Demystifying Motion Picture Investments
by Stan Williams, Ph.D.
An Oxymoron
For some investors the phrase "motion picture
investment" is an oxymoron. It is well known that most motion pictures
lose a lot of money. Yet as a whole, the film and entertainment industry experiences robust growth,
especially in comparison to the cyclical nature of many traditional blue chip
business sectors like energy and transportation. In fact, despite rising ticket prices and a slumping economy, the
2001 domestic motion picture box office revenue hit an all time high for the 8th
year in a row, exceeding $8.1 billion. It is also obvious from recent million
dollar book deals that major studios and established independent producers
appear to be financially robust, even as we read that their recent pictures
lost tens-of-millions of dollars.
How can that be? What don't we understand here? Let me try to explain.
The success formula for a motion picture company is really not that much different from any other business. The president of a well-run business or the producer of a motion picture company must be a student of: (1) good business practices, (2) market gap analysis, (3) product quality, and (4) distribution. But most motion picture producers disregard one or all of these elementary business requirements. Further confusing an accurate view of a film's revenue is (5) the popular press' incomplete business reporting.
Understanding the Numbers
Let's look at the numbers. On a macro scale, there are three different film industries. First, there is the studio industry that is made of 9 major companies. It is known for it's big stars, flashy projects, and expensive budgets. In 1997 the major's average production budget for a major release was $52.4 million plus an average marketing cost of $23.2 million[1]. Second, is the independent industry that is made up of over 100 companies and is rarely written about because their budgets and star power are so modest. In 1997 the average production budget for an independent film was only $6.4 million[2]. The better independent films are released by the majors with marketing costs to match. But, many times an independent film will never "open" because there was no marketing budget to promote it. Third, is the public industry which is really no industry at all but simply the public's perception of the industry fueled by the popular press. Because most of the news we read is about the "majors" very little is understood about the independents. Yet, most of the pictures released, as well as the most successful films, are produced by independents. It is this unbalanced reporting that gives the public an inaccurate image of the industry as a whole, especially the value and contribution of independent filmmakers.
But, the most egregious and misleading of this reporting is the way the popular press documents a film's revenue. Take for example reports about the major studio release Lost in Space (1998). It was reported that the film cost $80 million to make, $24 million to market, but grossed only $69 million at the domestic box office, of which only 50% was returned to the producers. Simple arithmetic makes Lost In Space sound like even the investors were lost—to the tune of $69.5 million.
But what the popular press did not report (probably because even the trades have a tough time tracking it) is the additional revenue collected from a variety of other potential distribution sources. These include foreign theatrical distribution (in some 40 territories); VHS and DVD home video rentals; rental store sell-throughs to consumers; wholesale video sales to retail stores; and licensing to premium cable, pay cable, and TV for network premiere and syndication. Then recall that all of those markets exist in many territories around the globe. There is also potential profit from the novelization and the film's music soundtrack. If this wasn't enough, savvy producers will negotiate with fast-food restaurants for cross promotion and the sale of toys or figurines, and for what is called "product placements" where manufacturers will pay the producers a fee based on the number of seconds that a star carries around a can of, say, Pepsi.
So, what did Lost In Space actually gross when all the revenue was counted? Only the producers know for sure. But inside reports say the gross was at least $350 million. Of that amount, the producers will likely profit 25% of the difference between revenue and cost, or $61.5 million. That's a far cry from a $69.5 million loss. Popular perception is often not close to reality. So much for news clippings.
4 Natural Laws of Business
During the last five years (Summer 1997–Spring 2002) there were about 3,300 theatrical films released doing about $40 billion at the domestic box office. One rule of thumb says that a film's domestic box office must be projected to do greater than 1.5X its budget to be considered a reasonable risk for investment. If that is true, then during this period of time there were about 700 films that had a reasonable chance of making a profit for the producers and their investors. That means there were 2,600 films that had less than a reasonable chance. You'll notice, by the way, that even the domestic box office closely adheres to Pareto's 80-20 rule—in this case 80% of the money is made by 20% of the product, a rule that holds true in most every area of economics. The motion picture business is really not that different.
But the question is still why do most pictures lose money? The answer is the same for why most businesses lose money. It is because most business owners (or producers) violate one or more of four natural laws of business.
First, successful movie producers must diligently apply good financial management. That means adherence to a budget, management of cash flow, and business decision-making based on financial statements and not the egomaniacal sense of an irresponsible director. Yet, most independent producers will think nothing of pursuing their pet projects without regard to budget, forecasts or statements.
Second, successful movie producers make most of their strategic decisions based on traditional market gap analysis and inventory management where there are really only two rules: (1) Make pictures customers want, and (2) Don't make pictures customers don't want. In the movie business this means forming close relationships with distribution channels early in the process and developing multiple films that have a ready market. Yet, most independent producers will develop only a single picture at a time without clearing the idea with their facing customers—the distributors. With the now significant investment in development, to say nothing of time, these same producers will push their film into production hoping against common sense that their movie will find an audience large enough to make it a commercial success.
Third, successful movie producers must produce a high quality product. Specifically, the most important elements of any narrative motion picture are: (a) the truth of the story's moral premise, (b) a professionally structured story and screenplay (there are rules not unlike a community's building code), and (c) the top notch performances by the film's stars that are the direct result of hiring a good director and capable department heads of the supporting crafts. In other industries, basics such as these are referred to as "professional standards." In new home construction a professional will put the carpet on the floor, not the ceiling. But, in some independent films the carpet is not only on the ceiling but also lining the bathtub.
Fourth, successful movie produces will ensure budget-covering distribution before production. This means money will not be spent on production until the distribution machinery guarantees revenue equal to the production budget. No manufacturer, in his right mind, would produce 10,000 widgets without first obtaining firm orders to cover the cost of production. Yet, many independent producers will spend their life savings, and the money of their investors, to make a film before ever approaching a distributor.
Yes, most motion pictures lose money. But they don't need to. If the natural laws of business were followed, fewer pictures would be produced but profits would be even greater. Not only does the motion picture industry need filmmakers who can tell good stories that reinforce natural law, but it also needs business men and women who understand how to apply the natural laws of business.
[1] Jack Valenti (2002). MPAA 2001 Annual Report.
[2] David Hancock. "Global Film Production." Working document prepared for the Venice Conference held by EURO-MEI, August 29-30, 1998.