Independent Film Financing
The following was written and edited by Mark Litwak. (Author’s note: These materials are
offered for use as a teaching tool only. They are designed to help you understand some of the
legal issues you may encounter in the entertainment business and enable you to better communicate with your lawyer. They are not offered as legal advice, nor should they be construed as such. They are not a substitute for consulting with an attorney and receiving advice based on your facts and circumstances. Moreover, the cases and laws cited are subject to change and they may not apply in all jurisdictions.)
Independent films can be financed in a variety of ways. In addition to
filmmakers using their own funds to make a movie, the most common methods
are: 1) loans; 2) investor financing; 3) borrowing against pre-sales (a loan against
distribution contracts); and 4) distributor-supplied financing.
Loans can be secured or unsecured. A secured loan is supported or backed
by security or collateral. When one takes out a car or home loan, the loan is secured
by that property. If the person who borrows money fails to repay the loan,
the creditor may take legal action to have the collateral sold and the proceeds
applied to pay off the debt.
An unsecured loan has no particular property backing it. Credit card debt
and loans from family or friends may be unsecured. If a debtor defaults on an
unsecured loan, the creditor can sue for repayment and force the sale of the
debtor’s assets to repay the loan. If the debtor has many debts, however, the sale of
his property may not be sufficient to satisfy all creditors. In such a case, creditors
may end up receiving only a small portion of the money owed them.
A secured creditor is in a stronger position to receive repayment. In the
event of a default, designated property (the secured property) will be sold and all
the proceeds will be applied first to repay the secured creditor’s debt. Unsecured
creditors will share in whatever is left, if anything.
The advantage of a loan, from a legal point of view, is that the transaction
can often be structured in a fairly simple and inexpensive manner. A short
promissory note can be used and the transaction often is not subject to the
complex security laws that govern many investments. Thus, there is usually no
need to prepare a private placement memorandum (PPM). Keep in mind that
if the agreement between the parties is labeled a “loan,” but in reality it is an
investment, the courts will likely view the transaction as an investment. Giving a
creditor a “piece of the back-end,” or otherwise giving the creditor equity in the
project, makes the transaction look like an investment.
The difference between a loan and an investment has to do with risk. With
a loan, the entity that borrows funds, the debtor, is obligated to repay the loan
and whatever interest is charged, regardless of whether the film is a flop or a hit.
The creditor earns interest but does not share in the upside potential (profits)
of a hit. Since the creditor is entitled to repayment even if the film is a flop, the
creditor does not share in the risk of the endeavor. Of course, there is some risk
with a loan because loans are not always repaid, especially unsecured loans that
don’t have any collateral backing them. That risk is minimal, however, compared
to the risk of an equity investment.
In a pre-sale agreement, a buyer licenses or pre-buys movie distribution
rights for a territory before the film has been produced. The deal works something
like this: Filmmaker Henry approaches Distributor Juan to sign a contract
to buy the right to distribute Henry’s next film. Henry gives Juan a copy of the
script and tells him the names of the principal cast members. Juan has distributed
several of Henry’s films in the past. He paid $50,000 for the right to distribute
Henry’s last film in Spain.
The film did reasonably well and Juan feels confident, based on Henry’s
track record, the script, and the proposed cast, that his next film should also do
well in Spain. Juan is willing to license Henry’s next film sight unseen before it has
been produced. By buying distribution rights to the film now, Juan is obtaining an
advantage over competitors who might bid for it. Moreover, Juan may be able
to negotiate a lower license fee than what he would pay if the film were sold on
the open market. So Juan signs a contract agreeing to buy Spanish distribution
rights to the film. Juan does not have to pay (except if a deposit is required) until
completion and delivery of the film to him.
Henry now takes this contract and a dozen similar contracts with buyers
to the bank. Henry asks the bank to lend him money to make the movie with
the distribution contracts as collateral. Henry is “banking the paper.” The bank
will not lend Henry the full face value of the contracts, but instead will discount
the paper and lend a smaller sum. So if the contracts provide for a cumulative
total of $1,000,000 in license fees, the bank might lend Henry $800,000. In some
circumstances banks are willing lend more than the face value of the contracts
(so-called gap financing) and charge higher fees.
Henry uses this money to produce his film. When the movie is completed,
he delivers it to the companies that have already licensed it. They in turn pay
their license fees to Henry’s bank to retire Henry’s loan. The bank receives repayment
of its loan plus interest. The buyers receive the right to distribute the film in
their territory. Henry can now license the film in territories that remain unsold.
From these revenues Henry makes his profit.
Juan’s commitment to purchase the film must be unequivocal, and his
company financially secure, so that a bank is willing to lend Henry money on
the strength of Juan’s promise and ability to pay. If the contract merely states that
the buyer will review and consider purchasing the film, this commitment is not
strong enough to borrow against. Banks want to be assured that the buyer will
accept delivery of the film as long as it meets certain technical standards, even if
artistically the film is a disappointment. The bank will also want to know that
Juan’s company is fiscally solid and likely to be in business when it comes time
for it to pay the license fee. If Juan’s company has been in business for many years,
and if the company has substantial assets on its balance sheet, the bank will
usually lend against the contract.
The bank often insists on a completion bond to ensure that the filmmaker
has sufficient funds to finish the film. Banks are not willing to take much risk.
They know that Juan’s commitment to buy Henry’s film is contingent on delivery
of a completed film. But what if Henry goes over budget and cannot finish the
film? If Henry doesn’t deliver the film, Juan is not obligated to pay for it, and the
bank is not repaid its loan.
To avoid this risk, the bank wants an insurance company, the completion
guarantor, to agree to put up any money needed to complete the film should it
go over budget. Before issuing a policy, a completion guarantor will carefully
review the proposed budget and the track record of key production personnel.
Unless the completion guarantor is confident that the film can be brought in on
budget, no policy will issue. These policies are called completion bonds.
First-time filmmakers may find it difficult to finance their films through
pre-sales. With no track record of successful films to their credit, they may not
be able to persuade a distributor to pre-buy their work. How does the distributor
know that the filmmaker can produce something their audiences will want to
see? Of course, if the other elements are strong, the distributor may be persuaded
to take that risk. For example, even though the filmmaker may be a first-timer, if
the script is from an acclaimed writer, and several big-name actors will participate,
the overall package may be attractive.
The terms of an agreement between the territory buyer (licensor) and the
international distributor can be quite complex. Parties may disagree about the
meaning of terms used in their agreements. The following terms are standard
IFTA definitions, which are generally accepted in the industry. They are used
to interpret whatever document they are attached to.
An equity investment can be structured in a number of ways. For example,
an investor could be a stockholder in a corporation, a non-managing member of
a Limited Liability Company (LLC), or a limited partner in a partnership.
An investor shares in potential rewards as well as the risks of failure. If a
movie is a hit, the investor is entitled to receive his investment back and share in
proceeds as well. Of course, if the movie is a flop, the investor may lose his entire
investment. The producer is not obligated to repay an investor his loss.
The interests of individuals and companies that do not manage the enterprise
they invest in are known as securities. These investors may be described using a
variety of terms including silent partners, limited partners, passive investors and
stockholders. They are putting money into a business that they are not managing
(i.e., not running). State and federal securities laws are designed to protect such
investors by ensuring that the people managing the business (e.g., the general
partners in a partnership or the officers and directors of a corporation) do not
defraud investors by giving them false or misleading information, or by failing to
disclose information that a reasonably prudent investor would want to know.
In a limited partnership agreement, for example, investors (limited
partners) put up the money needed to produce a film. Investors usually desire
limited liability. That is, they don’t want to be financially responsible for any cost
overruns or liability that might arise if, for instance, a stunt person is injured.
They want their potential loss limited to their investment.
Because limited partnership interests are considered securities, they are
subject to state and federal securities laws. These laws are complex and have strict
requirements. A single technical violation can subject general partners to liability.
Therefore, it is important that filmmakers retain an attorney with experience in
securities work and familiarity with the entertainment industry. This is one area
where filmmakers should not attempt to do it themselves.
Registration and Exemptions
The federal agency charged with protecting investors is the U.S. Securities
and Exchange Commission (SEC). Various state and federal laws require that
most securities be registered with state and/or federal governments. Registration
for a public offering is time consuming and expensive, and not a realistic alternative
for most low-budget filmmakers. Filmmakers can avoid the expense of registration
if they qualify for one or more statutory exemptions. These exemptions
are generally restricted to private placements, which entail approaching people
one already knows (i.e., the parties have a pre-existing relationship). Compare
a private placement with a public offering where offers can be made to
strangers, such as soliciting the public at large through advertising. Generally,
a public offering can only be made after the U.S. Securities and Exchange
Commission (SEC) has reviewed and approved it.
There are a variety of exemptions to federal registration. For example,
there is an exemption for intrastate offerings limited to investors all of whom
reside within one state. To qualify for the intrastate offering exemption, a
company must be incorporated in the state where it is offering the securities,
and it must carry out a significant amount of its business in that state. There is
no fixed limit on the size of the offering or the number of purchasers. Relying
solely on this exemption can be risky, however, because if an offer is made to a
single non-resident the exemption could be lost.
Under SEC Regulation D (Reg D) there are three exemptions from federal
registration. These can permit filmmakers to offer and sell their securities without
having to register the securities with the SEC. These exemptions are under
Rules 504, 505 and 506 of Regulation D. While companies relying on a Reg D
exemption do not have to register their securities and usually do not have to file
reports with the SEC, they must file a document known as Form D when they
first sell their securities. This document gives notice of the names and addresses
of the company’s owners and promoters. State laws also apply and the offeror will
likely need to file a document with the appropriate state agency for every state in
which an investor resides.
Investors considering an investment in an offering under Reg D can
contact the SEC’s Public Reference Branch at (202) 942-8090 or send an email
to firstname.lastname@example.org to determine whether a company has filed Form D, and
to obtain a copy. A potential investor may also want to check with his/her
state regulator to see if the offering has complied with state regulations. State
regulators can be contacted through the North American Securities Administrators
Association at (202) 737-0900 or by visiting its website at www.nasaa.
Information about the SEC’s registration requirements and exemptions is
available at www.sec.gov/info/smallbus/
An “offering” is usually comprised of several documents including
a private placement memorandum (PPM), a proposed limited partnership
agreement (or operating agreement for an LLC, or bylaws for a corporation),
and an investor questionnaire used to determine if the investor is qualified
to invest. A PPM contains the type of information usually found in a business
plan, and a whole lot more. It is used to disclose the essential facts that a
reasonable investor would want to know before making an investment. The
offeror may be liable if there are any misrepresentations in the PPM, or any
omissions of material facts.
State registration can be avoided by complying with the requirements for
limited offering exemptions under state law. These laws are often referred to as
“Blue Sky” laws. They were enacted after the stock market crash that occurred
before the Great Depression. They are designed to protect investors from being
duped into buying securities that are worthless – backed by nothing more than
the blue sky.
The above-mentioned federal and state exemptions may restrict offerors
in several ways. Sales are typically limited to 35 non-accredited investors, and
the investors may need to have a pre-existing relationship with the issuer
(or investment sophistication adequate to understand the transaction), the
purchasers cannot purchase for resale, and advertising or general solicitation is
generally not permitted. There is usually no numerical limit on the number of
A “pre-existing relationship” is defined as any relationship consisting of
personal or business contacts of a nature and duration such as would enable a
reasonably prudent purchaser to be aware of the character, business acumen, and
general business and financial circumstances of the person with whom the
Other documents may need to be filed with federal and state governments.
For example, a Certificate of Limited Partnership may need to be filed with the
Secretary of State to establish a partnership. In California, a notice of the transaction
and consent to service of process is filed with the Department of Corporations.
If the transaction is subject to federal law, Form D will need to be filed with the
Securities and Exchange Commission (SEC) soon after the first and last sales.
Similar forms may need to be filed in every state in which any investor resides.
In the independent film business, PPMs are usually a Rule 504 offering
to raise up to $1,000,000, or a Rule 505 offering which allows the filmmaker to
raise up to $5,000,000, or a Rule 506 offering which doesn’t have a monetary cap
on the amount of funds to be raised. A 506 offering also offers the advantage of
preempting state laws under the provisions of the National Securities Markets
Improvement Act of 1996 (“NSMIA”).
Under Rule 504, offerings may be exempt from registration for companies
when they offer and sell up to $1,000,000 of their securities in a 12-month period.
A company can use this exemption so long as it is not a so-called blank
check company, which is one that has no specific business plan or purpose. The
exemption generally does not allow companies to solicit or advertise to the public,
and purchasers receive restricted securities, which they cannot sell to others without
registration or an applicable exemption.
Under certain limited circumstances, Rule 504 does permit companies to
make a public offering of tradable securities. For example, if a company registers
the offering exclusively in states that require a publicly filed registration statement
and delivery of a substantive disclosure document to investors; or if the company
sells exclusively according to state law exemptions that permit general solicitation,
provided the company sells only to accredited investors.
Under a Rule 505 exemption, a company can offer and sell up to $5,000,000
of its securities in any 12-month period. It may sell to an unlimited number of
“accredited investors” and up to 35 non-accredited investors who do not need to
satisfy the sophistication or wealth standards associated with other exemptions.
The company must inform investors that they are receiving restricted securities that
cannot be sold for at least a year without registering them. General solicitation and
advertising is prohibited.
Rule 505 allows companies to decide what information to give to
accredited investors, so long as it does not violate the antifraud prohibitions of
federal securities laws. But companies must give non-accredited investors
disclosure documents that are comparable to those used in registered offerings.
If a company provides information to accredited investors, it must provide the
same information to non-accredited investors. The offeror must also be available
to answer questions from prospective investors.
Under Rule 506, one can raise an unlimited amount of capital. However,
the offeror cannot engage in any public solicitation or advertising. There is no
limit as to the number of accredited investors that can participate. However, only
35 non-accredited investors can participate.
Accredited investors include (among others) the following:
a) any natural persons whose individual net worth, or joint net worth with that
person’s spouse, at the time of the purchase exceeds $1,000,000;
b) any natural person with an individual income in the two prior years and an
estimated income in the current year in excess of $200,000 or joint income
with spouse of $300,000;
c) any director, executive officer, or general partner of the issuer of the securities
being offered or sold, or any director, executive officer or partner of a general
partner of the issuer.
Under Rule 506, each purchaser of units must be “sophisticated,” as that
term is defined under federal law. Note that an “accredited investor” is not the
same as a “sophisticated” investor. The term “accredited investor” is specifically
defined by the federal securities laws, while the term “sophisticated investor”
has no precise legal definition. Both terms generally refer to an investor who has
a sufficiently high degree of financial knowledge and expertise such that he/she
does not need the protections afforded by the SEC. An investor who is considered
“sophisticated,” might not meet the precise definition of an accredited investor.
As with Rule 505 offerings, it is up to the offeror to decide what information
is given to accredited investors, provided there is no violation of
the anti-fraud provisions. Non-accredited investors must be given disclosure
documents similar to those used in registered offerings. If the offeror provides
information to accredited investors, the same information must be given to
non-accredited investors. The offeror must be available to answer questions by
Under Rule 506, each purchaser must represent that he or she is purchasing
the units for his or her own investment only and not with plans to sell or otherwise
distribute the units. The units purchased are “restricted” and may not be resold by
the investor except in certain circumstances.
Intrastate Offering Exemption
Section 3(a)(11) of the Securities Act provides for an intrastate offering
exemption. This exemption is designed for the financing of local businesses.
To qualify for the intrastate offering exemption, a company needs to be incorporated
in the state where it is offering the securities; carry out a significant
amount of its business in that state; and make offers and sales only to residents
of that state.
There is no fixed limit on the size of the offering or the number of
purchasers. The company needs to carefully determine the residence of each
purchaser. If any of the securities are offered or sold to even one out-of-state
person, the exemption may be lost. Moreover, if an investor resells any of the
securities to a person who resides out of state within a short period of time after
the company’s offering is complete (the usual test is nine months), the entire
transaction, including the original sales, might violate the Securities Act.
Accredited Investor Exemption
Section 4(6) of the Securities Act exempts from registration offers and
sales of securities to accredited nvestors when the total offering price is less than
The definition of accredited investors is the same as that used under
Regulation D. Like the exemptions in Rule 505 and 506, this exemption does
not permit any public solicitation. There are no document delivery requirements,
but the anti-fraud provisions mentioned below do apply.
California Limited Offering Exemption
SEC Rule 1001 exempts from registration offers and sales of securities, in
amounts of up to $5,000,000, which satisfies the conditions of â‚¬25102(n) of the
California Corporations Code.This California law exempts from California state
law registration offerings made by California companies to “qualified purchasers”
whose characteristics are similar to, but not the same as, accredited investors under
Regulation D. This exemption allows some methods of general solicitation prior
All security offerings, even those exempt from registration under Reg. D,
are subject to the anti-fraud provisions of the federal securities laws, and any
applicable state anti-fraud provisions. Consequently, the offeror will be responsible
for any false or misleading statements, whether oral or written. Those who violate
the law can be pursued both criminally and civilly. Moreover, an investor who has
purchased a security on the basis of misleading information, or the omission of
relevant information, can rescind the investment agreement and obtain a refund of
Mark Litwak is a veteran entertainment attorney with offices in Beverly Hills,
California. Litwak also functions as a producer’s rep, assisting filmmakers in the financing,
marketing and distribution of their films. Litwak is the author of six books including Risky
Business, Financing and Distributing Independent Film. He is also the author of the
popular CD-ROM program Movie Magic Contracts.
Mark has provided legal services or acted as a producer rep on more than 100 feature
films. He has been the executive producer of such feature films as The Proposal (Miramax/
Buena Vista), Out of Line (First Look) and Pressure (Blockbuster). He is the creator of
Entertainment Law Resources.