Other People's Money

1/8/2000

OTHER PEOPLE'S MONEY:

Financing the Low Budget Independent Feature Film
With Private Equity Securities Offerings

By Daniel M. Satorius, Esq.

Lommen, Abdo, Cole, King & Stageberg, P.A.

In recent years, low budget independent films have been made in record numbers. Most are financed from sources outside of the motion picture and television industry. Major studios and distributors spend billions of dollars each year on the production and distribution of their own theatrical motion pictures. These companies are cautious and tend not to take risks on unusual projects, untested producers, and first-time filmmakers.

Filmmakers who are unable to secure financing for their projects from the majors, or who are unwilling to seek such financing because of the controls and other requirements accompanying such financing, often turn to private investors financing. Private investor financing comes from individuals or entities who contribute funds to the entity producing the film in exchange for an ownership interest. Frequently these private investors are outside of the motion picture and television industries with little or no knowledge of the industry.

Private investor financing can serve many purposes. Some filmmakers use investor financing to obtain the funds needed to acquire rights in properties, the writing of screenplays, and other development costs. Having secured such rights, these filmmakers may be able to secure pre-sale or negative pick-up agreements with studios, distributors, or other industry financiers. In instances where the amounts secured by pre-sale agreements and loans are insufficient to finance the project's entire budget, filmmakers may use investor financing to cover the gap. Other filmmakers use private investor financing to fund 100% of the production costs.
Private investor financing has stood the test of time as one of the independent filmmaker's best alternatives. This is especially true in these times of industry consolidation which has resulted in a shrinking number of traditional financing sources. Whatever circumstances lead a filmmaker to private investor financing, they enter the enigmatic world of securities law .

STATE AND FEDERAL LAWS APPLY

Let's begin with stating the obvious: equity financing must comply with state and federal securities law, an area that demands the assistance of a lawyer with knowledge and experience in securities law. Whether the filmmaker is selling stock in a corporation, membership interests in a limited liability company, or partnership interests in a limited partnership, ownership interests are likely to be deemed "securities" under state and federal law. Any arrangement under which one invests money in a common enterprise with the expectation of deriving a return primarily through the efforts of others can be considered a security. Even promissory notes and investment contracts can be considered securities.

Basically, in the context of financing independent feature films, any arrangement which includes a passive investor is probably subject to securities laws. A passive investor is a person or entity who provides financing but who is not actively involved in the business of making or exploiting the film and related properties, and expects to share in the profits of the film.
Failure to comply with securities laws. It is illegal to offer or sell securities unless a registration statement has been filed with the Security and Exchange Commission and appropriate state authorities or unless the securities or the transactions qualify for an exemption. Failure to comply with securities laws can result in severe penalties, not only for the offeror but in some cases also for lawyers, accountants, and others who have control over or knowledge concerning the securities. Offering or selling securities in violation of the Securities Act of 1933 (the "Securities Act") is a felony punishable by up to 5 years imprisonment and a $10,000 fine for each violation. It is common for criminal indictments to also include counts of violation of federal mail fraud, wire fraud and conspiracy statutes. In addition, the Commissioner of Securities is empowered to enjoin actions such as the sale of securities that violate the Securities Act and to suspend or revoke the rights of attorneys and accountants to practice before the Securities Commission. The Commissioner may also seek civil penalties up to $500,000 per violation.

The Securities Act also permits injured parties to bring civil actions against issuers for violations and against brokers, attorneys, accountants, and others who control the person liable under Sections 11 or 12 . Most civil actions involve claims seeking rescission of the transaction and the return of the investment. But damages, penalties, and other remedies are also available to plaintiffs in such actions.

State statutes provide for similar administrative sanctions, civil and criminal penalties, injunctive remedies, and civil causes of action.

Selecting an exemption. Registered public offerings are impractical for the single independent feature film because the transaction fees are expensive, the time commitment to prepare and register the offering is considerable and the exploitation of a film and its related properties is typically limited in duration and is not a continuing and expanding enterprise. Legal fees for registered public offerings often exceed $100,000 and underwriting fees can exceed 10% of the offering amount. Greater financial reporting requirements for public offerings also make them less suitable for the financing of a single film. However, the recently developed Small Corporate Offering Registration ("SCOR"), discussed below may be suitable film offerings. SCOR is intended to combine many of the desirable features of registered offerings with the reduced transactional costs feature of exempt offerings. Therefore, selecting the statute(s) or regulation(s) that will be relied on to exempt his/her offering from registration offering is one of the first step in helping a filmmaker structure his/her offering.

State and federal securities laws offer a variety of options for the independent feature film offering. The following chart lists the types of offerings under federal securities laws that may be suitable for independent feature films. The offerings are categorized according to some of the issues relevant to the financing of independent feature films.

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Selecting the regulation(s) and/or statute(s) to apply to a particular filmmaker's situation depends on the filmmaker's goals and the limitations he/she is willing to accept. For example, if the budget for the film is under $1 million, Rule 504 and SCOR are available for such offerings. If the budget is under $5 million, Reg. A, Reg. D, Rule 505, and §4(6)are available. If the filmmaker believes advertising is essential to the fundraising process, then Rule 504, SCOR, Reg. A, and in certain situations §3(a)(11) are available.

Although other options are available, Rule 504 for films under $1 million and Rule 505 or Section 4(6) for films between $1 and $5 million, are the most likely exemptions from registration to be relied upon for independent feature film projects.

The Regulation D ("Reg. D") exemptions (Rules 504, 505, and 506) are a safe harbor for those who comply with the exemptions to avoid registration. But no statute exempts the offeror from fraud claims as discussed below. The Reg. D exemptions are non-exclusive and can be utilized along with other exemptions such as §4(2).

The §4(2) or "private offering" exemption requires a subjective determination as to whether an offering qualifies as a "private placement". The relevant factors include: the degree to which the dollar size of the offering and the number of units offered is limited, the degree to which number of offerees is limited, the degree of sophistication of the offerees (i.e. whether the investors are accredited), the extent to which information is available to the offerees, the extent to which the offering is private in nature, and the extent to which purchasers are restricted from reselling their securities . Because evaluating these factors requires subjective analysis under §4(2), whereas the factors are more objectively specified in Reg. D exemptions, it is generally advisable not to rely strictly on §4(2).

However, in limited circumstances reliance solely on §4(2) may be appropriate. For example, where there is a small number of accredited and sophisticated investors (e.g. five or less), particularly where the offeror is well known to the investors such as family members, and where the investors are given complete access to all relevant information about the offeror and the offer, in these situations it may be reasonable to save the expense of an offering memorandum in favor of abbreviated documentation.

The §4(6) exemption may be useful if financing can be raised solely from accredited investors. Accredited investors are institutions such as banks and insurance companies or natural persons whose net worth (with spouse) is greater than $1 million or whose net income exceeds $200,000 per year ($300,000 per year with spouse) for the past two years.

The §3(a)(11), the "Intrastate Offering" exempts "[a]ny security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory." To qualify for this exemption, the offering must be strictly within a single state, including, for example, the offeror, all offerees and purchasers, and the business -- all of which must come to rest in a single state. There is no specific disclosure requirements under this exemption or the SEC's Rule 147 , but, as discussed below, anti-fraud rules and the state securities laws apply.

SCOR has been much touted as the answer to the entrepreneur's financing prayers. The SCOR registration form and disclosure document uses a question and answer format known as the Small Corporate Offering Registration Form (Uniform Form U7 ) to create offering documents which are registered under state securities laws to qualify for exemption from federal registration under Rule 504, Regulation A, or Rule 147 of the Securities Act.
The publicized advantages of SCOR over other offerings include: (a) the issuer may sell to an unlimited number of unaccredited investors, (b) investors can resell their shares, (c) advertising and general solicitation is permitted, (d) the use of a question-and-answer, fill-in-the-blank form, lightens the disclosure burdens and simplifies the registration procedure compared to other registered offerings, (e) the prospect of a uniform registration device may allow Rule 504 offerings to be registered efficiently and inexpensively in multiple states , and (f) "minimum investments" are lower than typically available from traditional stock offerings.

In reality, the SCOR Program is of limited benefit to the independent filmmaker. First, SCOR is only available to corporations with an existing business. This eliminates start-up production companies. Second, SCOR's advantages of advertising the sale of securities and selling units to an unlimited number of subscribers must be weighed against some significant limitations. For example, since SCOR is limited to $1 million, the right to advertise and sell to an unlimited number of persons does not seem particularly powerful. The filmmakers must ask themselves whether they will actually be able to use advertising effectively to generate sale of units; and whether they want a large number of strangers in their deal. Furthermore, the advertised sale of securities for an offering with a very low-cap, is likely to result in a low per unit price, thus increasing the likelihood that there will be large numbers of equity holders thereby increasing the paper work for the filmmaker/offerer at the time of sale and later accountings. Given the right to advertise and the more public nature of the SCOR offerings, preparers of SCOR offerings are well-advised to take greater care in the drafting of the offering memorandum which adds to the expense of document preparation. Finally, SCOR offerings generally take more time to complete, file, and qualify for than exemption offerings. It may take two months or more to get such registrations approved. Most state agencies have little experience with SCOR offerings. In most situations qualifying for an exemption is faster.

The selection of federal regulation or statute must be made in conjunction with the state securities laws (the Blue Sky Laws) of each state in which the offering is offered and/or sold.

ANTI-FRAUD.

S.E.C. Rule 10b-5 , other anti-fraud provisions , and state "mini-10b-5" laws offer disgruntled investors causes of action for misrepresentation or failure to disclose risks associated with the investment. Simply stated, 10b-5 says it is unlawful for anyone to make a false statement about a material fact, to omit a material fact, or mislead someone in connection of the sale of, or the offer to sell, securities.

Although some securities laws such as Rule 504 do not require the offeror to provide an offering document to the offeree, it is advisable to provide a thorough written document for several reasons. First, the offering document memorializes the terms of the offering and the representations and disclosures given to the offeree. Second, in all cases and irrespective of whether the offering is registered or exempt and whether documentation is required or not, the offering is subject to 10b-5 and certain other laws relating to fraud. A properly drafted offering memorandum can provide a defense to claims of fraud and misrepresentation.

Not every offering demands an offering memorandum. In situations involving highly negotiated transactions with a small number of sophisticated accredited investors who have extensive access to the offeror's books and records, an offering memorandum may not be necessary and the costs of preparing it may be avoided.

Nevertheless, the practical effect of the fraud rules is to require the full disclosure of all material facts relating to the offering and to require the offeror to make no misrepresentations. In most situations the prudent course is to present the potential investor with a carefully written memorandum fully describing all relevant material risks and terms.

THE OFFERING MEMORANDUM

The following discussion addresses aspects of offering memorandums specific to feature film offerings, especially independently produced films.
Rights in underlying properties.

The genesis of a film can come from a variety of sources such as original screenplays, books, articles, short stories, life stories, and songs. The company financing the film must acquire certain rights in these materials including not only the rights to make a motion picture but also other derivative and ancillary works such as the rights to make sequels and remakes, television programs, merchandise based on the film and/or characters from the film, soundtrack albums, books, and new media/interactive works. The agreements by which the company acquires rights in the underlying material should specify the types of media in which the film and the derivative and ancillary works can be exploited. The offering memorandum should include a discussion of the company's ownership and/or control of such rights, including the copyright status.

Production/Distribution Arrangements with Other Parties.

It may be necessary or advantageous for the financing company to associate with other companies such as production companies, or distributors, to obtain financing for the production and/or distribution of the film, or for production services. These associations may take the form of co-productions, agreements for the pre-sale of distribution rights in certain territories, agreements for the distribution or broadcast of the film, or other arrangements. The offering memorandum should discuss the company's rights to make such agreements. When the company is required to assign a portion of its rights in the film to such distributors or production companies, the terms of the assignment should be disclosed in the offering memorandum.

Disclosing risks.

Investments in the production of independent films are highly risky. Securities laws do not prohibit investors from taking such risks, but they require complete disclosure of the material risks.

Disclosure of risks was believed to be the best way to regulate securities by the three lawyers who drafted the Securities Act over a weekend 65 years ago. Along with president Franklin Roosevelt who commissioned their efforts, the drafters subscribed to Louis Brandeis' admonition about disclosure in the sale of securities: "sunshine is said to be the best of disinfectants; electric light the most efficient policeman" .

In the spirit of disclosure of material risks, the offering memorandum must be drafted to carefully spell out all material factors that contribute to increased risk. In preparing the offering memorandum, careful thought must be given to the risk factors section. The following risk factors are particular to independent film offerings and deserve special mention.
The highly speculative feature film industry. First, the motion picture industry is a highly speculative and competitive industry. It is impossible to predict the market appeal and profitability of any particular motion picture with any degree of certainty. The revenues of each film depend on a number of factors, such as the popularity of other films being distributed at the time, competition for exhibition time at theaters, critic's reviews, how the distributor perceives the commercial value of the film word of mouth, and the often fickle and unpredictable public taste. The offering memorandum should describe these risks and the fact that the filmmaker has limited or no control over these factors upon which the success of the film is in large part dependent.

In recent years, the cost of producing and distributing films has increased. Many other films and production companies who will compete with the film for theater and shelf space will be better funded than the filmmaker's production. These competitors include the so called "major" studios, most of which have substantially greater resources. They also have a successful history of attracting talent, obtaining properties, hiring key employees for the production of films, and distributing the completed film to choice exhibition outlets. The combination of these and other factors means a small number of films account for very large percentages of total box office receipts while increasing large percentages of films never return their investment.

The experience of the principals. Second, an inexperienced filmmaker at the helm increases the investors risk. The filmmaker has the primary responsibility for developing the film, securing financing, hiring cast, directors and other personnel, overseeing the production of the film, and arranging for its distribution. The effective completion of all these tasks is critical to the successful completion and distribution of the film. If the film will be the first theatrical feature?length motion picture developed and produced by the filmmaker, this fact must be disclosed.

Distribution. Third, the offering memorandum should disclose the risks involved in the distribution of the film. In particular, it should discuss whether any distribution agreements have been entered into and whether those agreements are with major or independent distributors.
In most cases the funds raised via an offering are only sufficient to produce the film and market it to distributors. No funds are raised to distribute the film. Until the film is distributed or an agreement is made for distribution, there will be no revenue and, consequently, no return to the investor. Therefore, the existence or lack of a distribution agreement is an important risk factor to be discussed in the memorandum.

Independent distribution may be more risky for the investor than distribution by a "major". In the motion picture industry, "independent distributor" refers to a distributor unaffiliated with the so-called "majors" such as The Walt Disney Company, Paramount Pictures, Sony Pictures Entertainment, Columbia/Tri-Star Pictures, Twentieth Century Fox, MGM, Warner Brothers, MCA/UA, Universal Pictures and their affiliates such as Touchstone Pictures, Fine Line/New Line, and Miramax. Majors often have greater bargaining power than independent distributors, which gives them a competitive advantage when booking films into theaters and negotiating distribution agreements in other media. Majors usually devote more resources to the marketing of a film, resulting in greater prerelease exposure .

Modification to the film. It is common in the motion picture industry for a screenplay to undergo significant revisions prior to production. In addition, after production, the film may be further revised during the editing process. These changes are made by the filmmaker or third parties involved in the production or distribution of the film. The filmmaker is given the discretion to make these changes, a fact which should be disclosed in the offering memorandum to alert investors that the story represented in the screenplay which is synopsized in the offering memorandum and often made available to investors may and probably will change.

Distribution of proceeds.

The offering memorandum specifies the order of distribution of the proceeds from the exploitation of the picture (and any other revenues). The filmmaker must carefully structure the distribution of proceeds to strike the appropriate balance between the rewards to the investor and the rewards to those who make creative contributions.

Customs in the distribution of proceeds. A common distribution of proceeds arrangement in an independent feature film offering memorandum is as follows: The first receipts are disbursed to the company's unpaid expenses (such as over-budget costs), operating costs, loans, and reserve (if one is provided) for future expenses. Second, if the distribution of proceed provides for deferrals, the next proceeds are distributed to a level one deferral (described below). Third, the investors receive their first payment which is commonly distributed at the rate of 99 percent to the limited partners and one percent to the general partners until the investors are paid back 100% of their investment. In some cases, the investors are paid something more than their investment; for example, 100% to 140% of their investment. Fourth, after the limited partners get their investment back (and in some cases a return thereon) the next funds may be applied to the level two deferral participants (if any). Finally, after level two deferrals (if any) are paid, the balance of the proceeds are divided on a fifty-fifty or similar basis between the investors and the general partner in a limited partnership or between the members and the manager in a limited liability company.

Deferrals. To investors who are accustomed to evaluating offering memorandums for investment opportunities in fields such as real estate, medical technology, or computer technology, the concept of "deferrals" may be new. In independent film financing, the use of deferrals is common.

A deferral is the delayed payment to key persons and entities involved in the production of the film in exchange for paying such persons and entities a lesser cash payment at the time their services are rendered, for example, during pre-production, production, and/or post-production. The filmmaker/producer negotiates deferrals with actors, writers, the director, producers, creative personnel, equipment suppliers and other trade creditors providing goods and services to the film on terms which require payment before and/or after the return of the investors' contributions. Deferrals are paid out of the entity's revenues from the exploitation of the rights in the film. Usually such revenues come from advances from the sale or licensing of the film's distribution rights to a distributor. Thus, the deferral participant participates in the risk that the film will be sufficiently successful to pay the deferral.

A deferral is, in a sense, a future "bucket of money" of a fixed amount. The filmmaker/producer uses this bucket of money to make favorable deals with suppliers of goods and services. These deals help finance the film.

Sometimes more than one level of deferral "buckets" is created, commonly referred to as "level one" and "level one" deferrals. Level one deferrals are paid out before investors get their investment back. Therefore, participation in level one deferrals is usually limited to those parties who are essential to the sale of the film to distributors. Participants in level one deferrals include talent with name recognition value likely to help draw patrons into the theaters. Level one deferral participants may also include writers, directors and producers.

Deferrals are particularly important to the filmmaker when it comes time to put together a deal with actors whose names have marquee value. These actors help "open" a film, that is, help to sell tickets in the first days and weeks of the film's theatrical run. The use of such actors can have considerable financial benefits to the theatrical run of the film and to the film's performance in other markets. Actors with television or studio credits have what is called a "quote". A quote is what an actor was paid on his/her last picture. Producers of small budget independent films may not be able to afford to pay the actor's full quote, but may be able to make a deal to pay union scale or a multiple thereof. The balance of the actor's quote is paid on a deferral basis (plus in many cases, a percentage of filmmaker's or the partnership's profits).

The justification for such arrangements is apparent. Talent who sell tickets (and therefore make distribution agreements with distributors feasible) deserve substantial compensation. That compensation may be beyond the means of the filmmaker's cash budget, but the filmmaker can offer to make up the difference out of amounts advanced by the distributor for the right to distribute the film.

All of this may be to the benefit of the investor because without marquee-value actors, there may be no distribution agreement, and without distribution, the investor's investment is worthless. Furthermore, under this arrangement investors part with less money up front for the actor's fee, although they may have to wait behind the level one actor to recoup their investment.

Deferral arrangements are a material factor affecting an investor's investment, and therefore must be disclosed in the offering memorandum. The following factors must be treated in that disclosure: (1) the priority in which the deferral 'bucket(s)' will be paid from the distribution of the entity's revenues; (2) the amount of money to be put in the deferral 'bucket(s)'; (3) the filmmaker's discretion in committing funds from the deferral 'bucket(s)' funds; and (4) the filmmaker's discretion to determine the value of the goods and services subject to the deferred payment.

Striking a balance. Let's return to our concern that a balance must be struck between rewards to the investors and reward to the creatives involved in the production of the film. The investors must feel they are being treated fairly or it will be difficult to sell the securities. The talent must feel that they are being treated fairly or they may not participate in the project.
When the investors are allowed to take out their investment before the talent's deferral, the return to investors may be limited to, for example, 100% and no more of their investment. In such a case, the talent's deferral pool may be larger. On the other hand, where the talent's level one deferral is paid out before the investors receive the return of their investment, the talent's deferral pool may not be as generous and the investors may get a percentage in addition to the return of their investment.

Distribution of profits. As a further incentive, important and powerful actors (also writers, directors, and producers) often receive a percentage of the filmmaker's profits in addition to the deferral payments discussed above. This percentage, commonly called "profit participation" or "points", is usually paid by the filmmaker/general partner and the limited partners in proportion to their split of the profits. So, for example, if the profits are split fifty-fifty, the payment of profits to the talent would be shared equally. In some situations the arrangement will be structured so that all points for talent and other profit participants are paid out of the filmmaker/general partner's share. In that case, each point payable to the talent and other profit participants will be worth less than if the same point was paid out of both the filmmaker/general partner's share and the limited partners' share.

CHOICE OF ENTITY.

Separating the production company from the financing company. The business of producing a film (hiring and firing crew and talent, operating vehicals and equipment, renting locations, entering into contracts with suppliers, and the like) can create substantial liability. Claims such as breach of contract or personal injury may be brought. To better manage the risks associated with such liabilities, a separate entity is formed to undertake the business activities and transactions associated with the production of the film.

A corporation is often used as the business structure for the production company. The assets of the corporate production company, which are usually limited to cash on hand and the expectation of payments under the agreement with the distribution company, are the only assets exposed to liability. By creating separate entities, the liabilities associated with the business of producing the film can be insulated from production funds (until payable to the production company), and other assets of the financing company such as the screenplay, film footage, and revenues from the distribution of the film and derivative works. The agreement between the production company and the financing company is a work-for-hire agreement by which the production company acquires no copyrights in the film footage and associated works.

The financing company. When choosing an entity for the financing company, the selection is generally between a limited partnership, limited liability company, or, to a lesser extent, as we shall see, a corporation. General partnerships comprised of individuals and sole proprietorships should be avoided because unlike limited partnerships, limited liability companies and corporations, they do not limit owners' exposure to liabilities. Investors find such exposure unacceptable. Joint ventures and general partnerships of corporations or LLCs are useful when production companies come together to make one or more films, but because of the control issues, these forms may not be desirable from the filmmaker's point of view.
A factor of paramount importance to the filmmaker is control. Filmmakers want control of creative and management decisions affecting the production and exploitation of the film. Arguably, they are the best parties to make those decisions in normal circumstances. At any rate, investors must closely scrutinize the filmmakers' creative and management skills as part of the investor's decision to invest. An investor who invests in a limited partnership cannot participate in the management of the partnership (and therefore the creative and production decisions) without losing limited liability status. Limited liability companies can be similarly structured to separate the managerial rights from the ownership rights.

Another factor to consider in the selection of the type of entity for the financing company is how much flexibility the type of entity allows in structuring the return of capital and losses to the investors. Investors generally expect most of the film's income and losses to be distributed to them before the filmmaker participates to any significant extent. After the investors are paid back their investment and perhaps a return, the division of proceeds may switch to favor the filmmaker. This variable manner of distributing proceeds does not necessarily correspond to the parties' ownership interests. This flexibility in distribution of profits and losses is useful and is relatively easy to achieve in limited partnerships and limited liability companies. It is difficult to achieve in Subchapter S-corporations where profits must be distributed prorata on a per share bases annually. Subchapter C-corporations can achieve some of that flexibility through the use of classes of shares but the resulting structure may be complex and cumbersome.
Tax considerations. A knowledgeable tax attorney or accountant with experience in film production should be consulted to analyze the tax law issues involved in the creation of the financing and production entities. Put simply, Subchapter C-corporations are subject to double taxation, once at the corporate level and then at the shareholder level, whereas Subchapter S-corporations are taxed once at the shareholder level much like a partnership where the partners are taxed and the entity is not. Like partnerships, Subchapter S-corporation shareholders are required to pay taxes on their share of the corporation's profits regardless of whether the profits are actually distributed. Certainly the avoidance of double taxation and other tax considerations are important factors in the selection of the type of entity for the financing company.

 

FREQUENTLY ASKED QUESTIONS

The following questions are commonly asked by filmmakers raising money for their feature films.

"Must the offering memorandum use such negative language?"

This is a frequently-expressed lament of clients who are unaccustomed to securities offerings. As creators of an artistic project, filmmakers react strongly to what they perceive as negative and disparaging descriptions of their project.
The response to this complaint is two-fold. First, for the reasons expressed elsewhere in this article, offerors are required by law to fully and factually describe all material aspects and risks of an offering, without misrepresentation or omission of relevant factors. This duty is imposed not only on the offeror but also on the lawyer preparing the document. The properly drafted offering memorandum serves to protect the offeror and others from disgruntled investors who seek to bring actions against the offeror for fraud or breach of contract.

Second, a thoughtful and thorough offering memorandum expressed in the customary language of securities offerings is actually a better sales tool. Sophisticated investors, typically those with disposable income to invest in projects such as feature film, are accustomed to lengthy offering documents which emphasize the extreme risk of the investment.

"Why do investors invest in independent feature films?"

At some point in the review of the offering memorandum, usually in the 'Risk Factors' section, the filmmaker will pause and in frustration ask, "Why would anyone in their right mind ever want to invest in an independent film?"

In our experience investors who buy units in an independent feature film offering are motivated by both the potential for profit and for personal reasons. The independent film investment represents a relationship with an artistic project and a group of creative people. The investment may express the investor's desire to help the filmmaker, patronize the arts, or get close to the making of a film for other personal reasons. Many potential investors with an interest in a film project have family members who are pursuing a career in film or television.

Most investors are also strongly motivated by the opportunity to make a profit on their investment. Although risky, investments in independent features have the potential for significant profits and may therefor appeal to investors who seek to balance their portfolio with high risk and high return potential investments.

"How do I set the minimum and maximum amount of the offering?"

The minimum is the least amount of dollars it will take for the filmmaker to make his/her film and the maximum is a larger, more ideal sum that would produce a better, perhaps more marketable film with higher production values. The filmmaker should be advised to include in the budget appropriate amounts for marketing and administration costs, e.g. legal, accounting, office overhead, entering and attending film festivals, presentations to distributors, reporting to the investors, and operating the production company.

The minimum/maximum arrangement restricts the offeror\filmmaker from using any funds unless at least the minimum is raised. Thus if the minimum is not raised within the offering period, all funds must be returned to the investors. If the minimum is raised, the offeror is given the option to move directly into production or attempt to raise additional money up to the maximum. The use of the minimum/maximum arrangement protects the early investors by giving them the assurance the investors' funds will be returned if the offeror fails to raise sufficient funds to cover at least the minimum.

There are several issues that arise from setting minimums and maximums. First, the offering memorandum should contain an explanation of the difference between the minimum and the maximum. This can be as simple as a description of the additional items to be purchased with money exceeding the minimum such as salaries for talent with greater box office draw, more production days, additional special effects, or more car crashes.

However, justifying the difference between the minimum and the maximum to a potential investor sometimes makes the filmmaker a bit nervous. It is well known that independent films are produced on a shoe-string budget. A larger budget, if spent wisely, is likely to produce a film with greater production values which, in turn, can enhance its marketability (and, more importantly to the investor, the profitability) of the film. The filmmaker's concern is that, having explained why the maximum budget will make a better film, the potential investor may hesitate to invest unless the maximum is raised fearing the minimum may be insufficient to produce a film of sufficient quality to achieve a desirable return from the investor's point of view. The resolution lies in the offeror/filmmaker's powers to persuade the investor that while the minimum budget will produce a great and profitable film, the maximum budget will produce an even better and more profitable film.

Another issue sometimes raised by filmmakers is whether sources of funds other that funds from the sale of units can be used to make the film and can be counted against the minimum. Offering memorandums are easily drafted to give the offeror\filmmaker the discretion to tap sources other than the sale of units to finance the film.

"How long do I have in which to sell the offering?

Realistically it may take the filmmaker years to develop and raise financing for his/her film. What happens if the filmmaker fails to raise the minimum before the offering period specified in the offering memorandum closes? If the offering is made on a minimum/maximum basis, the investors' funds must be returned at the end of the offering period.

How long the offering will be open must be carefully considered. If the offering period is too long, it may be difficult for the filmmaker to get investors to commit to the purchase of units. Investors do not want their capital sitting idly for long periods of time in an offeror's bank account or an escrow account while the offeror attempts to raise other funds to make the film. So investors tend to put off writing checks until the last minute. The longer the sales period, the longer the investors will put off buying the securities offered in the offering and the greater the opportunity for other investments to come along and draw the investors' funds away from the filmmaker's offering. The filmmaker must strike a balance between the benefits of a short sales period and the reality of the market which may make it difficult to raise the minimum in a short period of time.

One option is to set the sales period at a relatively short period, say 90 to 120 days, and give the filmmaker the option to extend the offering period. This strategy may strike the right balance between creating a sense of urgency while at the same time giving the filmmaker the flexibility to extend the offering period for the additional time needed to raise the minimum set in the offering memorandum.

Certain regulations and exemptions restrict the length of the offering period. For example, the maximum offering periods for Rule 504, Rule 505, and SCOR offerings is 12 months.

"How do I set the purchase price of units?"

To set the purchase price of units offered in the offering memorandum, the maximum number of investors that may purchase units in the offering must be determined. Rule 505 and Rule 506 and certain Blue Sky statutes limit the number of unaccredited investors (and in some cases the number of offers) in an offering. For Rule 505 and Rule 506 offerings the number is 35 unaccredited investors. Under other rules, including state laws and regulations, the number may be less. Relevant laws and regulations must be examined and the maximum number of purchasers/offerees must be determined. Accredited investors do not count when counting the maximum number of investors purchasing units but in some states may be counted toward the maximum number of offers.

For several reasons it is advantageous to build flexibility into the minimum purchase requirement. First, it is usually impossible to know ahead of time how many accredited and unaccredited investors will purchase units . Second, for that reason, and because it cannot be known ahead of time how many units each investor will purchase units, it cannot be known how many units will be sold. Third, it is useful to have a low unit price to allow the sale of units at lower purchase price threshold .

"Can I use brokers and finders?" "Can I pay my friends finders fees?"

Generally, the officers of the offeror and, if the financing company is a limited partnership, the general partner, can sell units. Broker/dealers are permitted to sell securities in most types of offerings although the extent of their solicitation may be limited, as for example, in those types of offerings where general solicitation is prohibited. However, in reality, most single-production, independent film offerings are not brokered.

Finders are persons or businesses who receive a fee for soliciting and directing potential investors to the offeror. Finders who are not registered broker/dealers can be used in limited circumstances but neither the offeror nor the finder should do so without the advice of counsel. Certainly finders must not undertake activities, such as general solicitation, that the offeror is prohibited from undertaking. Generally, risk is created for both the finder and the offeror when finders do more than merely introduce potential investors to the offeror. Potential liability may occur when the finder discusses the terms of the offering, negotiates the sale of the securities, is paid based on the outcome of the offering, or has acted as a finder or broker in prior transactions. Many states have regulations restricting the ability of offerors to use finders.

"Can my attorney help me sell units?"

The short answer is, "No." The sale of securities creates significant liability for lawyers and their firms. Attorneys are probably not licensed as broker/dealers and participation in the sale could violate state and federal licensing regulations. Also the attorney's participation in the securities transaction creates a potential conflict of interest between the client and the attorney.

"Can I give potential investors projections and comparables?"
The decision to make oral or written projections of the future value of an investment in an offering must be made cautiously. The statutory safe harbor for projections (so-called "forward-looking statements") is not available for offerings of a partnership or a limited liability company. Without a safe harbor it is difficult to predict the extent to which an offeror will be liable for his/her projections. However, the reality is that projections are common. In fact it is difficult to discuss the proposed sale of securities in an independent film offering without making projections. Offerors may feel it is necessary to provide projections to attract investors. Those choosing to make projections should be careful to put them in writing, identify them as forward-looking statements, include meaningful cautionary statements and disclaimers, and identify the assumptions and important factors that could cause actual results to differ materially from those in the forward-looking statements. Obviously, such statements must not be made if the offeror or the person making the projections knows them to be false or misleading.

 

DANIEL M. SATORIUS is a shareholder and officer with the firm of Lommen, Abdo, Cole, King & Stageberg, P.A. He practices in the area of entertainment law, including contract, intellectual property, financing, and business structures. His clients include independent producers, writers, and distributors in the motion picture and television industries.

©2000 Daniel M. Satorius, ALL RIGHTS RESERVED