WHEN YOU DON’T NEED A BUSINESS PLAN
By John W. Cones, Attorney
In film finance situations, it is common for independent filmmakers here in the U.S. to get the advice that they need a business plan. Aside from situations where putting your ideas on paper may be helpful for planning the future of any business, or helpful in obtaining a collateral-based bank loan, when filmmakers are looking to actually raise production funds for a film, there are many instances when a business plan is not needed. Filmmakers need to know when it is appropriate to use a business plan and when it is not.
1. Film Industry Sources – As a general rule, when seeking financing from film industry sources, a business plan is not needed.
a. Studio In-House Development Deal – When seeking a studio in-house development/production/distribution deal, a business plan is not needed. In that situation, you are merely pitching an idea. That idea may be expressed in writing as a synopsis, outline, treatment or even a script (hopefully registered with the U.S. Copyright Office), but in any case, you are just pitching an idea and you do not need a business plan, nor is the project far enough along to support the creation of a producer’s package. On the other hand, the filmmaker in this situation needs to be concerned about theft of ideas and should review the body of law relating to that issue. [For definitions of film finance terminology see my book “Dictionary of Film Finance and Distribution – A Guide for Independent Filmmakers”, Marquette Books, LLC, 2008]
b. Studio P-F/D Deal – Next, when talking to a creative executive and seeking a studio production-financing/distribution deal from a major studio or other vertically integrated film organization, you do not need a business plan. In that situation, you should use a producer’s package. A producer’s package is not bound like a business plan and at minimum contains the script, budget, chain of title documents and evidence of attachments.
c. Negative Pickup Deal – In the alternative, when talking to an acquisitions executive at a distributor, you do not need a business plan. In that situation, you again need a producer’s package. For those not familiar with the term “negative pickup” it is a term of art used in the film industry to describe a film finance and distribution transaction in which a producer obtains a distribution agreement and guarantee to pay a specified sum, upon delivery of a completed film, the elements of which are described in the negative pickup agreement. The producer then takes that distribution agreement to an entertainment lender and obtains a production loan, effectively using the distribution agreement and guarantee as collateral. The bank will require that the producer also obtain a completion bond, so in all, there are four parties involved in a negative pickup deal: producer, distributor, bank and completion guarantor. In any case, to seek a negative pickup, you do not need a business plan, rather a producer’s package. [For additional detail on the negative pickup arrangement and other forms of film finance briefly mentioned here, see my book “43 Ways to Finance Your Feature Film – Third Edition”, Southern Illinois University Press, 2008]
d. Split Rights Deal – In another variation on the lender financing described above as a negative pickup, you may want to split the distribution rights to a film between domestic and international markets. In that situation, you would be seeking two separate distribution deals, a domestic distribution deal and an international distribution deal – one from a domestic distributor and a second from an international distributor. The presumed advantage of such an arrangement is that the revenue stream generated by the exploitation of the film is not cross-collateralized, since there are two distributors involved. In other words, if the film is financially successful in one of those two markets, but not in the other, the distributor for the market in which the film performed poorly does not get to participate in the profits of the distributor where the film performed well. In any case, just as with the negative pickup arrangement, the producer takes the two distribution agreements to a bank, seeking a production loan. The bank still requires the completion bond. The producer delivers the film to each distributor upon completion and assuming the distribution agreements are properly drafted, the distributor is obligated to pay the amount specified in the agreement. The bottom line for purposes of this article, this film finance transaction does not require a business plan, rather a producer’s package.
e. Foreign Pre-Sales and Gap Financing – A third variation on the lender financing described above is the foreign pre-sale, and that extension of foreign pre-sales, “gap” financing. In these situations, the producer is usually working through a foreign sales agent and is seeking to obtain distribution agreements and guarantees from five or six of the top ten foreign territorial distributors. The idea is not to seek full funding for the film using these territorial distribution deals, but a significant portion of the film’s budget, with the rest coming from other sources. The foreign pre-sale deal works like the negative pickup and the split rights deal described above. The producer obtains, in this case, the multiple distribution agreements and guarantees, takes them to a bank that will make loans on foreign paper, gets the completion bond, and assuming the production loan is provided, delivers the completed film to the distributors who pay the guaranteed amount upon delivery. “Gap” financing differs slightly in that the foreign-pre sale is not actually obtained, but the bank goes ahead and loans a specified amount of production funds based on the good-faith foreign sales estimates of an experienced foreign sales agent the bank knows and trusts. Once again, no where in these transactions is it necessary to use a business plan, but instead, the foreign sales agent will be using something akin to a producer’s package including glossy promotional materials to sell your package to the territorial distributors.
2. Investor Financing – The appropriate time to use a business plan involves investor financing, that is financing provided by companies or individuals from outside the film industry. But not even all investor financing transactions (often referred to as the equity component of a film finance plan) require a business plan.
a. Active Investors – The most appropriate situation in which to use a business plan is when seeking to raise some or all of your financing for your film from one or a few active investors. For many filmmakers, this is the ideal situation, getting all of the money needed from just a few people. Sometimes such investors are referred to as “angel” investors. But let’s be clear about who active investors are. The definition of an active investor is not one of those “grey” areas of the law, as filmmakers and others sometimes pretend. It is actually rather precise. That is because the term has been defined by at least two federal appellate courts in cases involving the question of whether a security was being sold.
The leading federal case on when a general partnership interest (and by analogy a joint venture, a member-managed LLC or any other so-called active-investor investment vehicle) constitutes a security is the 1981 case of Williamson v. Tucker. [Williamson v. Tucker, 645 F.2d 404, 5th Cir. 1981] Basically, in the Williamson case, the federal Fifth Circuit Court of Appeals said that a general partnership or joint venture interest can be designated as a security if the investor can establish, for example, that:
(1) the agreement among the parties leaves so little power in the hands of the partner or venturer that the arrangement in fact distributes power as would a limited partnership (i.e., units in a limited partnership are always considered securities); or
(2) the partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or
(3) the partner or venturer is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.
Further, California courts have supported the securities regulators' view that an active investor must have some level of knowledge and understanding of the field in which he or she is investing. In the case of Consolidated Management Group, LLC versus the California
Department of Corporations [162 CA4th 598, 75 CR3d 795, 2008] a California appellate court ruled that "the investor's inexperience and dependence on a managing venturer served to establish that the joint venture interests were in fact securities." The court further stated that these business promoters "were soliciting investments from people who would, as a practical matter, lack the knowledge to effectively exercise the managerial powers conferred by the joint venture agreements . . ." The court went on to say that "the success of the particular projects marketed was uniquely dependent on the efforts of the . . . managing venturer, and that investors would be relying on those efforts in making their investments." Ultimately, the court observed that the investments were solicited from persons with no experience in the relevant industry.
To summarize the law on active investors, when seeking to fund a film through such persons, the number of active investors needs to be limited to no more than several (i.e., the more investors, the more likely that one will be considered passive and thus a security has been sold). In addition, the investors need to have “knowledge and experience” in the film industry, the investors need to be actively involved in helping to make the important decisions associated with the undertaking and the agreement with these investors needs to clearly set out their authority to participate in that decision-making. If we step back from the courts’ decisions and the case law in this matter, we have to admit that there are not really that many active investors outside the film industry, who have the requisite knowledge and experience in the film industry. So there is always a risk when using a business plan to seek financing from a few active investors (the appropriate use of a business plan when seeking financing for a film), that such investors and the transaction will not meet the criteria set out by the courts. If that is the situation and if an investor ever complains to federal or state securities regulators (who are only a phone call away), the transaction may be considered to have involved the sale of a security and the filmmaker may be civilly and criminally liable for failing to register the same.
It is true that where profits are expected to come from the joint efforts of partners (the typical case in a general partnership, joint venture or a member-managed LLC) the courts are not likely to consider that arrangement a security. [Fundamentals of Securities Regulation, 4th Edition, Louis Loss and Joel Seligman, Aspen Publishers, 2007]. So again, those are the situations in which use of a business plan to seek active investors may be appropriate. However, keep in mind that the courts will not rely on the form of the transaction (i.e., the use of an active investor investment vehicle), but instead will look to the substance of the transaction and use the criteria set out above to determine whether a security has been sold. If you are selling a security (whether you know it or not) and you have not attempted to register the security with the SEC at the federal level and with the state securities regulatory authority in each state where the security is being sold, or failed to qualify for an available exemption from the registration requirement, then it is very likely that you are guilty of selling an unregistered security, which is a felony. So, the best advice we can provide to filmmakers is to be careful when choosing to raise money through the use of a business plan and from a few active investors.
b. Passive Investors – The alternative film finance approach involving investors is to seek to raise the money needed (whether the full budget or the equity component of a film finance plan) from a larger group of passive investors. In this situation, the film producer recognizes he or she is selling a security (usually structured as a manager-managed LLC or a limited partnership) and typically seeks to qualify for an available exemption from the securities registration requirement. The federal exemption may be Regulation D, Rule 505 or 506 and the compatible state exemptions, or the state level Model Accredited Investor Exemption (paired with the SEC’s Regulation D, Rule 504). In any case, the information document to be provided to passive investors is not a business plan. It is a securities disclosure document, most commonly referred to as a private placement offering memorandum or PPM. Some people mistakenly believe that a business plan and a PPM are the same thing. They are different, however, in at least two ways. Although there is some overlap in the contents, a PPM is required by law to include a considerable amount of information that is not required to be in and will never been seen in a business plan. In addition, the business plan and PPM are intended to be used in different situations. The business plan is to be used when seeking to raise money from a few active investors. The PPM is to be used when seeking to raise money from a larger group of passive investors (when the security has not ben registered).
3. PPM Supplements – When some filmmakers and their advisors learn about the law relating to the limited use of business plans, they sometimes argue that a business plan still should be used as a supplement to a PPM. They reason that a PPM is typically more of a “compliance document” than a “selling document” and therefore not as effective in persuading prospective investors to invest. It is true that one of the primary purposes of the PPM, which is required by law to be delivered to each prospective passive investor prior to the sale of a security in an unregistered securities offering, is intended to help the filmmaker comply with the federal and state securities laws (i.e. prevent them from running afoul of the law). However, some PPMs are more appealing than others, so you cannot assume that all PPMs are the same. In addition, if a business plan used in such a manner duplicates significant portions of the PPM, that’s a waste of trees. The better practice, in my view, if you feel a supplement is needed at all, is to supplement the PPM with a four-page, full-color brochure, or something to that effect. It is important however, that the language, numbers and graphics included in the supplement be consistent with the PPM and approved by the securities attorney who prepared the PPM, since that supplement becomes part of the offering materials and can be requested for review by securities regulators. Securities fraud committed in a supplement can be just as detrimental to your filmmaking future as securities fraud in a business plan or any other document.
Thus, as you can see, there are many film finance situations where it is not appropriate to use a business plan, and there are some limited circumstances where it is appropriate to use a business plan. Hopefully, filmmakers and their advisers will be able to use the law-based information in this article to know and observe the difference.
John Cones, Attorney, Author, Lecturer
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