Debt vs. Equity in Film Finance
In my work with independent film producers in the area of film finance over the past twenty years or so I have often observed that many such filmmakers do not have strong opinions about what form of film finance to pursue. They just want the money to produce their films and don’t really want to be bothered with the details. After all, most film schools do not offer courses in film finance and most independent filmmakers simply do not have the background or training in finance generally, or in film finance specifically. Partly due to this lack of experience and sophistication in finance on the part of the filmmakers, and partly because the costs associated with producing films are often significant, the film finance marketplace sometimes attracts unscrupulous promoters of various forms of film finance. These promoters of film finance repeatedly use bogus reasons in their attempts to persuade filmmakers to use whatever form of film finance they promote, not because it’s the best form of film finance for the specific film project, but because it is to the benefit of that particular film finance promoter. The advent and wider use of the Internet and its various subject matter oriented blog sites offer greater opportunities for these unscrupulous promoters of film finance methods to market their ideas and confuse filmmakers. Thus, independent film producers must be very cautious. Watch out for the overly aggressive promoters of any particular film finance method when they do not seem to be able to acknowledge that their form of film finance has not only some advantages in certain situations, but also some disadvantages.
In my book, 43 Ways to Finance Your Feature Film I took the position that there is no single best way to finance a feature or documentary film. Rather, there are quite a few different ways to accomplish this objective and each form of film finance has its own set of advantages and disadvantages. It is important that independent producers embarking on the film finance challenge develop a good solid understanding of which form or forms of film finance may be best suited for their particular project. This article focuses on the advantages and disadvantages of lender and investor financing, also known as debt versus equity.
In a general sense, debt involves borrowing money to be repaid, plus interest. Repayment is usually on a date certain. On the other hand, equity involves raising money by selling interests in the company. For a corporation, those interests would be stock. For a limited liability company (LLC) or limited partnership (LP) those interests are commonly referred to as “units”. The following table discusses the advantages and disadvantages of debt financing as compared to equity financing.
Advantages of debt compared to equity:
- A lender does not typically have a claim to equity (i.e., ownership) in the business and debt does not dilute the owner’s ownership interest in the company.
- A lender is entitled only to repayment of the agreed-upon principal of the loan plus interest, and has no direct claim on future profits of the business. If the company is successful, the owners may reap a larger portion of the rewards than they would if they had sold ownership interests in the company to investors in order to finance the venture.
- Except in the case of variable rate loans, principal and interest obligations are known amounts which can be forecast and planned for.
- Interest on the debt can be deducted on the company’s tax return, lowering the actual cost of the loan to the company.
- Raising debt capital is less complicated because the company is not required to comply with state and federal securities laws and regulations.
- The company is not required to send periodic mailings to large numbers of investors, hold periodic meetings of shareholders, and seek the vote of shareholders before taking certain actions. These latter two considerations only apply to corporations. Manager-managed LLC and limited partnerships do not require the meetings and investor approval on most issues.
Disadvantages of debt compared to equity:
- Unlike equity, debt must at some point be repaid, and if not repaid, whatever assets were put up as collateral for the loan, will be taken by the lender.
- Interest is a fixed cost which raises the company’s break-even point. High interest costs during difficult financial periods can increase the risk of insolvency. Companies that are too highly leveraged (that have large amounts of debt as compared to equity) often find it difficult to grow because of the high cost of servicing the debt.
- Cash flow is required for both principal and interest payments and must be budgeted for. Most loans are not repayable in varying amounts over time based on the business cycles of the company.
- Debt instruments often contain restrictions on the company’s activities, preventing management from pursuing alternative financing options and non-core business opportunities.
- The larger a company’s debt-equity ratio, the more risky the company is considered by lenders and investors. Accordingly, a business is limited as to the amount of debt it can carry.
- The company is usually required to pledge assets of the company to the lender as collateral, and owners of the company are in some cases required to personally guarantee repayment of the loan.
The bottom line is that debt must be repaid. If any form of collateral is put up for that debt, and the loan is used to produce an independent film, there is a really good chance that the independent producer will not be able to repay the loan principal and interest on the specified due date, thus whatever collateral is put up will be lost. That is not to say that there may be some situations where an individual producer may want to take that approach. That’s fine. As noted above, in investor financing situations (i.e., equity) there is more work involved in the offering and some burdensome regulations with which to comply (and with which securities attorneys are available to help), but the investor financing approach allows the independent producer to spread the risk amongst a large group of passive investors who know that their money may be lost. As pointed out in my article on investor motivation, there are quite a few reasons why people may want to invest in one or more independent films other than solely for profit, although in the back of their mind, there may always be the hope that the film will turn out to offer a significant upside potential.
Now, the above represents the more traditional pros and cons of a debt versus equity discussion, much of which is drafted for the context of corporate finance (not often used for independent films). The manager-managed LLC or the limited partnerships are the more common investment vehicles for such project financing.
In addition, the most common lender transactions in the film industry do not quite fall into any of the categories described above. They typically are not supported by hard assets, so to speak, rather by distributor contracts. Those transactions may take the form of worldwide negative pickups, domestic and international split rights deals or foreign pre-sales. If the film producer can obtain a distribution agreement and guarantee from a credit-worthy distributor, the producer may be able to use that agreement or those agreements as effective collateral for the loan. Unfortunately, this form of lender financing of feature films is not available for most of the films sought to be produced by independent film producers (see discussion of lender financing in my book “43 Ways to Finance Your Feature Film” (published by Southern Illinois University Press). Also see my article “Contingent Promissory Notes as a Film Finance Method – Are Filmmakers Being Misled?” at ArticlesBase.com.