FINANCING OF INDEPENDENT FILMS: OVERVIEW OF PRODUCTION COMPANY BUSINESS FORMATION AND FINANCING BASI
FINANCING OF INDEPENDENT FILMS: OVERVIEW OF PRODUCTION COMPANY BUSINESS FORMATION AND FINANCING BASICS
Hi everyone, my name is Justin Sterling. I am an Attorney and Founder of The Sterling Firm. We are answering the question: How to form an independent film production company?
WHAT IS AN INDEPENDENT FILM PRODUCTION COMPANY
To be taken serious in the entertainment industry, a filmmaker will want to form a production company to create their projects and pitch to investors and Hollywood executives. An independent film production company is a business that creates independent feature films. Technically speaking, an independent feature film is any film not made by any of the major Hollywood studios – Warner Bros., NBC Universal (which includes the Comcast Corporation), The Walt Disney Company, Paramount, Viacom, CBS Corporation, News Corporation, Fox, or Sony (which includes Columbia Pictures, MGM, and United Artists). What is a major studio? Essentially, a major studio differs from an independent production company in that it has all of the following:
(1) Its own production capacity; (2) Its own studio lot; (3) Its own financing capabilities; and (4) Its own distribution and marketing capabilities.
Generally, with independent film production the filmmaker retains artistic and budget decisions concerning the film. However, if the film obtains studio distribution, the major decisions in the production will be subject to the approval of the studio.
The form of the business structure for the independent film production company should take into consideration the objectives of the filmmaker – is this going to be simply a one film project, or is this going to be a career and make multiple films? It must be decided whether this is a business that will require ongoing investor relations and whether the filmmaker intends a slate of multiple projects (in which one project should always be in pre-production, one in production, and a third in distribution).
The filmmaker will also have to decide whether the operating production company is kept separate from the investment vehicle for financing of the filmmaker’s individual projects. An investment vehicle is in itself a separate business entity. In essence, one business form will be for the production company and another business form will be used to raise funds for a particular project in which the company is producing. In order to provide the most protection, it is preferred to have separate business entities for the production company and the individual film projects. An investment vehicle is a separate business entity in which investors can contribute funding capital for the film project. In doing so, if the individual film project ends up being a failure, only the capital contributed to the investment vehicle is at risk and not the capital in the production company itself. This enables the production company to continue business and make up for any losses with other projects.
The business formation that the production company takes may give an opportunity for a first level of startup investment capital. A subsequent second business entity which the production company takes an active part in can be utilized as a financing vehicle to attract additional investor capital. There are four applicable business forms:
I. SOLE PROPRIETORSHIP II. PARTNERSHIP III. CORPORATION IV. LIMITED LIABILITY COMPANY (LLC)
When choosing the proper business structure, there are four main areas of concern:
(1) Control – The filmmaker’s creative control of the project; (2) Financing – Financing capabilities and funding of the production company and the individual film projects; (3) Liability – Exposure for contractual obligations and tort liability (which is the duty to pay compensation for accidents or intentional misconduct); and (4) Taxes – Federal and State tax obligations owed and whether the tax can be shifted to the company or its owners.
Each business entity form offers advantages and disadvantages regarding the four main areas of concerns. There is no one size fits all, as each production company and each individual film project has its own circumstances to be considered when forming the business or the investment vehicle to raise funds.
INDEPENDENT FILM PRODUCTION FINANCING
The filmmaker should utilize a combination of financing. A filmmaker should not try to finance a film alone. The old saying is the filmmaker should use “OPM” – Other People’s Money. However, that is not totally accurate. Nowadays, the filmmaker is likely to put in some of his or her own funds toward the financing. This shows faith in the success of the production company and the film project.DEBT FINANCING
Debt financing must be repaid. This type of financing consists of credit cards, personal loans, and promissory notes. Debt financing can be secured by collateral or unsecured. If the filmmaker defaults on a secured loan, the lender can take over the property that was put up as collateral. If it was an unsecured loan, the lender must file a lawsuit against the debtor to recover the money.EQUITY FINANCING
Equity financing represents investments that are ownership interests in the business. This type of financing includes shares in a Corporation, units in a Limited Partnership, or membership interest in a Limited Liability Company. As opposed to debt financing, there is no obligation to repay the money invested as capital when dealing with equity financing, which can be very attractive to filmmakers.
Rather, the investors share in the risks and rewards of the business. However, in dealing with such financing, the filmmaker must comply with State and Federal security laws. If the filmmaker offers membership interests in a Limited Liability Company, units in a Limited Partnership, or shares in a Corporation to potential investors in exchange for money, the filmmaker is conducting an “offering” pursuant to State and Federal security laws, and if the filmmaker does not comply with all the disclosures and legalities, they may find themselves civilly or even criminally liable.
THE DISTINCTION BETWEEN ACTIVE INVESTORS AND PASSIVE INVESTORS
The biggest factor determining whether the filmmaker must comply with security laws and provide detailed disclosures to investors is whether such investors will be active or passive in the business.
If an investor participates in the management of the business, then the investor is considered to be an active investor. Members of a member-managed Limited Liability Company, shareholders who are also officers or directors of a Corporation, and general partners in a Partnership are considered to be active participants in the business. These investors not only invest their money, but they also take active control on the success of the business. Active investors take on a regular involvement and help the filmmaker-producer make important decisions in managing the production company or the individual film project.
Whereas, if an investor does not take part in the management of the business, the investor is considered to be a passive investor. A passive investor is one who is not involved in the active participation of a business and does not have immediate control over the activity that produces income. The business investment is considered a security because it involves the investment of money in a common enterprise with the expectation of profits from the efforts of others. Members of a manager-managed Limited Liability Company, shareholders who are not also officers or directors of a Corporation, and limited partners in a Limited Partnership are considered to be passive participants in the business. The passive investor provides money, but does not run the business. This type of investor is more attractive to the independent filmmaker-producer because it allows them to maintain the sole creative control of the direction of the production company and the individual film projects.SECURITY LAWS
Passive investments are subject to compliance with State and Federal security laws. A passive investment of money for an equity ownership in a business is considered a sale or offer of a security.
The United States Securities and Exchange Commission defines a security very broadly as: "Any note, stock, treasury stock, bond, debenture, certificate of interest or participation in any profit-sharing agreement…, any collateral trust certificate, preorganization certificate or subscription, transferable share, investment contract…"
Moreover, pursuant to the Howey Test created by the United States Supreme Court in 1946, an investment contract is subject to security laws if it contains the following elements:
(1) An investment of money in a common enterprise; (2) An expectation of profits by the investor; and (3) The profits are derived solely by the efforts of others.
See SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
The purpose of the test is to protect the investing public against fraud. The laws regulating securities are designed to promote full public disclosure. Generally, most issues of securities are offered in interstate commerce – that is, the issuer of the security uses the mail or the internet. Therefore, the securities must be registered with the Securities and Exchange Commission, unless an exemption from registration applies. When dealing with securities, it is important to have the counsel of an Attorney.COMBINATION OF FINANCING
In most cases, the filmmaker will use a combination of different kinds of financing. A common example of the financing combination that may be utilized includes:
(1) Gifts; (2) Grants; (3) Investment in a start-up production company (capital contributions provided by active investors in a C Corporation, S Corporation, or member-managed Limited Liability Company, and the investment of the intellectual property written, acquired, or optioned by the filmmaker-producer); (3) Financing of development and packaging funds or a portion of production funds raised by a passive investment vehicle compliant with security laws; (4) Crowdfunding; (5) Product placement; and/or (6) Domestic or international negative pickup deal, foreign presales, or tax incentives.
Now that we’ve covered the general overview of the independent film production company and the investment vehicle, you can be more aware of the legal issues involved in forming the business and the basics of financing an independent film. However, again, this only provides a general overview. Many of the terms referenced in this video need more explanation. Please refer to the additional videos discussing each of the topics in more detail.
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