Filmmaking 2.0

Making a Federal Case out of Film Financing

Financing the Production Company – the Limited Liability Company

August 2009

By Jon M. Garon*

This is part of a series of book excerpts from The Independent Filmmaker's Law and Business Guide: Financing, Shooting, and Distributing Independent and Digital Films designed to introduce filmmakers and others interested in creating content on the legal issues involved in the filmmaking process.

When financing the production company, the filmmaker is selling interests in the business entity that is making the motion picture. This is a sophisticated transaction involving securities laws, federal disclosure requirements, and complex tax and reporting obligations. Although quite common, selling interests in a film company is a complicated transaction no different from forming any other sophisticated business.

Production company financing is generally accomplished by selling interests in the film company created for the production of the movie. The basic rules discussed below apply to all business forms, corporations, limited partnerships (LPs), and limited liability companies (LLCs). Because the LLCs are the most flexible of the three as planning devices, the book assumes that the business is formed as an LLC.

Basic Requirements & the Meaning of "Disclosure" – Making a Federal Case out of Film Financing

The investor, any person investing money into the film project, expects a return of the investment or capital and profit on the money if the LLC has made a profit. Under both state and federal law, the first obligation a business has when raising capital is to provide full disclosure of all the material facts regarding the investment and its risks. This simple rule – that the filmmaker must fully disclose all the terms of the investment – is often overlooked, but at the filmmaker's peril. Failure to fully disclose all the material terms can result in the investor being entitled to a complete return of her investment directly from either the filmmaker or the film company, depending on which of the parties has assets. The filmmaker could also be held criminally liable, for knowingly misrepresenting the risks involved in the investment. All the other planning done by the accountants and lawyers will be worth nothing if the filmmaker hides information or misrepresents the facts regarding the production.

All information provided to investors must be accurate when made and kept updated. The harder aspect of understanding the obligation of full disclosure is identifying what facts and issues are material. At its heart, material means that information which is important to the investor, information a reasonable person would consider important in deciding whether or not to invest.1 Put another way, the information is material if there is a substantial likelihood that the information would be considered as having significantly altered the “total mix” of information made available. This includes the terms of any investment deal, but it also includes information regarding the film, the production, the competition and anything else the filmmaker thought was important to say when promoting the project to the investor.

Structures of Film Business Entity

The basic structure of the film business entity must provide the core ownership and management for the filmmaker with limited protections for the investor. Depending on the business form, a filing of organizational papers must be completed and submitted to the Secretary of State along with a tax payment. In addition to this filing, a film company must have written, signed articles and bylaws or an Operating Agreement that sets out the rules for operations, governance, and payments.

Business of the Company

The first question to answer is whether the film company is being created for the purposes of the particular film project or whether it may be used for multiple projects – sequels, unrelated films, or other projects entirely. The typical corporation today has its bylaws state that it can conduct “any lawful business” meaning any business that exists. For Disney that makes sense. To protect small investors, however, the better choice is to limit the investment to a single film project. The filmmaker can always try to amend this decision at a later time, but of course, the investors will then have a voice and a vote in such a modification. If the purpose of the company is not limited, the filmmaker can continue making movies until the money runs out, so that even if the first film returns a nice profit, the income is retained for future films. In such a case, the investor may still receive nothing. Given the risks involved in motion picture investing, the more equitable approach is to limit the investment to the production or productions agreed upon at the time of investment.

Control

The filmmaker must retain management control, at least throughout the initial production and distribution of the project. The Operating Agreement of the LLC should be drafted to guarantee that the filmmaker retains control of the film company’s management, to the greatest extent permitted by law. Even here, this cannot be absolute. The filmmaker will eventually die,2 or become unwilling or unable to manage the operations of the film company.

Personal Obligation of the Filmmaker

The nature of an independent film is a highly personal undertaking. As a result, the Operating Agreement should reflect the importance of the filmmaker’s role and include specific provisions in the event the filmmaker becomes disassociated with the project. In many ways, this serves as a form of protection for the investor, but it also recognizes that this film project is a personal endeavor. For example, the death or incapacity of the filmmaker may terminate the project. Similarly, the professional unavailability of the filmmaker – whether because the person has become too famous or too frustrated – is irrelevant; the project should end.

Project Milestones

Like the personal nature of the filmmaker, films can languish for years as money is found to complete them. The Operating Agreement must be very clear regarding the rules about the availability of the investor’s money. The investor should be obligated to pay immediately, and should receive no interest in the company until payment is received. If the budget calls for a minimum amount of $150,000 cash available, the investor must agree that her funds can be spent prior to the company raising the entire $150,000. If not, the investor’s purchase payment should be put in escrow and held until the film company has sufficient funds. Most typically, the investors’ funds are released under the terms of the Operating Agreement when there is enough to make meaningful progress. Here, for example, if the film can be made for $150,000, then the agreement may provide that the funds will be released when $100,000 is received, because that is enough to get through pre-production and principal photography.

Management Fees

The filmmaker, as manager of the LLC, may choose to receive some portion of the revenue as payment for services provided. The choice to pay oneself is neither a good or bad choice. So long as the payment structure is fully disclosed, rather than hidden in fine print or unstated, the investors can have no legitimate complaints. Such payment is akin to the producer’s fees charged to the studio. On the other hand, if all participants in the project worked without pay, and the investors assumed a very high risk, then it may be appropriate to forgo any producer’s payment. Both approaches have been used, the key is to specifically explain the basis for the investors’ return on capital and participation in net revenue.

Wrap-Up of Ownership

The structure should also provide for a mandatory repurchase of the investor’s interests at some point in the future. For example, this may be triggered by a lack of production company revenues for a three-year period. Such a clause would provide that if the production company has not more than a minor amount of income (say $5,000), then the manager can repurchase the interests of the investors by paying a pre-set fee, or by providing for mandatory arbitration if the parties cannot voluntarily agree on a price.

Deferred Compensation for some Participants

Most independent film companies are unable to pay all their expenses. Instead, they rely on locations, cast, crew and service providers to work on credit. To balance the risk of non-payment, filmmakers often promise revenue or profit participation to those parties as well. The company must plan carefully regarding these contingent payment obligations. They must be incorporated into the budgeting process and clearly identified in defining the revenue returns to which the investors are entitled.

For example, it is common to grant the investors a return of capital before the producer takes his portion of gross revenues. Often, investors are entitled to as much as 125% of their initial investment before the producer receives payment. The Operating Agreement must specify whether the deferred compensation due to the cast, crew and other service providers are entitled to payments prior the investor’s payment. If the motion picture has a cost of $150,000, an investor may think the film has a reasonable chance to return the majority of the investment and the potential to return far more. If instead, the picture has a “cost” of $150,000 reflecting the expenses that could not be deferred and an additional $250,000 in deferred compensation, then the investor may not receive her first dollar until after $400,000 in revenue have been earned. This dramatically changes the risk and is therefore highly material to the structure. The Operating Agreement can provide that the deferred compensation is paid first, the investors are paid first, or both paid proportionately at the same time.3

Limitations

As legally recognized businesses, the filmmakers undertake business and professional obligations towards their investors, as well as the employees and other participants of the project. If the filmmaker utilizes other individuals to serve as managers of the LLC or directors of the corporation, those individuals have a similar duty to act in the best interests of the business.

Further, the law does not like to vest unbridled discretion in a single business person’s hands. State laws will protect the investors in some situations, requiring that the filmmaker provide the investors with information and an opportunity to vote on the suggested change. For example, if the company has insufficient funds to start its movie and another film company has insufficient funds to complete an unrelated picture, the filmmaker might wish to merge the two companies in order to receive producer credit and associate director credit on that picture. Nonetheless, the merger can take place only if the shareholders or members of the LLC agree. Similarly, the filmmaker could not take the money invested in the first film to the second film, because that would breach his duty of good faith to the investors and the film company.

Footnotes.

1. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976); Basic, Inc. v. Levinson, 108 S. Ct. 978 (1988).

2. This is not apocryphal – copyright lasts seventy years past the life of the author, so management of the work must include some planning for the period after the lifespan of the author.

3. Proportional or pro rata payments would mean that each dollar earned is split by each group in proportion to the amount that person or group is entitled to receive. In the example above, $40 in income would be paid $15 to the investor and $25 to the group of parties entitled to deferred compensation.


* Jon Garon is admitted in New Hampshire, California and Minnesota.

Adapted from Independent Filmmaking, The Law & Business Guide™ for Financing, Shooting & Distributing Independent & Digital Films, A Capella Books (2d Ed. 2009) (reprinted with permission). Jon Garon is professor of law, Hamline University School of Law; of counsel, Gallagher, Callahan & Gartrell.

Return to Entertainment Law articles
Return to Resources index

You may contact
Jon Garon at
800-528-1181.

 

Bookmark and Share