CHAPTER 10

Making Money

Net Profits, Hollywood Accounting, and the Relative Simplicity of Online Revenue Sharing

More content from this chapter is available at www.focalpress.com/9780240824239

“Hollywood accounting” has become a somewhat infamous phrase, but in practice it simply takes effort to understand the jargon and rules. The greatest single area of confusion is the fact that the term “net profits” has no correlation to the concept of net profits that most companies use in a typical corporate income statement. Rather, the term net profits used in Hollywood contracts is a carefully crafted and defined term of art.

Because most people fail to peel back the onion and learn the nuances (which can be frustrating, and appear unfair devoid of context), an element of prejudice has been affixed to the calculation of profits in Hollywood contracts. There is a pervasive feeling that the studios and networks are “cooking the books”: How else can a project earn over $100 million at the box office, sell successfully into large secondary markets such as TV and video, and be in the red? The answer is that under traditional income statements and/or tax accounting, the project may in fact be profitable, but that pursuant to a contractual profit-sharing definition (somewhat unfortunately also labeled net profits), the project still posts a loss.

This gulf creates the common perception that the accounting system is either rigged or unfair. In fact, the system, by many accounts, is very fair, if not generous. From the standpoint of the studio or network that would be paying out net profit participations, it is sharing the upside even though it may have taken all or most of the risk. In what other business proposition would you find the following formula: Party A takes on 100 percent of the financial risk, Party A knows that on the majority of its projects it may lose money, Party A takes no defined or preferred return on its investment before other participants share in the upside, and Party A shares 50 percent of the profits after a defined break-even point with its partner in the project? Nowhere.

This is the context behind why studios and networks have created padded profit-sharing definitions to protect the recoupment of their investment and build in an internal ROI factor before actually paying out profit-sharing; as disruptive online/digital trends put strain on the interplay of value drivers in Ulin’s Rule, and by-title profitability comes under attack (as is evidenced from various sources described throughout the book, including the decline in the video market), the desire to protect profits and ensure recoupment becomes heightened. It is simply unfortunate that the resulting payout comes under the heading of net profits, for the use of the phrase is misleading relative to common sense and commonly applied methods of calculating profits in other business contexts. As far as a profit-sharing mechanism that protects the investor first, and shares an upside with the people that helped make the project a success, it makes perfect sense; the only debate, then, is whether the profit-sharing scheme is a good or poor one. The best way to understand “profits” definitions is to acknowledge that any reference to net or gross profits is a misnomer and instead refers to contractually defined schemes of contingent compensation (see Figure 10.1 depicting general structure).

Figure 10.1 Profit Participation Chain

If the system was not already confusing enough, the introduction of online revenues has the potential of creating another level of nuance—simply read the new talent guild agreements (see Chapter 7) where certain residuals are calculated as a percentage of “distributors gross receipts” and are applied, for example, on a sliding-scale basis tied to download volumes (with different tiers tied to different types of content such as TV versus features). Because the online world has evolved a relatively straightforward system of revenue sharing and is not beholden to the arcane Hollywood net profits system, the methods of calculating relative shares are on a collision course. I will discuss some of the implications later, and argue that the root of the problem is trust: net profits has become shackled and institutionalized by feeding on lack of trust between parties, while online revenue sharing has become commonplace and accepted because of the trust engendered by detailed, by-click, electronically tracked metrics. Is Hollywood more likely to challenge the revenues from online clicks by Google, or are the Googles of the new millennium more likely to challenge the perceived revenue-sharing smokescreen thrown up by convoluted net profits definitions?

Finally, given the complexity of profit accounting, the following discussion primarily focuses on the context of film; nevertheless, the same general principles can apply to a network’s profit participation accounting to a TV producer or a video on a made-for-video production.

Profit Participation Accounting

Profit participation accounting, which I need to emphasize is not “accounting” in the sense of GAAP or tax books, is simply a contractual revenue-sharing arrangement negotiated between parties; what started out as a rational basis of sharing risk is now usually discussed in pejorative terms (aka Hollywood accounting), and over time has evolved into a bit of an arcane science that I will try to decode.

One threshold point worth mentioning is that all participations are phrased in terms of “X percent of 100 percent of Y” such that 5 percent of net would contractually read “5 percent of 100 percent of the net profits of …” This is because net and gross profits are artificial methods of dividing up certain revenue streams and are based on limited pools of receipts and costs. To avoid ambiguity, the definitions are careful to stipulate that the percentage tapped into is 100 percent of the defined pool described—not just of the profits of the contracting party. If Party X were contracting for 10 percent of the profits, and the contract referenced profits as the share of financing entity Party Y (e.g., studio) that had 50 percent of the profits (with the balance going to the talent/production entity), then Party X would find they only had 5 percent of the total pool; whereas, if the contracts of Party X and Party Y both referenced a defined profit pool (100 percent of net profits, out of which they may share differently), then Party X’s 10 percent stake is preserved.

Because the pool is shared by multiple people, and the calculations of different individuals are impacted directly by the participations of third parties, it is possible to only share in part of the pool; as described later, and making things even more complicated, it is further possible to share in only part of the revenues in part of the pool.

History of Net Profits

Whether true or not, Hollywood lore attributes the genesis of net profits to a deal made between Jimmy Stewart and Universal Pictures on the film Winchester ‘73 in the early 1950s. Jimmy Stewart was already a major star, and his customary fee was deemed too high for the budget that Universal was willing to approve. Stewart’s agent, Lew Wasserman, reportedly struck a deal that granted Stewart a share of the film’s net profits in lieu of his customary above-the-line guaranteed fixed compensation/fee; in essence, Stewart became a partner with the studio, sharing the profits equally with the studio once the film had earned twice what it cost to make.

The key phrase is “in lieu,” for in the original concept the sharing was a parceling of risk where the actor risked his or her salary, and on success reaped a large upside. Today, much, if not all, of that risk has been eliminated and major profit participants get large upfront fees plus share in a big chunk of the upside.

The trend started by Lew Wasserman is a bit ironic vis-à-vis his career. Wasserman, regarded as one of the true Hollywood moguls alongside the likes of Jack Warner and Louis B. Mayer, started the talent agency MCA, becoming an enormously powerful agent and defining the type of clout that is now taken for granted when referring to agencies such as CAA, ICM, and WME. Wasserman’s agency later took over Universal, and Wasserman ran Universal as the last of the original Hollywood moguls until the sale of the company to Matsushita (Panasonic) in the early 1990s. (Note: Since then, Universal has changed hands several times, next to Seagrams, then to Vivendi, then to GE to form the combined NBC Universal, and most recently to Comcast). In his capacity as chairman of Universal, he sat on the other side of the table. One can only imagine what he thought about profit participations when Universal struck deals with leading talent, such as Steven Spielberg and Amblin Entertainment for Jurassic Park.

Net profits seemed to take a public turn in the 1990s with the cost of talent and budgets growing at an unprecedented pace. Maybe it was the combined growth of the video market, the international free TV market, and the global pay TV markets that gave participants a wake-up call: How could this avalanche of ancillary money be rolling in and pictures seemingly performing well still post losses? Whatever the reason, the concept of net profits, or lack thereof, seemed to start making its way into the headlines, and reached a peak with Art Buchwald’s lawsuit against Paramount Pictures over his rights and participation in the film Coming to America, starring Eddie Murphy.

Celebrity Lawsuits Spotlight Accounting Practices

Seemingly every few years, a new lawsuit brought by a celebrity alleging mistreatment in his or her profit participation catches media attention. On occasion, some of these suits delve into the nitty-gritty of net profits.

Art Buchwald v. Paramount Pictures in Case Involving the Film Coming to America

Probably no case has reached the fervor of Art Buchwald v. Paramount Pictures, a case in the 1990s that dragged on in the media and courts for several years. In his suit, Art Buchwald very publicly asked the question: How can this picture have grossed hundreds of millions of dollars and lose money? His claim and the underbelly of Hollywood’s net profit accounting system were played out on the front page of Variety over the course of the trial. When Eddie Murphy referred to net profits as monkey points during the litigation, it tainted the perception of net profits as never before.

The case involved a treatment called King for a Day that Buchwald, a famous columnist and humorist (arguably the most famous humorist/political humorist at the time), wrote and optioned to Paramount (the development of which at the time fell, at least in part, under Jeffrey Katzenberg). The same studio went on to produce the Eddie Murphy vehicle Coming to America, which Buchwald argued was based on his treatment. The court found that Coming to America was indeed based upon Buchwald’s treatment, and then reviewed in detail the intricacies of net profits in the “accounting phase” of the trial. Among the reasons the case became a cause célèbre is that in the context of this mega-hit film that grossed over $350 million, where Buchwald was initially paid no participation and the studio argued was in the red, the court found “that certain provisions of Paramount’s net profit formula were unconscionable.”¹

The book Fatal Subtraction: How Hollywood Really Does Business, written by Buchwald’s legal team after the case, is a roller coaster ride through the trial, and is about as entertaining a read as one is likely to find concerning the world of net profits.²

Sahara Case—Clive Cussler v. Philip Anschutz Company

More recently, Clive Cussler, a best-selling author who had 19 consecutive New York Times bestsellers (and since, several more), was embroiled in a case over the movie Sahara, based on his book of the same name. The case, against Bristol Bay, one of the film companies within the Anschutz Film Group controlled by mogul Philip Anschutz (who also controls Regal Entertainment Group, consisting of Regal Cinemas, United Artists Cinemas, and Edwards Theaters, and The Chronicles of Narnia producer Walden Media), was primarily about Cussler’s claims regarding his creative rights in the film. However, because of the people involved and the losses reported, the nature of net profits was again put in the limelight. All of the pieces were there for media drama: two high-profile stars in Matthew McConaughey and Penelope Cruz, a famous author in Cussler, a reclusive billionaire financier in Anschutz, an award-winning screenwriter, and even Michael Eisner’s (former Disney CEO) son, Breck Eisner, as the director.

The Los Angeles Times wrote an exposé, with the headline: “How Do a Bestselling Novel, an Academy Award-Winning Screenwriter, a Pair of Hollywood Hotties, and a No. 1 Opening at the Box Office Add Up to $78 Million of Red Ink?”³ What it detailed was simply how a movie with revenues of over $200 million was projected to lose approximately $80 million. Table 10.1 is a high-level summary of the net loss based on the numbers highlighted in the article.

The grist for the media was the public listing of star salaries and excesses on the film, but it again thrust the nature of Hollywood profit accounting into the public eye.

Table 10.1 Expenses and Net Loss for Sahara (Based on Projections for 10 Years, Through 2015)

Negative cost	$160 million
Print and advertising	$ 61 million
Home video costs	$ 21.9 million
Distribution fees	$ 20.1 million
Other	$ 18.2 million
Total expenses	$281 million
Total revenue	$202.9 million
Net loss	$ 78.3 million

Peter Jackson v. New Line in The Lord of the Rings Claim

Although it never led to the publishing of figures, as resulted in these cases of Buchwald and Sahara, the nature of net profits was thrust onto the front pages when Peter Jackson sued New Line Cinema in 2005. Fresh off his Academy Award wins and having catapulted into the superstar league with his The Lord of the Rings films, Jackson alleged that he was underpaid $100 million in net profits from the blockbuster trilogy, which grossed nearly $3 billion collectively. One eye-catching part of the claim was the argument that the studio used “preemptive bidding,” allowing divisions within the vertically integrated corporate Warner Bros. group to obtain related rights (e.g., books, DVDs) rather than put them out to the competitive market. The battle, which became a public saga, and held up Jackson’s willingness to be involved with the planned The Hobbit films, was eventually settled.

In the context of the lawsuit, the New York Times quoted former Carolco Pictures CEO (Rambo films), Peter Hoffman, as follows: “Once upon a time, Hollywood studios paid a lot of money to net profit participants, and it was a fair deal … Then the studios got greedy and stopped paying, and now we have gross players who used to be net players fighting over vertical integration. The studios brought this problem on themselves.”⁴

Why So Complicated—Endemic to the Talent System?

At some level, it is possible to argue that the complexity of profit definitions is a necessary outcome of needing to negotiate individual talent agreements. If talent were merely a commodity, akin to an assembly line input, and wage rates could be fixed, then everyone would accept a level of standardization; this is, in fact, what happens with most labor union contracts. However, there is a profound difference when dealing with experience goods of infinite variety with a parallel infinite range of variance in creative input. This is even harder than sports, which in many ways is the most similar market. At least in sports, it is possible to measure an individual’s performance via objective metrics such as batting average, points per game, goals, or tackles. With experience good entertainment products, there is such a complex matrix of inputs and variable results that individual contributions are more subjectively measured. Key creative talent is therefore not considered fungible, and cannot easily be homogenized into standard compensation schemes. Even if this was not the case, ego and agents would argue that an individual’s value is unique and must be measured on a one-off negotiated basis.

The result of one-to-one varied deals is not efficient for either side. It creates delays for talent, who are usually anxious to close deals rather than postpone them (as virtually all employment is on a per-project basis, and insecurity regarding landing the next project and/or being replaced by the new, younger, hotter X runs high). On the producer/distributor side, negotiating each deal not only creates an upfront overhead burden (plus the political anxiety of haggling with agents/lawyers that can point fingers when deals fall through), but in accounting for contingent compensation they frequently have to customize reports and construct a labyrinth of deductions where one person’s share is dependent on another’s and another’s …

I asked Jim Mullany, managing director of Salem Partners LLC, a Los Angeles-based investment bank and wealth management/advisory firm primarily involved in media and entertainment M&A advisory transactions and library valuations, if he ever envisioned a more simplified system, especially in light of new, growing revenue streams from new media and technology distribution platforms. He noted the following in confirming the underlying pressures that shape the current system:

While participation accounting is brushed off as a “Hollywood accounting,” implying the worst meaning of the phrase, each participation statement that is rendered has to reflect the financial terms of the talent and financial contracts: the revenue and expense definitions, and the order and priorities of cost recoupment are spelled out in the negotiated contracts.

The accounting systems required to create monthly, quarterly, semi-annual, or annual participation statements (the timing of which is also contractually set out) are so massive and complex that many accounting departments have to revert to preparing statements manually using reported data from financial reporting systems from the various divisions (domestic and international) of the distribution company. Sometimes, the participation accounting department will have accumulated the unfiltered financial numbers for revenue and expenses, and must begin the manual customization of reports for each contractual party. They have to take into account:

■  the many different definitions of what is reported as revenue, and what is reported as deductible or recoupable expenses;

■  the variable distribution fees per source of revenue;

■  calculation of contingent compensation paid to other participants are deducted if the contract specifies that priority;

■  the addition of studio overhead surcharges to various expense categories, or not;

■  surcharges on other costs and fees are to be included or excluded; and

■  home video revenue is typically defined as a 20 percent royalty on gross adjusted wholesale video revenues; or an alternative for financial partners is to calculate video revenue as wholesale revenues less an allowance for returns, and then deduct costs of manufacturing, packaging, and shipping video units.

It is not uncommon for each member of the creative and financing team of a television or film project to have a different set of definitions for reporting revenue and expenses deducted, before the defined profitability is declared.

In an ideal world, a studio would insist on standard contract terms with uniform definitions for all contracts entered into by the studio. Unfortunately, those fixed, carved-in-stone standard terms would hold only until the studio tries to sign an “indispensable” talent element, and waives policy to craft an individualized contract reflecting more favorable terms negotiated by the talent agent or lawyer representing the indispensable creative talent. The contact terms would be negotiated section by section. The formerly standard template of participation accounting for back-end purposes and payment of contingent compensation would be modified henceforth.

Gross and Net Profits: How are They Defined and Calculated?

All studios and networks have similar gross profits and net profits definitions, but it is critical to remember that these vary by contract and are not fully standardized. The following parameters are industry custom, and have become “terms of art,” but nuances exist and any profit participation can only be understood and administered by reference to its defining document.

Included and Excluded Revenues

A key to understanding net profits is to understand the baseline of what revenues are included in the calculation, and which revenues are excluded: not all revenues are counted. Film, video, and television revenues are all included in gross and net profits calculations; however, which specific revenues are captured (e.g., film rentals or box office), at what point they are captured (on television sale or broadcast), and what portion of revenues are counted (e.g., video wholesale or video royalty) are issues defined by contract.

Fully Included Revenues (A)

With respect to theatrical revenues, 100 percent of film rentals are included (see Chapter 4); no revenue retained by the exhibitor, even if the theater is an affiliate or directly owned by the studio, is included. Revenues from sales of films to television are similarly accounted for at 100 percent.

Allocations and Timing A wrinkle on the inclusion of TV sales revenue is that it was (and still can be) common practice for films to be sold in packages. A studio will combine, for example, 15 to 30 films and receive an overall fee for the entire package. What revenue should be attributable to any particular film within the package (see Chapter 6)? This can be a hotly contested area, for allocations can swing revenues on a picture millions of dollars and the interests of the studio and producer may not be aligned.

In addition to allocation issues, television revenues can be subject to timing delays, setting back when revenues are accounted for and shrinking the upfront pool of revenues upon which profits are calculated. Whoever is responsible for paying participations (e.g., studios) may not be apt to adopt the GAAP revenue recognition rules (which accelerate the reporting of revenue over the term of the license in year one, as discussed in the following section). Instead, they will take the logical position of recognizing advances once holdbacks have expired and match the revenues to the term of the contract. Money in hand may not be counted until downstream when the broadcast it has secured takes place.

Partially Included Revenues (B)

Video revenues are included, but only a fraction of the actual video receipts are customarily put into the pot. As discussed in Chapter 5, video revenues are typically accounted for at only 20 percent, equating to a royalty on the gross revenues. Beyond segmenting only a fraction of video revenue for inclusion in profit calculations, the video revenue number is further reduced or delayed by the calculation of return reserves (see also Chapter 5). These reserves set back revenues, and only if and when they are liquidated are the amounts put into gross revenues (off of which the royalty will then be calculated).

Excluded Revenues (C)

Revenues from merchandising and theme parks are generally not included. Also, the following items are usually referenced as simply being excluded: theme park royalties, music and record royalties, books, and royalties derived from derivative works or the underlying material.

A + B + C = Baseline Revenue for Calculating Net Profits

Merchandising and Other Revenues as a “Separate Pot”

Sometimes certain ancillary revenues, such as from merchandising, will be put into a separate pot. In this instance, the participant will receive a separate accounting statement tracking the definition of revenues of that single revenue stream; a distribution fee may or may not be charged, and the timing of payment may be linked directly to the right or may tie into a separate definition (e.g., 5 percent of 100 percent of merchandising receipts, but only after such point as …). If there is a separate pot, these revenues need to remain separate, and not be included in the definition of revenues for net profits; otherwise they would be double counted.

Certain Costs Always Deducted

Certain costs are almost always deducted as “off-the-top” expenses for all participants. Even in the context of “gross” or “gross revenues,” these terms are actually net of off-the-top expenses; the amount remaining after the off-the-tops are sometimes conceived of as “gross” in terms of the revenue line from which all participants then look to apply deductions or percentages of revenues. The following are standard categories of off-the-top expenses.

Trade Fees and Dues

The studios are members of trade associations that lobby on their behalf and also fight common issues such as piracy. The most well-known group, as referenced in several instances throughout this book, is the Motion Picture Association of America (MPAA). The MPAA maintains affiliated regional offices throughout the world, and plays a key role in lobbying foreign governments on laws impacting piracy and the protection of intellectual property (see Chapter 2) Another association is the Association of Motion Picture and Television Producers, Inc. (AMPTP). This organization, including all the major studios and independents, negotiates union agreements with the various Hollywood guilds (see Chapter 7 for a discussion of new media residuals impacting SAG and WGA negotiations, and leading to strikes). Associations such as the MPAA charge dues and assessments that cover legal and administrative costs, and the studios recoup this money by charging these costs back to pictures as an off-the-top deduction.

Checking

Checking here means costs borne by the studios to send “auditors” out to theaters to ensure that box office receipts (given the predominantly cash nature of the business) are accurately reported. Depending on clout, these costs are often capped. (Note: The cost of collecting money due is also typically an off-the-top.)

Duties, Tariffs, and Licenses: Conversion

These involve costs incurred to permit the exhibition of the picture in foreign territories and the associated costs to convert foreign currency to U.S. dollars, including related costs of converting and transmitting restricted funds (restricted funds are less applicable today given the global economy).

Residuals

These are the payments (see Chapters 2 and 7) required under union collective bargaining agreements (e.g., Screen Actors Guild, Writers Guild of America, Directors Guild of America) for use of the picture in media post its initial release medium (e.g., television following theatrical).

Taxes

This does not refer to income tax, but rather taxes of whatever nature that may be levied on the picture (e.g., relating to the exhibition).

Distribution Fees

Distribution fees are the not-so-hidden charges that compensate the distributor for its work in selling the picture and managing the license (including collections, delivery, and all related back-office functions). Rather than charging a mark-up on a per-product basis, the distributor charges a percentage on the revenues (akin to an agency fee). This percentage, in theory, is designed to: (1) cover the distributor’s overhead cost of its sales and distribution infrastructure (including people/salaries and offices, as outlined in Chapter 1); and (2) provide the distributor a profit margin for its work (though many will argue it is only intended to cover costs).

Range of Fees

Distribution fees are charged on theatrical, non-theatrical, television, video, and merchandising receipts. The standard fees, although they will vary by distributor, tend to be in the ranges shown in Table 10.2.

When looking at these fees, it highlights the importance of below-market fees discussed in Chapter 3. If Producer X benefits from a 10 percent fee, then on $100 million of revenues it bears only $10 million, versus a party with a standard fee of 30 percent that would bear $30 million.

Table 10.2

Revenue Stream	Distribution Fee
US theatrical	30%
Foreign theatrical	40%
US network TV	25%
US cable and syndication	35–40%
Home video	30–35%
Merchandising	50%

Sub-Distributors and Affiliates: Fees as Overrides

With respect to foreign exploitation, studios that do not have captive subsidiaries within a territory will distribute via an independent subdistributor or an affiliate. The sub-distributor is a full-fledged distribution company, and will charge a distribution fee for its service. The corresponding risk is that the studio may receive a net amount that it reports as its gross receipts, and then charges its own fee on this sum. For example, a sub-distributor in Asia charging Studio X a fee of 20 percent receives $500,000; it would remit $400,000 to Studio X, who in turn would charge 40 percent ($160,000). The net into the pot is $240,000, even though $500,000 was taken in at source. Many contracts will accordingly negotiate either that: (1) the studio fee is inclusive of all sub-distributor fees; or (2) the studio takes a smaller override fee on receipts from the sub-distributor.

The concept of an override needs to be carefully defined. Depending on interpretation, it could mean a fee charged on the net amount remitted (akin to a commission) or a fee in addition to the sub distributor’s fee such that there is a cumulative fee; in the latter instance, the contract would define the total fee to be inclusive of any subdistributor’s fee. Table 10.3 is an example of how this subtle distinction can vary the participation.

Table 10.3

	($ million)	Assumptions
Box office gross	20.0
Rentals	10.0	50% of box office
Sub fee	2.5	25% fee
Distribution expenses	4.5
Revenue remitted	3.0
Override commission	0.3	10%
Net receipts	2.7
	($ million)	Assumptions
Box office gross	20.0
Rentals	10.0	50% of box office
Sub fee	2.5	25% fee
Override	1.0	10%
Distribution expenses	4.5
Revenue remitted	2.0	Revenue remitted = Net receipts

At-the-Source Recognition

In the context of revenues that are earned in one locale and then remitted upstream, it is vital to pinpoint where and when revenues are captured. A simple example of how this can vary accounting is to consider how an advance is treated. A participant with clout will want to ensure that they are not disadvantaged by a sub-distributor guaranteeing an amount that ends up higher than the receipts taken in (this can occur when a guarantee is credited but not ultimately earned out), and having the reporting only reflect the actual territory receipts rather than the higher amount received by the studio. (Note: This scenario also raises timing issues. It can be debated whether the guarantee should be recognized when committed, paid, or earned out.)

Second, beyond an advance/guarantee scenario, a participant will want to account for revenue “at the source” simply to ensure it is capturing the greatest amount of revenue. The important rule when capturing items at a certain tier of distribution is to ensure symmetry, such that if costs are applied at the source, so are revenues.

In the case of a third-party foreign distributor (as opposed to a branch of the studio), the studio will report 100 percent of revenues received from the foreign distributor and take a fee on this “gross.” In reporting to a participant, however, the cash to the studio is less than at the source gross, because: (1) the foreign distributor may deduct its distribution fee and expenses, with the net amount remitted to the studio being considered the gross receipts; and (2) there may be withholding taxes that further reduce the cash amount tendered. The amounts accounted for become exponentially skewed if there is more than one level of sub-distribution, which can occur absent contractual caps and prohibitions.

To account at the source, the revenues received by the sub-distributor from exploiting the property would be considered gross and then any deductions would be applied from this point. Accordingly, if there were a distribution fee applied, it may be aggregated with any fee of the studio (capped so that the aggregate fee is no greater than X); alternatively, the studio may simply apply an override to sub-distributor remittances.

Expenses should be treated in a similar manner, such that if receipts are captured at the source, then expenses are applied at this level as well. A corollary to this issue is how costs of affiliates are treated; some may argue that these are not arm’s length transactions and the studio can arbitrarily elect to use its own affiliates at rates it establishes. There is, of course, danger for abuse, but checks and balances can be put in place, such as requiring the same (or no worse than) rate card pricing as charged to unaffiliated third parties.

Distribution Costs and Expenses

The “off-the-tops” described previously are simply a subset of the overall category of distribution expenses that are deducted by the distributor. In general, the distributor will be allowed to deduct any and all expenses relating to the distribution and exhibition of the picture. This will be expressed contractually in a catch-all phrase covering monies paid, advanced or incurred by the studio “in connection with the distribution, exhibition, marketing, and exploitation of the picture.” The only carveout is that these costs relate to the sale of the picture and are not part of the costs of making the picture. While this sounds straightforward, as mentioned earlier issues can arise such as whether trailers are a production or distribution expense (although the foregoing is routinely accepted as a distribution cost). The principal costs other than off-the-tops are in the following sections.

Prints and Physical Materials

The costs of prints, duplicate prints, masters, etc. are obviously a large and legitimate expense (and, as discussed in Chapter 4, part of the impetus for D-cinema, which holds the promise beyond presentation improvements of eliminating the bulk of these costs). The key here is to capture the actual costs, which, when charges go down to the level of tape stock (which may not be easily separable on a per-film basis), can be tricky.

Advertising

This is perhaps the largest single cost relating to distributing a film. “Advertising” is a catch-all for advertising, marketing, and promotional costs, and includes subcategories such as the following:

■  publications, including local and national trade and consumer press (e.g., newspapers)

■  television, radio, online, mobile advertising

■  screenings

■  artwork

■  promotional materials (e.g., free giveaways)

■  trailers

■  travel and entertainment costs of marketing executives.

Negative Cost

“Negative cost” means the cost of creating the finished product; namely, the cost of production through to the final delivered film negative. When people are asking the simple question: “What did it end up costing?” the answer will be: “The negative cost was X.” As mentioned in a few sections, what costs are included in negative cost can be subject to debate. For example, should advances against gross participations be included in costs, and again where is the line between production costs and distribution costs (e.g., a foreign-language master)?

Other Distribution Costs

Other distribution costs may include the following:

■  dubbing and subtitling costs for foreign versions

■  shipping and delivery costs (significant in delivering prints to theaters)

■  insurance

■  copyright registration and protection costs and expenses

■  litigation related to the property/picture (e.g., copyright infringement claims).

Gross Participations, Deferments, and Advances as Cost Items

Deferments

A deferment is simply a payment that is agreed to be made in the future, but is tied to the occurrence of a specified event. That event could be something like box office reaching two or three times the negative cost, or when a break-even point with a specified fee (e.g., imputing a reduced distribution fee) occurs. Deferments are a type of contingent compensation since they are not guaranteed, but are usually structured to kick in at a point deemed more certain than the point at which net profits would be due.

Deferments are also a way to skirt budget items, as certain compensation to above-the-line talent may be taken out of the budget to hit a magic mark for green-lighting the project, while promising the dollars at a point that everyone expects to attain. If there is a perceived risk involved, then the deferment will likely be higher than the upfront guaranteed compensation would have been (this also makes sense, since the payment is also delayed).

Gross Participations as a Cost Item

Participations payable before net profits are due, such as gross participations, may sometimes be added into the cost of production and treated as part of the negative cost for the purposes of calculating net profits. As further illustrated, this can obviously have a profound impact on net profits ever being realized.

Advances

Advances are often lumped in with deferments, but are different because a deferment generally refers to the timing of paying a fixed sum, whereas advances are tied to a variable contingent element. The contingent element is the back-end, and by paying a portion of that contingent back-end as a non-refundable advance, the scheme of Hollywood accounting basically turns a contingent payment into a guarantee. A star, for example, may take a budgetary cash fee of $2 million, which is structured as an advance against his or her back-end. While this methodology may have no ultimate impact on the participant (other than accelerating compensation), it can have a profound impact on third parties whose participations are subject to recoupment of production costs; as discussed further, by accelerating the payment, the $2 million goes into the salary/production cost line, thereby increasing the production costs that are then further increased by both overhead and interest, setting back the point of recoupment for all non-gross participants.

Imputed Costs: Production and Advertising Overhead, Interest

Advertising Overhead

Salaries of studio personnel working on advertising and marketing for the picture are not allowable charges. However, it is customary to add an advertising overhead charge (e.g., 10 percent), which is a gross up of the total advertising costs deducted. Some may find this unfair, and argue that the studio’s distribution fee is supposed to cover overhead costs, but the advertising overhead fee is generally accepted as a standard provision in net profits definitions.

Interest on Negative Cost

In addition to the negative cost and the administrative fee, the studio will also charge interest on the cost of production from the time the costs were incurred until the production costs are fully recouped. This interest cost is charged whether or not monies are actually borrowed to make the film. Often studios will self-finance, but the argument is there was an opportunity cost and that the studio has, in effect, loaned the money to itself.

Interest costs can add up quickly because costs of production are so high: 7 percent on $50 million is a large number, and interest continues to be recalculated on the unrecouped production costs and then becomes an additional cost to be recouped. Because interest is recouped first (banks are usually at the head of the line), there is a compounding effect of interest delaying recoupment: interest continues to accrue on unrecouped production costs, such that receipts may pay down interest charges but during the same period new interest is accruing on the production costs. This interest treadmill is made more cumbersome from the participant’s standpoint to the extent interest is also charged on the overhead added to production costs; further, timing issues can exacerbate interest charges. Does interest accrue from the time expenses are committed or actually paid, and similarly are advances counted into receipts to pay down/stop interest or only recognized when earned?

Overhead Gross Up

In addition to the actual costs, it is customary to add a standard gross up to cover elements of studio overhead, similar to the advertising overhead fee discussed previously. Here, the net profits definition will invariably state that an administrative fee of 15 percent of the cost of production (excluding this fee) will be added to the cost of production. Accordingly, the negative cost is really the cost of production plus 15 percent.

Phantom Revenues: Allocating Taxes and Other Non-Picture-Specific Items

Allocations are always a hotly debated element given the tension between subjective calls inherent in the nature of allocations and what participants want to believe are “exact” costs in accounting. When properties are bundled and fees and/or costs need to be apportioned, what should the formula be (e.g., straight-lined based on relative box office, or another formula)?

Rebates

In the case of rebates, these may be part of a multi-picture deal, where a supplier may grant preferential terms to a customer based on a variety of factors, including length of term and volume of business. Most will consider overall incentive deals as part of the cost of doing business and not allocable on a line-item basis; however, others will dispute this and argue that any rebate incentive must be pro-rated or otherwise allocated back on a by-title basis and passed along.

Taxes/Tax Credits

Many countries impose withholding taxes on remittances of royalties (e.g., Japan), which are triggered because the intellectual property basis of the content means payments are remitted via a license. Moreover, these taxes can be challenging to assess because their application involves both the individual picture and the ultimate tax position of the entity bearing the withholding tax. When withholding taxes have been applied against a specific picture attributable to a specific license, then arguably a corresponding matching tax credit ought to be applied to the picture (the concept being that per tax treaties, a party should not be “double taxed” such that if you bear the tax locally, it should be offset by a tax credit on your corporate taxes). The problem is the utility of such tax credit is tied to the company’s overall tax situation, and whether it avails itself of that tax credit is dependent on its corporate tax profile and not the individual transaction.

If, for example, a $1 million license is subject to a 10 percent withholding tax given the tax treaty between the United States and Country X, such that only 90 percent of the license fee is remitted and 10 percent is captured via a tax credit matching the deduction (i.e., a $100,000 tax credit), should the licensee that has 90 percent of the cash reported be grossed up to 100 percent? While the answer may seem a simple yes, issues of “if and when” are significant because at the time of remitting the 90 percent, the distributor/licensor may not know whether it will use the corresponding tax credit. The decision will be determined by unrelated factors, including whether it is even eligible (it needs sufficient overall profits to claim the credit in the first place) and then, if eligible, what strategy is deployed in its overall corporate tax planning. For its part, the content owner bearing the 10 percent with-holding tax is likely to only account for the 90 percent received, arguing it has no control over the withholding (governed by law/tax treaty) and it may or may not use the tax credit (a likely scenario if high production costs/investment and revenues are not matched in timing).

Net Profits: An Artificial Break-Even Point and Moving Target

Net profits are the point at which gross receipts have recouped: (1) distribution fees; (2) distribution expenses; (3) interest on the cost of production; (4) the negative cost, including the studio’s overhead fee; and (5) gross participations and deferments payable prior to net profits.

Net profits basically track the definition of initial actual break-even (see later): the point at which gross receipts, from the sources of revenues that are counted toward gross receipts, equals the total costs on the project, including any imputed costs that are included in the definition of costs. The difference between net profits and initial break-even is that with net profits, there is no fixed stopping point; new distribution costs and fees paid or incurred are applied with each accounting period, and continue to “roll” forward. Accordingly, with each accounting period, additional costs, fees, and revenues are thrown into the equation, and the “net profit” line calculated anew. Table 10.4 is an example.

Table 10.4 Net Profit Calculation A

Revenues and Costs	Assumptions	Net Profit Calculation ($ million)
Cost of production	$35 million
Box office	Gross box office	$200 million
Film rentals	Assume 50 percent of box office	$100 million
Distribution fees	Assume 35 percent on average	$35 million
Distribution costs		$45 million
Prints	$10 million
Advertising	$35 million
Interest on negative cost	Assume 10 percent	$3.5 million
Total negative cost (cost of production + overhead allocation)	Cost of production + 15 percent studio overhead on costs	$40 million
Profit/loss		($23.5 million)

Gross Participations/Profits

There are multiple types of gross participations, but in general a gross player receives money at a defined point prior to net profits. It could be as early as “first dollar gross,” which means participating at the same time that the studio takes money without deductions (although, even in this rare case, individuals are still customarily subject to the “off-the-top” deductions detailed earlier).

The key to gross participations is that distribution fees, print and advertising costs, and costs of production—the major expense categories in making and releasing a film—are not deducted. Individuals participating in true gross profits literally earn a percentage of the defined gross revenues with hardly any deductions at all.

Table 10.5 is an example, comparing the previous net profit participation scenario to one where talent has a 10 percent gross participation.

Table 10.5 Net Profit Calculation B—with Gross Participant

Revenues and Costs	Assumptions ($ million)	Net Profit Calculation
Cost of production	$35 million
Box office	Gross box office	$200 million
Film rentals	Assume 50 percent of box office	$100 million
Gross participant	Assume 10 percent gross points	$10 million
Distribution fees	Assume 35 percent on average	$35 million
Distribution costs		$45 million
Prints	$10 million
Advertising	$35 million
Interest on negative cost	Assume 10 percent	$3.5 million
Total negative cost (cost of production + overhead allocation)	Cost of production + 15 percent studio overhead on costs	$40 million
Profit/loss		($33.5 million)

Impact of Categorizing Costs as Production versus Distribution Costs

Timing

As discussed in the section on advances (page 575), as well as what charges are included within the negative costs, the line between what is a production versus distribution cost may be dependent on timing and contractual definitions; this is because the line is not always clear. Is a trailer a production item? Are certain masters or prints such as foreign language versions properly distribution cost items? If talent delays payment to the back-end, are these fees part of the cost of the picture, and is it fair that advances against a back-end instead are categorized as production costs that then are grossed up by an overhead component and are subject to interest?

In general terms, timing can create a relatively clear line—any costs to get to a finished negative can be construed as a production, and all subsequent costs (foreign masters, dubbing, etc.) for other versions would be distribution expenses.

Online Accounting: Simple Revenue Sharing and the Net Profits Divide

Gross is Gross and Net is Net—Sort of

The online world has not yet descended into the complexity of net profits seen in film and TV, and to date employs relatively straightforward definitions of gross and net revenues. In the context of sorting out what sources of advertising maximize the value of their content, this new breed of distributor (whether online ad streaming or downloads) has been first grappling with what is an appropriate revenue split of the resulting advertising mix. To a degree, the corollary question of how a participant (e.g., writer, director) is compensated from this pot has been deferred because the participant in this case is more often than not simply the producer, and the revenue share and participation one and the same.

As far as gross and net are concerned, there are few exclusions from “gross.” However, it is possible to segment a website and exclude certain sections or categories (e.g., Yahoo! News could be treated differently from Yahoo! Sports); similarly, certain overall revenues, such as run-of-site advertising, may not be counted on a particular subsection of a website where the revenue sharing/deal is focused on targeted revenues from a discrete area of the site. When thinking about this question, it is easy to postulate how much more complex it could grow, but the dissection has not yet occurred, and generally “gross is gross.”

In terms of calculating net profits, there will be various contractual deductions from gross, but again this area has not evolved excruciating complexity. It is more typical to find limited deductions, such as for direct third-party costs incurred (e.g., ad serving fees), but also typical to employ a catch-all percentage deduction from gross to capture the basket of administrative and third-party costs incurred in serving, hosting, tracking, and reporting revenues. Paralleling the treatment of gross revenue recognition, costs are lumped in a rational range and not reallocated back on a line-item basis and subject to allocation scrutiny. Therefore, “net is net” and more generally accepted given parties believe the ability to track by impression results in accuracy and transparency. The question is, however: Is that really the case when baskets of costs are lumped together?

What has happened is that the ability to track costs and revenues at a more detailed level has engendered a culture of trust, even though the ultimate reporting often does not reflect the greater level of detail that the metrics conceptually enable. In the end, actual participant reporting can be just as detailed (if not more so) in film and television even though the information being cumulated is less precise. It will be interesting to watch whether this anomaly continues.

Revenue Sharing

Regarding how to split the revenue, the issues are not dissimilar to the economic analysis in determining what percentage of video revenues should be paid—either as a profit split or royalty—to the content owner/producer (see Chapter 5). What has started to evolve in the online space is a formula of revenue sharing, where parties negotiate a split such as 60/40 or 70/30, with the majority to the producer if the site’s share is deemed tantamount to a distribution fee. In the video context, one of the issues in setting formulas is whether true net revenues (“off-the-top” revenue splits) can be tracked and audited, and licensors often default to a royalty basis to approximate what they expect a split to be given the easier monitoring and auditing. The online world, however, is premised on detailed metrics (cost per click, CPM, unique visitors, etc.) and the ability to drill down and share true, actual revenues and costs is assumed.

Again, this underlies one of the fundamental differences the online space is forging: because of the detailed metrics, there is implicit trust in the system, and the accuracy (even, arguably, veracity) of the revenue splits. Simply, people trust and accept revenue sharing. This is in stark contrast to the traditional media world, where skepticism of profit splits and accounting has evolved the byzantine system of net profits discussed throughout this chapter and has provided a subtext to Hollywood guild strikes and stalemates. Actors and writers, in an attempt to provide certainty in the context of where they mistrust accounting, want guarantees of what they will be paid online, as well as assurance that the accounting includes revenues attributable to online usage of their work. Revenue sharing is anathema if some of the revenues to be shared may not be included in the pot in the first place.

Is all this trust properly placed when, in fact, there are a myriad of issues that can arise online, ranging from fraudulent clicks/impressions to allocations of delivery/bandwidth costs? There are only two logical next steps: either online revenue sharing, which to date has been relatively straightforward, becomes more complicated (e.g., “gross revenues” are more finely sliced, and delivery and infrastructure costs allocated) or everything becomes simpler and the “trust in revenue sharing” spreads from Silicon Valley to Hollywood, and everyone accepts simple division of the pie (e.g., 70/30 split of gross revenues, where gross retains its common sense, all in, meaning).

What I believe is likely to develop is a hybrid weighted toward the current Internet structure: the Internet world will not stand for a convoluted net profits system, and economic reality is that “gross” and “net” are not as simple as “gross” and “net,” and there will be important and legitimate tweaks that need to be made in accounting. I believe this is already taking shape in deals with a Web component, and a simplified system premised on revenue sharing of a straightforward definition of net profits will become the de facto standard.

I turned again to Jim Mullany (from Salem Partners) for his opinion regarding what I am labeling the net profit divide. In terms of whether there would be an element of convergence in accounting given new media delivery systems, he noted that in terms of downloads-to-own, online viewing services such as Hulu, and yet to be invented services, there would be a shift in the revenue versus expense construct; namely, the costs to generate revenues (e.g., advertising, usage fees, subscription fees) would be nominal because only a digital version of the program needs to be provided to the host service, no physical good is delivered to the end consumer, and nothing is manufactured (and therefore not subject to packing, shipping, and inventory logistics). However, he advised that this shift would not so easily lead to a shift in how profit accounting is treated, given the incentives and strong institutional forces at play:

This streamlining of the distribution process should help simplify financial participation reporting for revenue and costs for these sources for a studio or property owner’s financing partners and creative talent involved in the project, who have a stake in the “back-end” (contingent compensation) based on the terms of their employment contracts—whether it be a percentage of adjusted gross revenue or adjusted gross proceeds, or a percentage of a defined net profit.

The reality, however, might be different.

■  The company providing the delivery service (Netflix, Hulu, Amazon, Comcast, et al.) in the current and announced projects (other than the network websites) will take a fee from gross revenues for providing their delivery service.

■  There is no uniform standard digital format requiring the preparation of multiple digital masters.

■  Depending on the contractual agreement with the delivery service, there may be a reimbursement or recoupment of the service provider’s advertising and promotional costs, along with amounts or percentages for operating overhead.

■  There will likely be recoupable costs associated with the sale and collecting of advertising revenues.

■  SVOD has inherent tracking and reporting problems in the fair/contractual allocation of subscription revenues to suppliers of product.

■  It is also conceivable, and now probable, that the company owning the “pipe” that provides the signals to the home or business will take a slice of gross revenues generated from the consumer and/or the delivery service as a fee for providing the DSL or wireless signal, and allowing the delivery service to provide a high-quality signal or priority streaming access.

However, assuming all the above issues didn’t exist—if the revenue streams were very easy to track and collect, the idea of simplifying the profit participation equation is counter to the usual way that studios and/or distributors operate. Typically, the more complicated (causally defined as “creative”) the structure of the cash flow waterfall, and opaque the definitions of standard terms, the better.

Accordingly, an industry observer can easily conclude that it is in the studio’s best financial interest to keep the contract process and the reporting as complex and opaque as possible. Participation accounting for new streams of revenue and related costs therefore will be interpreted and inserted into templates already established, until a talent guild negotiates different contract terms with the distributors/studios that will define it otherwise. That is why video-on-demand (whether it be from downloading, streaming, or other delivery variations), pay-per-view, and other new media utilized for home viewing of filmed entertainment will be considered as “home video” revenues for participation reporting purposes rather than “television” revenue. These revenue streams will be calculated to the studio/distributor’s benefit as a 20 percent royalty based on gross adjusted revenue, rather than a gross revenue subject to deduction of identifiable costs.

But what happens when a company such as Netflix, which started as an aggregator of video to become the leader in video rental, morphs into a kind of pay TV operator, with its subscription aggregation model competing with the likes of HBO and content deals being harmonized with the pay window? Does that mean revenues jump in reporting from 20 percent to 100 percent? Rationally, 100 percent of revenues from Netflix should flow into the gross revenue pot, but as revenues from DVDs overall are declining, there are institutional pressures to try to maximize cash flows at all levels. Conceptually, there are many more battles to be fought as the landscape shifts.

Variations of Profit Participation

Types of Break-Even

Break-even, in theory, is the point of recoupment of all actual costs expended in making and releasing a picture. Depending on the definition, a participant may receive funds with or without additional charges applied. There are at least three types of break-even concepts routinely utilized.

Initial Break-Even (aka Initial Actual Break-Even)

Conceptually, initial break-even is the point at which costs are initially recouped, or in other words, the point when gross receipts equals the aggregate of expenses on the project. The expenses that need to be recouped have all been previously discussed: (1) distribution fees; (2) distribution expenses; (3) negative cost, including the studio’s overhead fee and interest on the cost of production; and (4) gross participations and deferments payable before or at initial break-even. Initial break-even is essentially the same point at which net profits are first due.

This creates a trigger point defining which costs are subsequently deducted; for example, a participant that has a right to gross proceeds kicking in once initial break-even is reached will not have additional distribution fees or expenses (save standard off-the-tops) deducted. Essentially, the adding on of additional costs and fees stops at initial break-even for participants that have a gross participation or deferment starting at initial break-even.

Cash Break-Even

Cash break-even differs from initial break-even in that there will often be a reduced negotiated distribution fee; this is, in theory, because the distribution fee includes a profit margin element that is backed out with a reduced fee. Since cash break-even is only granted to players who command a participation in something better than net profits, gross participants and deferments are generally not deducted. Cash breakeven is reached when there are gross receipts available to recoup: (1) the distribution fee; (2) distribution expenses; (3) interest; and (4) the negative cost, including the studio’s overhead fee. Similar to initial break-even, once this point is reached no further distribution fees and expenses are charged. Although at one level it may seem cash break-even ought to exclude imputed overhead and a distribution fee, some distribution fee and overhead charge needs to be factored in to cover the costs of distribution and production management; the studios are carrying real and significant overhead to bring the product to market (see, again, Chapter 1).

Talent that receives a participation at “cash break-even zero” bears no distribution fee (i.e., the zero fee), and are pushed back only by the film’s cost and its distribution expenses (P&A). To the extent they are also not bearing any gross players, and talent has taken a reduced fee betting on their back-end gross points, there may be some juggling. For example, if an A-level star who customarily receives some form of gross participation takes a small cash fee in the budget (e.g., to help get the picture made), then for the purpose of someone else’s cash break-even zero deal there may be an amount imputed to the budget on the theory the budget is artificially low; namely, the studio needs to account for the fact that it is paying out significant sums to talent, which need to be deducted at some level before the other participants.

Adjusted Gross and Rolling Break-Even

Adjusted gross refers generically to an intermediate type of participation, which has elements worse than first dollar gross and better than net. This can mean there has been a reduced negotiated distribution fee, including a zero fee; typically, however, adjusted gross means that: (1) there is a modified distribution fee; and (2) major distribution expenses, including print and advertising costs, are deducted.

Comparison Website

For additional discussion of adjusted gross, rolling break-even, how net profits may be modified by over-budget penalties, and schemes applying box office bonuses in lieu of profit participation, please refer to the comparison website. This supplementary material also includes a section on how producers’ shares may be reduced by bearing participants (applying hard and soft floors), as well as a section on how GAAP and tax accounting (e.g., capitalization rules) differ from profit participation accounting.