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Film
financing is analogous to surfing. The goal is to keep
your eye out for, and catch, the next big wave. Each ride
is different and exhilarating, but sooner or later the
ride ends when the wave breaks upon the shore. I have
had the pleasure of "surfing" these financing waves for
the last twenty year, during which time we have experienced:
*The U.S. public equity wave (witness Cannon
and Carolco).
*
The foreign bank wave (e.g., Credit Lyonnais).
*The
Japanese financing wave (culminating in Matsushta acquiring
Universal and Sony acquiring Columbia).
*The
insurance-backed financing wave, which crashed eighteen
months ago.
*The
German public equity wave, which crashed six months ago.
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So
what's next? I had initially thought the next wave would
be the Italian or Spanish public stock markets, but they
have petered out. Instead, the next wave is clearly building
again in Germany, which would seem to defy gravity (they
must have way too much money in Germany), but this time
the funding is coming from the German tax shelter funds.
This wave is being driven by a number of factors, including
the following:
*Germany has closed down most other
tax shelters (such as for ships), so films remain one
of the last viable tax shelters.
*The
impetus behind all film financing waves is that the film
industry is sexy, and investors would rather have
a prospectus on their coffee table that has sexy pictures
from films than pictures of widgets.
*Investors believe it is better to invest
"directly" in films than in once high-flying publicly
traded German film companies.
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The
tax benefits available in Germany are astonishing.
German tax law permits the immediate deduction of
the cost of creating "intangible" assets, including
films. Thus, investors are able to immediately write
off the entire cost of producing a film. This is in
stark contrast to almost all other tax systems, which
require the cost of creating a film to be amortized
either over a number of years or as a percentage of
revenues received (in order to match deductions and
income). Under the German tax system, investors get
deductions now and income later, which is the stuff
tax dreams are made of. With tax rates in excess of
50%, the up-front deduction is a substantial benefit,
which is magnified if the investment is leveraged
with debt. For example, if the debt/equity ratio is
1:1, the investor immediately gets back more in tax
changes than the amount of the investor's actual cash
investment (although the investor will be liable for
repayment of the debt later on).
Most importantly, the films do not have to be produced
at all in Germany. Most countries that have film tax
shelters require production in the home country, and
the tax shelters serve as an indirect, but intended,
subsidy for local production. In contrast, Germany's
system results in an unintentional subsidy for worldwide
production. This fact has not escaped the German government's
attention, and over time, Germany has passed increasingly
restrictive requirements on German tax shelters. These
restrictions have changed the business model (discussed
below), but they have not - by any means - changed
the fundamental benefits of film tax shelters outlined
above.
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German
tax funds come in two basic flavors: (a) net-benefit funds
and (b) equity funds. Historically, most funds have been
net-benefit funds, which are typically structured similar
to the classic sale-leaseback model; a film company sells
underlying film rights to a German fund, which finances
the film's production budget by borrowing funds that are
directly or indirectly lent by, or guaranteed by, the
film company. The German fund then licenses the film rights
back to the film company (or its affiliate) for essentially
fixed payments over time. The film company defeases its
obligation to pay these fixed payments by depositing a
fixed amount with a bank up front. The amount deposited
with the bank is less than the total investment by the
German fund, so the net result is that the film company
gets to pocket the net benefit. In most transactions,
when the dust settles (net of commissions, transaction
costs, etc.), the film company pockets about 10% of the
budget of the film. In some cases, the film company also
owes some theoretical back-end participation to the German
fund, but these are typically structured in such a way
as to rarely kick in.
Since
the bottom line with a net-benefit fund is that the film
company pockets about 10% of the budget, and this is often
paid after production, the film company must have the
financing for the budget itself or from another source
(such as a bank loan). In other words, net-benefit funds
do not really provide the funds to fund the budget itself.
On the other hand, film companies do not owe much, if
anything, on the back end to net-benefit funds. Based
on this combination of factors, studios typically prefer
net-benefit funds.
In
contrast to net-benefit funds, German equity funds actually
cash flow all or a substantial part of the film's budget
and take a true equity position in the success or failure
of the film. While these funds absolutely care about the
economics of the deal, the German tax benefits take some
of the edge out of the negotiations. Thus, these equity
funds can typically accept more risk (and the possibility
for a lower return) than other equity investors that do
not have the German tax benefits. German equity funds
are not willing to be completely at risk. Typically, they
insist on minimum guaranties of at least 50% of the budget,
with estimates from a reputable sales agent of sales in
excess of the total budget. For marketing purposes, the
equity funds also like to have a guarantee of repayment
of at least a substantial part of the investment, even
if this guarantee is payable after a number of years without
interest. Also, the fund managers definitely want the
funds to earn a decent return; their hope is to raise
the next fund and the next… and this won't happen if the
first fund is a bust.
Many independent film companies relish German equity funds
because they can cash flow production and demand less
in return than a normal equity investor. Life doesn't
get better (unless you think the film will be a blockbuster,
which would result in the payment of a share of profits
to the equity fund, and you have a cheaper alternative
to fund production). As a result of increasing restrictions
under German law, including the requirement that investors
be at-risk, net benefit funds are waning and equity funds
are gaining favor. What was once a nice financing structure
for generating approximately 10% of the budget has thus
blossomed into the next full-fledged equity wave of film
financing.
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All
German tax shelter funds, including net-benefit funds
and equity funds, must meet a number of structural requirements
to obtain German tax benefits, but the two most important
ones are as follows:
*The
German fund must own the copyright to the picture. While
this causes film companies heartburn, it is
usually not a significant concern. First, all distribution
rights can be licensed back to the film company
(or its affiliate), and the value of a film lies in its
distribution rights, not in owning naked copyright.
Further, the copyright can be reacquired down the road
through a repurchase option granted up front.
*The
German fund must be the "producer" of the film. As such,
it is supposed to have substantial input (both creative
and otherwise) as to production of the film. In practice,
however, most of this authority is delegated one
way or the other back to the film company or its affiliates.
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For
U.S. film companies, an important consideration is the
U.S. tax characterization of the transactions. Issues
that need to be addressed include the following:
*Will U.S. or German withholding be imposed
on any of the payments?
*Will the arrangement with an equity fund
be treated as a deemed partnership between the film company
and the equity fund, possibly resulting in the equity
fund being taxed in the U.S. (and the film company
being liable for this tax)?
These
issues can usually be dealt with in advance by carefully
structuring the transaction, but it is better to address
these issues up front than on audit.
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Surf's
up! It is good to know that just as the last film financing
wave (the German stock market) is receding, the next wave
is coming in, and this rhythm will remain for so long as
the film industry needs money and sex sells.
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