" market price to watch or own a feature film turns out in due course to be $3 (some say it will be even lower than this, but it doesn't look likely to remain above $5 for longer than a few more years). This means that $3 would be the maximum amount a consumer would typically be prepared to pay to buy the film, and so it follows that this can be taken as the price that films will sell for at the point-of-sale. It might not sound too much, but with substantially less distribution costs involved than for TV broadcast and DVD manufacture, a larger proportion of the end-user's payment should end up in the Producer's collection account. Plus the fact that, at the right price, more people might buy (although not necessarily watch) the small-screen experience than do today.

So who gets the $3? As far as the end user is concerned, s/he will pay the website from whom s/he is buying the movie. This will be the site(s) s/he feels most comfortable visiting and purchasing from, which in turn will depend on a number of factors, including the branding of the site, the ability to search for films that might appeal (by genre, stars, director, length, language, even price), download speed and, importantly, the general ease of use. This doesn't necessarily mean the site with the biggest size of library will succeed. Research shows that a prospective viewer will tend to use a site where s/he can quickly and easily find a film to match his/her mood, price, or other personal requirements.

These popular consumer "film sale" websites, which we will call "filmsites", may be run by established brands in movie retail (such as Blockbuster, HMV and Virgin), "refocused" TV film-channel brands (such as IFC, HBO, Showtime, and FilmFour), mainstream TV channels (ABC, Fox, BBC, MTV, Sky, Channel 4), dedicated arms of studios (Warner, Sony, Fox, Disney, etc), general retailers (K-Mart, Wal-Mart, Tesco), current online content sellers (Real.com, Amazon, emusic.com), internet community sites (Orkut, MySpace, bebo), film-specific websites (IMDb, RottenTomatoes, aintitcoolnews.com), video sites (Revver, Blip.tv, iFilm, Youtube), standalone players (iTunes, Joost, Miro), internet service providers (NTL, AOL, BT), web portals (Google, Yahoo, MSN), or new emerging site brands that simply manage to get the marketing right. They may end up, for those viewers who prefer to be "told" what to watch, "streaming" content to paying subscribers in a similar way to current-day television channels.

What is abundantly clear, however, is that no Producer will want to grant any one of these filmsites a totally exclusive right to sell his/her movie, as s/he will almost certainly lose end-user sales from the numerous other competing sites. In fact, s/he will probably want his/her movie available to buy from as many sites as possible in order to maximise sales. So why would any filmsite pay up-front for the right to sell a movie to the public? If it is clear that the seller (Producer) wants the product on as many websites as possible, would market forces really create competition amongst filmsites or encourage them to scramble to pay money upfront in return for the "privilege" to sell the movie? Further, with technology allowing each $3 paid by the end-user automatically to be transferred electronically to those entitled to it, the risk element of pre-buying is taken out of the equation. The ultimate income payable to the Producer can be calculated directly with the reference to the number of actual purchases, and paid over in real time (at the exact point the end-user buys the film).

Who would pay an MG?

However, Producers will argue that, with the loss of TV and DVD revenues in pre-sales, they need an up-front payment for internet rights to put towards production costs. Their argument is simply "If you want it, you have to pay for it". One option might be to offer certain filmsites exclusivity after all, but only for a limited time period (from initial release). In other words, Site XYZ could pay the producer an MG of $XXX in return for the exclusive right to sell the film online for a limited period, maybe a week or two, or perhaps a day or even just an hour. Only then would the film be released to all the other filmsites (by which time the pirates will probably have got hold of it anyway!). Site XYZ would have to estimate how much it thinks it will make during the exclusivity period in order to calculate how much it is willing to pay for the MG (as distributors similarly do today). This would probably depend on the negotiation of an agreed "split" of the consumer's $3, with this split being dressed up as either a royalty payable to the Producer (with the filmsite keeping the rest), or a commission being retained by the filmsite (with the remainder being paid over to the Producer). Only market forces will determine whether this kind of pre-sale would generate a high enough MG to fill the production financing vacuum. The length of the exclusivity period would probably be a determining factor (but marketing policies and the risk of piracy might dictate a natural limit to this), as will any premium the filmsite might be able to charge the end-user during the exclusivity period. There is also the question of whether a particular filmsite's contract will be sufficiently bankable (ie. reliable enough for a bank to discount it) in order to get the film made in the first place.

Although territorial exclusivity is clearly not a realistic option , it might be possible to enhance revenues by pre-selling to different filmsites on a language-by-language basis. In other words, if Site XYZ (an English-language filmsite) pays for the exclusive right to market the film in English for the first week of release, Site PQR could be given the equivalent right concurrently to market it exclusively in French. This would allow more than one filmsite to sell the film during the exclusivity period, but each to a different customer base, in a similar way to the territorial distribution model in use today. The reference to language would more likely to refer to that used on the filmsite rather than the language of the film itself, as any one filmsite may have the film available for purchase in more than one dubbed language, but its market would be defined by the language (be it English, French, German, Japanese, etc) of its interface with the public.
Middlemen and a New Breed of Buyer

Under this 2-format scenario, the traditional sales agent would still sell to territorial theatrical buyers for the big screen experience but, in relation to selling the small-screen experience, it would have to familiarise itself with a whole new breed of buyer. These buyers would represent the various filmsites, and sales agents will need to create new relationships and networks, possibly with output deals, first-look deals, alliances and so on. It may be that a new type of "middleman" materialises specialising in having all the relevant filmsite contacts and relationships, and is appointed specifically to make internet rights sales to the filmsites. These middlemen could be seen as pseudo-distributors, taking a fee or commission for their services. They might be appointed by the lead sales agent (as a kind of sub-agent), or even by the Producer directly, effectively meaning there are two sales agents, for big and small screen rights respectively. It may even be that these distributors themselves put up the MG in return for the right to make sales to filmsites. They would then keep any income received from such sales until the MG is recouped. In particular, if it turns out that giving exclusivity periods to certain filmsites just doesn't work, it might be that these "middlemen" distributors simply agree splits with all the filmsites, and calculate the MG based on projected income from those splits. In other words, if the end-user's $3 is to be divided (say) $1 to the filmsite and $2 paid over to the distributor, the distributor might pay the Producer an MG based on how many $2s it thinks it will ultimately receive as end-user purchases of the completed film take place. Remember, money moves on the web in "real-time" these days, so payment terms, accounting procedures and auditing become much easier. Some have even suggested that, with technology, these middlemen might even turn out to be not much more than a piece of software, into which you submit your film, and it automatically distributes it to all the relevant film sites and collects money on your behalf. Others have suggested that, ultimately, end-users will simply refuse to pay for online content at all, and income will instead come solely from a share of advertiser revenue on the filmsites.

The Future is Nigh

All this still leaves open a number of questions, not least who is responsible (and who pays) for marketing and advertising the film on the web, who these new middlemen would be (specialist arms of existing sales agents, studios and/or distributors?), and what happens to the internet rights to existing films already "sold" on a territory basis (would they all be bought back for a dollar - because they're currently worthless - and then resold?).

Of course, all of the above is really mere speculation, but most of these technologies are actually already in place, money already moves on the web in real time, movies are already available to end-users online for a fee, and internet rights are already being valued and their ownership negotiated hardball in sales contracts. If you also consider that, today, mobile phones are capable of "playing" entire feature films, TV advertising revenue is dropping like a lead balloon, and DVD sales have already peaked in many countries, perhaps the future is not so far away after all. Any distributor buying rights these days for 7 to 15 years must think seriously about these internet issues, as they will clearly have a huge impact on the distributor's ability to receive income from traditional sources (TV, DVD, etc) well before the expiry of the distribution contracts. Likewise, any Producer reading this should already be considering the impact of internet rights on the ability to finance for his/her next film.

The Future of the Mainstream Financing Model by Adam P Davies, taken from the Film Finance Handbook: How To Fund Your Film (Netribution, 2007).

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