Why Indie Movies Are An Endangered Species

Today's guest post is from Edward Jay Epstein.

Up until 2008, it was not easy to finance an independent film but, with the right script, stars, and director, the entire budget could be borrowed from banks on the strength of pre-sale agreements. What had made this business model work then was the likelihood the film had of getting meaningful distribution in the US domestic market (which includes Canada). Most of the better financed indie distributors, such as Miramax, New Line, and Paramount Vantage, were owned by the major studios that had bought these companies for, among other reasons, to expand their DVD shelf spaces at WalMart and other retailers. Their willingness to make commitments to distribute movies domestically had a great advantage overseas: it greatly increased the value of pre-sales, since foreign distributors benefitted from the buzz and publicity from an American opening.

Indie producers also could rely on domestic market to get a substantial part of their financing. Prior to 1990, they could get over fifty percent of their movie financed based on the value of the domestic market. Even though the value fell as distributors cut their commitments in the 1990s, the domestic market could provide a producer with 20-30 percent of his budget as late as 2007. And with that keystone in place, a producer could get the balance from foreign pre- sales and government subsidies. This formula was not perfect but it allowed indie producers to make such award winning films as The English Patient, Traffic or Babel. In 2008, however, he value of the American market virtually disappeared for the purpose of financing a movie. As one top producer told me in late 2010 ,”it is now zero.”

What caused this sudden decline was the closing of most of the studio-backed specialty distributors. Within the space of a few months, New Line Cinema, Miramax, Fine Line Features, Picturehouse, Warner Independent Films, Fox Atomic, and Paramount Vantage shut down. Most of the remaining ones, sharply cutback on making advance commitments. The causes of this cratering ranged from faltering DVD sales in large retail chains to the ending of output deals by HBO and other Pay-TV channels.

The result was that indie producers had to base their ability to borrow money almost entirely on the foreign market. Yet, foreign distributors then greatly reduced the amount they were willing to commit because they could no longer be confident that indie films would have the publicity and hype that goes with an American release. Making matters worse, three of the top seven markets, Japan, Spain, and Italy, sharply cut back on making pre-sales deals. So it was nearly impossible for a producer to assemble enough pre-sales in the remaining major foreign territories– Germany, Britain, France and Australia– to finance the film.

Even so, in theory, it was possible to raise the additional funds through government subsidies and tax shelter (which can provide 30 percent of the budget.) In reality, however, both pre-sales and subsidy agreement are just pieces of paper. To convert them to cash, the producer must bring them to a bank willing to accept them as collateral. And no bank will make such a loan without another piece of paper, called a completion bond, which guarantees that the movie, come hell or high water, will be delivered to the foreign distributors with all the elements, such as stars, specified in the contracts. So the producer must accede to the terms of one of the companies who sell completion bonds. The problem here is that the accommodations that must be made eat up a large part of the loan.

To begin with, banks will no longer will provide 100% of the value of the contracts. The best a producer can obtain is 80 percent minus the bank fees and pre-paid interest. From what remains,the foreign sales agents will deduct their fees, which usually run about 20 percent of total foreign sales. Then the completion bond company will deduct its fee and require a portion of the loan be segregated in an account under its control for unforeseen contingencies. As a result, it is not unusual for the producer to wind up with no more than half the money he needs for the movie.

Consider, for example, the case of a producer who needs to raise $10 million to shoot a film. Assume that he has lined up all the ingredients necessary for international sales, including three stars, that his foreign sales agent, who got the standard 20 percent commission, arranged $8 million in pre-sales contracts, and that he has received commitments for government subsidies and tax credits worth $3 million.. So, on paper, he has $11 million to make a $10 million movie. In addition, he has bought a completion bond from an insurer and found a bank willing to loan him money

In this case, the bank lent him 80 percent of the value of the $11 million collateral, or $8.8 million. From that sum, the bank deducted its 3 percent fee, or $264,000. It also required 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 amounted to $660,000. So there is only $7,876.000 available from the loan.

Next, the producer was contractually obligated to pay the foreign sales agent his 20 percent fee, or $1,600,000. Now he had only $6,276,00.

Then the completion bond company takes its 2.6 percent fee, or $260,000, and requires that 10 percent of the budget, or $1 million, be set aside for “contingencies” and $200,000 be set aside for the “deliverables” (which is the material that has to be delivered to foreign distributors before they pay for the rights.). After meeting these terms, the producer has only $4,816,000 left from the loan, or less than half the money he needed to shoot the movie.

How can a producer close such a yawning gap? If he 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 collateral since he has mortgaged his production to the hilt.

This leaves the producer only one feasible way to fill the gap: finding an equity investor to buy part of a movie that has not yet made. Making this even a harder task, , all the salable foreign markets have been disposed of. So the only real asset that remains is the 20 percent tier of the foreign contracts and subsidy contracts which is not covered by the bank loan. This is also the riskiest tier. But if all goes well that 20 percent will yield $2,200,000 which can be committed to repaying the equity investor after the film is delivered in all the foreign markets. But that still leaves an unsecured gap of $3 million. If the producer manages to bring the movie in on budget, the $1 million fund held for contingencies is released by the completion bond company, and this money then can be used to repay the equity investor. Even so, 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. But not all indie films ever get distributed in theaters of America . Every year tens of thousands of movies are submitted to film festivals, only a few dozen get meaningful distribution in theaters. And without such distribution, a movie has little chance of being licensed for TV or getting shelf space in major retailers for its DVDs.

Despite these odds, indie producer often do succeed in finding investors to fill the gap and produce award-winning movie. But this flawed business model also exacts a price. As one of the leading indie producers told me “The new number crunching game has caused the production budgets of films to collapse, so that what we used to make for $10 million a few years ago, needs to be made for $5 million now -- if it can be made at all! And meanwhile, all the hard costs of production (union rates, equipment, locations, etc.) have gone up, which means that producers now have to figure out how to deliver the same production value for much less than 50 percent of what they used to get to get the job done.” The picture may of course brighten in the future with new specialty distributors, such as the new Miramax, Anchor Bay, Film District, and reorganized MGM, getting into the act. It is also possible producers may soon be able to borrow against new forms of distribution, such as Video-On-Demand. Even so, as long as the American market lacks value for the purpose for the advance financing of movies, indie producers have a difficult, if not impossible, road to hoe.

Edward Jay Epstein received a PH.D. in giovernment from Harvard and has written 15 books, including two on the economics of the movie business-- The Big Picture (Random House, 2005) and The Hollywood Economist (Melville House 2010).  The I[pad/I phione app of the Hollywood Economist will be released next month.