BY:
Elliot H. Brown, Daniel M. WasserLots of people know how money is raised for the theater. A well-dressed group of prospective “angels” gathers at twilight in a chic Manhattan apartment in the East 60’s. The composer sits down at a grand piano and, perhaps joined by the lyricist and a few attractive, young, out-of-work actors and actresses, plays the score of the new musical. The book writer chimes in with notes on her story. The costume designer displays color sketches of the costumes and the set designer manipulates a working model of the sets. The producer makes an enthusiastic speech and the 30 or 40 attendees put down their champagne glasses long enough to applaud and write out their checks.
The problem with this scenario, of course, is that finding substantial investors at a soiree of this nature has become immensely difficult, especially because theatrical investment is quite risky compared to other investment opportunities and because purchasing a substantial share of any show requires a significant investment.
There was a day when it worked, apparently. In the fall of 1944, Michael Todd produced “Up in Central Park” for $150,000, paid off the show (and the opening night party!) in nine weeks, and “netted over $20,000 a week during the first year’s capacity run.” Today, with musicals costing $6,000,000 to $12,000,000, a payoff in one year is considered a miracle, and a payoff in 18 months is considered spectacularly successful. A show which can “net” $100,000 a week would be a gift from heaven, and very few producers would close a show clearing the $20,000 a week which Todd and his investors apparently saw.
In this article we will attempt to describe the securities law considerations affecting theatrical financing, as well as the practical considerations faced by producers as they raise money.
WHO INVESTS?
Given the risks, who invests in the theater today? Broadway investors can be broken down into two broad categories:
The old-fashioned “angel”: The extremely wealthy person who has decided that he likes the producers, likes the play, and likes the stars. Likes them so much, in fact, that, even with the knowledge that a return of his investment is a long shot, he still wants to be a part of it: he is enamored, perhaps, by the idea of a credit in the playbill, a pair of tickets for opening night, and years of cocktail party conversations with friends.
The second group consists of more flinty-eyed investors who have reasons to invest in a play or musical beyond the possibility of the New York run of the show turning a profit. This category of investors includes the following:
Theater owners. With the rental of a Broadway theater now running at over $30,000 per week plus a percentage of the gross, and a guaranteed rental of four weeks required in advance, it is not difficult for a theater owner to determine that it is in his best interests to help fund a production which will play in his theater, particularly if the alternative is for the theater to be “dark,” that is, unrented. Not only do theater owners collect rent, they also generate income streams from their share of merchandise receipts and from the sale of drinks and candy, both of which heighten the potential return on their investment.
Road Producers and Presenters. To some extent, Broadway has become a loss leader for the “road” (all of the U.S. and Canada outside New York City), where a show with a Broadway reputation can be opened and run at much lower production and operating costs than on Broadway and potentially sell out in theaters larger than the largest Broadway theaters. Road producers and presenters need “product” to keep their pipeline of hit shows flowing, and for that reason they often invest heavily in New York City productions. Of course, investments are designed to position such entities to acquire (on arm’s length terms) the road rights in a play or musical.
Booking agents. The entities which “sell” plays on the road to local presenters also need product to sell, and consequently often will invest in anticipation of being appointed tour booking agent.
General Managers. The parties who manage shows (the equivalent of motion picture “line producers”) make money on a weekly basis whether or not there is money available to repay capitalization or to pay net profits. Thus, for the same reasons as theater owners, they often find it advantageous to invest in a production prepared to engage them.
Merchandising Companies. While not a crucial source of Broadway financing, merchandising companies have invested in shows in exchange for merchandising rights.
Cast Album Companies. In days gone by, when cast albums were more popular with the record-buying public, most musicals could count on a cast album company investing in the show and simultaneously acquiring cast album rights. There appears to be a rebirth of interest in cast albums, and thus a rebirth in cast album company investment in shows with the proper pedigree.
Motion Picture and Television Companies. These companies have an interest not only in the potential motion picture or television rights in a show (which could range from an HBO-type live or taped telecast of the show itself to a feature length motion picture version of a play or musical), but also appear to regard Broadway investment as a valuable device for increasing the prestige of the company and signifying its commitment to the arts.
Groups of theatrical professionals with complementary interests often invest in one another’s shows on a regular basis, particularly on the road. In that way, each party knows that it will acquire the rights which initially drove its investment. For example, a theater owner will require that the show play in its theater, a road presenter will require that it have the right to present the play in “its” cities (that is, the cities where it normally presents), a booker will require that it have the right to book the show, and the general manager will require that it have the right to general manage the show.
The traditional “angels” and the theater professionals who invest in new productions tend to have an “accredited” investor status in common. In general, “accredited” investors, as defined in Rule 501 of Regulation D, promulgated under the Securities Act of 1933, are investors of significant net worth. In the case of individuals, an accredited investor is defined as an individual with a net worth in excess of $1 million, or who, in each of the last two years, has earned income in excess of $200,000 per year (or $300,000 with spouse), with a reasonable expectation of reaching that amount in the current year. To the extent any of the investors described above might not technically qualify as “accredited” investors, they presumably are financially sophisticated. As will be seen below, limiting offerings to accredited investors and a small number of financially sophisticated unaccredited investors eases the process of raising funds for new theatrical productions.
An additional category of investors is the family and friends of the producer and playwright. Non-professional investors of this sort typically appear when an author or producer without a reputation first ventures into theatrical production, and a large percentage of such investors often turn out to be unaccredited. Usually, the budget will be considerably less than the Broadway-type budgets discussed above. In fact, an off-Broadway non-musical (or “straight”) play might be financed for as little as $400,000, and an Off-Off-Broadway production in a 99-seat theater might involve considerably less. Ironically (and distressingly for the producer trying to get started in the business of theatrical production), despite the limited amount of funds to be raised, the presence of unaccredited, unsophisticated investors actually complicates the task of complying with relevant securities laws and results in legal fees which are disproportionately large in the context of the proposed capitalization.
FINANCING STRUCTURES
The ways in which theatrical productions are financed are generally as follows:
Self-financing. Self financing is rare, since it violates one of the cardinal principles of the entertainment industry: spend only other people’s money. Nevertheless, this is the manner in which Disney and Livent, for example, are now financing their productions.
Co-production or joint venture financing. Co-productions or joint ventures are particularly common in connection with touring productions, and generally involve a handful of sophisticated parties which finance and manage the production together. Joint ventures do not involve the sale of passive investment interests, and therefore do not implicate securities laws. To avoid exposure to potential liability beyond the assets of the production, co-producers or joint venturers often associate themselves through a limited liability company (“LLC”).
Syndication. The syndication of theatrical investment interests, typically via a limited partnership or an LLC, is the most common method of financing theatrical productions. Until the 1990’s, limited partnerships were the only practical way to structure theatrical syndication financing arrangements. However, the adoption of state legislation during the 1990’s authorizing LLC’s created a viable alternative financing structure.
In general, the desired result – limited liability and partnership tax treatment – can be achieved either through a limited partnership or an LLC. However, if the producer is an individual, and not an incorporated entity, the producer becomes personally liable for the obligations of the partnership by serving as the general partner of a limited partnership, a risk not faced by the manager of an LLC. If the producer is incorporated, the issue of personal liability for the producer disappears, and either the limited partnership or the LLC will serve equally well. Note, however, that due to state income tax considerations, some theatrical accountants recommend limited partnerships over limited liability companies for touring productions. Moreover, in New York, quirks in the law make the formation and maintenance of an LLC more expensive than that of a partnership, although the amount involved is unlikely to be of any consequence for Broadway productions of the sort described above.
SECURITIES LAW CONSIDERATIONS
The sale of limited partnership or LLC interests to investors constitutes the sale of securities, and therefore, state and federal securities regulation must be taken into account. Under authority granted in the New York Arts and Cultural Affairs Law, the New York Department of Law has developed an extensive regulatory scheme governing the issuance of theatrical investment interests. Subject to the superseding effect of federal law discussed below, the New York theatrical syndication financing regulations pertaining to offerings of theatrical investment interests from or to New York generally require advance filing and review of offering papers by the Department of Law in a manner similar to the way public offerings are reviewed by the Securities and Exchange Commission. In addition to New York State regulation, if applicable, producers need to take into account the securities laws (or blue sky laws) of other states in which investors are located and, of course, federal securities law.
Overlapping state and federal securities regulation has long been identified as a factor in increasing the cost and time involved in raising capital. In 1996, Congress addressed this concern with the passage of the National Securities Market Improvement Act (the “NSMIA”). A principal feature of NSMIA is the federal preemption of state securities laws in connection with offerings of securities which comply with the requirements of Rule 506 of Regulation D. Thus, theatrical offerings which qualify as Rule 506 offerings are no longer subject to substantive state regulation (although it may be necessary to make certain state filings and fee payments). Given the extensive substantive review procedures adopted by the New York Department of Law, adoption of NSMIA constituted a major innovation for New York producers.
Regulation D describes different types of private offerings in Rules 504, 505 and 506. A private offering made pursuant to Regulation D which involves the sale of investment interests in excess of $5 million must satisfy the requirements of Rule 506. Since the budgets of Broadway musicals now routinely exceed $5 million, such financing, if privately raised, must be raised pursuant to Rule 506. If less than $5 million is to be raised, the offering could be characterized as a Rule 506 offering if the applicable requirements are met: potential investors must be furnished with a thorough disclosure document (unless all the investors are accredited, in which event no particular type of information is stipulated); and there may be no more than 35 unaccredited investors, all of whom must demonstrate that alone, or together with a purchaser representative, they have the financial knowledge and experience necessary to evaluate the merits and risks of the offering.
If an offering of theatrical securities does not qualify as a Rule 506 offering, producers must comply with substantive state securities regulations. Particularly in the case of an offering to or from New York, compliance with state law could significantly increase the time and cost of completing the offering. Not surprisingly, the vast bulk of the recent theatrical financings with which these writers are familiar are Rule 506 offerings.
BASIC FINANCIAL STRUCTURE
The deal traditionally offered to theatrical investors is as follows: Initially, all operating profits (the excess of income from ticket sales, merchandise, etc. over operating expenses such as authors’ royalties, actors’ salaries, light rentals and theater costs) are paid to investors until the amount of operating profits equals the amount invested. Thereafter, the investors are deemed to have “recouped,” and any additional operating profits (now referred to as “net profits”) are split fifty percent to the investors and fifty percent to the producers. Better deals are available, but generally only for those who take greater risks or who are investing large enough amounts to demand their own terms.
The customary limited partnership or LLC structure contrasts with the joint venture structure in which each of the parties commits to a certain proportion of the capitalization, receives that proportion of the profits, and bears that proportion of losses. While it is possible that there may be an “edge” for a managing joint venturer, it would not be uncommon for all profits and losses to be shared in direct proportion to the financing.
Who gets a better deal? As in every context, money talks, and the investor in a position to furnish a substantial portion of the financing generally will find himself or herself negotiating terms with a flexible producer. Investors accepting an increased risk may also get an enhanced deal. One type of high-risk investor is the “front money investor,” who puts up the seed money needed by the producer to secure rights, hire attorneys, and pay other pre-production expenses before offering papers are prepared. A second type of high-risk investor permits her investment to be utilized by the producer prior to the point of full capitalization, risking that her money will have been spent in vain if the producer ultimately fails to raise the funds necessary to launch the production. Other high-risk investors fund developmental productions from which there is no possibility of a profit, but the possibility, if the developmental production is well-received, of a full-scale commercial production.
To understand the special deals described below which may be offered to theatrical investors, it is necessary to identify what the producer is entitled to from a production, since additional consideration for special investors will be at the expense of the producer, not at the expense of other investors. The producer’s financial remuneration consists of a share of the profits of the production, a weekly royalty of 2%-3% of the gross weekly box office receipts (generally calculated pursuant to a royalty pool formula), and a cash office charge (which might be $2,000 per week for a Broadway musical) designed to cover the producer’s out-of-pocket costs.
A form of non-cash consideration under the producer’s control is billing credit, which is accorded great value by theatrical investors. When a Playbill lists six names above the title and eight below, you can be sure that most of the persons named are major investors or high risk investors rather than actual producers.
Finally, the producer, through management of the production, controls the selection of parties contracting to perform services for, or lease equipment or facilities to, the production or which will be licensed to exploit rights such as merchandising, cast album or touring privileges. The producer has an obligation to investors to enter into arm’s length deals with these third parties. However, the producer can potentially use the power to, for example, select the general manager or grant touring rights as leverage to secure investments for the production.
PRE-CAPITALIZATION MONEY
A substantial outlay of funds is normally required before producers make a final decision about how a play or musical will be financed. Early costs include advances for options on underlying rights and/or rights in the play or musical; payments to attorneys to prepare rights agreements, production contracts and offering papers; payments to general managers to begin to negotiate deals and to prepare budgets; and other preliminary costs such as sums required to secure the commitment of a director or star. Money used prior to preparing formal offering documents is commonly referred to as “front money.”
While a producer can, of course, use his own money for front money, the laws of the state of New York permit front money to be raised from up to four people and to be used for all categories of expenses which would normally be included in the production budget of a play. In view of the preemption of state law by federal law under the NSMIA discussed above, it could be argued that, even in New York, front money could be accepted from an unlimited number of accredited investors, even in the absence of offering documents, as a Rule 506 offering. Nevertheless, most New York-based theatrical practitioners remain likely to continue to advise their clients to abide by the four person limitation, especially since, at the early point when front money is most needed, it may be impossible to predict whether the offering ultimately will fall under Rule 506.
Offering papers typically include a production budget which corresponds to the capitalization sought by the producer. The offering documents also will recite the producer’s undertaking to hold all investments in a special account and not to spend those funds for production or pre-production purposes until the full amount of the capitalization has been raised. Since the producer will need the full budgeted amount of capital to launch the proposed production, it is understandable that most investors will refuse to permit their funds to be spent unless all funds have been raised; otherwise, investors’ funds could be spent on a potentially worthless effort for which there will not even be an opening night party.
Notwithstanding the foregoing, while producers are raising the capitalization, they typically will be in desperate need of money to meet the production schedule. Thus, producers will approach investors about furnishing written authorization to utilize their funds for pre-production and production purposes prior to full capitalization. In fact, producers often will request that investors not only authorize such use, but that they also agree to waive any right of refund (i.e., any personal obligation on the part of the producer) if the full capitalization is not raised and the production is abandoned. Needless to say, any investor authorizing pre-capitalization use of her investment is taking a significant risk and is entitled to an enhanced return for doing so.
Front money investors and investors authorizing pre-capitalization use of their funds normally receive substantial “rewards” for putting up this risky money. These “rewards” could include an enhanced financial participation in the production, billing credit and other benefits, such as the right to participate in meetings or have access to house seats.
Most commonly, the high-risk investor will receive an enhanced participation in the net profits of the production. For example, a front money investor of $100,000 may insist that, beyond the percentage of profits he would receive as a “mere” investor (for example, 1% if the full capitalization is $5 million), he also receive a fifty percent share of that profit participation out of the producer’s profits (so that, in our example, he would end up with a 1 1/2% profit participation). Since the producer shares not only in net profits, but also in the weekly cash office charge and the weekly producer’s royalty, an important front money investor may also attempt to negotiate a share of the producer’s royalty and, less frequently, the cash office charge.
Getting an extra 1/2% of profits is, of course, only an example. Deals may be as low as 1/4% or, when the going gets really tough and money is very difficult to raise, as high as 1% of profits from the producer side for each 1% purchased as an investor. The problem with a one-to-one deal for a producer, of course, is that it leaves the producer with nothing.
FINANCING DEVELOPMENTAL PRODUCTIONS
In addition to front money investors and investors authorizing pre-capitalization use of their funds, there is a different type of high-risk investing which has become more common as the cost of mounting full-scale productions has risen. Rather than risk $5 million dollars or more on a Broadway production of a musical, a producer may opt to spend $400,000 to mount a private “workshop” or $800,000 to “enhance” a regional theater production in exchange for the opportunity to see the production professionally produced and to better assess its chances of commercial success. To fund the workshop or to furnish “enhancement” money, producers sometimes organize developmental financing entities. Investors who invest therein know there is no possibility of a return on the developmental production. Their reward for investing in the developmental production is that if a commercial production occurs, they may have any combination of the following rights: a first priority right to invest in the commercial production; recognition of their investment in the developmental production as part of the capital of the commercial production (so that they secure an interest therein without further investment); an enhanced financial return, payable out of the producer’s entitlements; billing credit; and any additional benefits they can negotiate.
ADDITIONAL BENEFITS FOR LARGE INVESTORS
Investors who make substantial financial contributions towards the full capitalization of a production may also get special deals. Generally, an investor who contributes 20% or more towards the total capitalization could expect to receive an advantage over a smaller investor. As noted above, this advantage would come out of the producer’s share, not at the expense of other investors.
Most producers, faced with the prospect of countless nerve-racking, expensive and uncertain backers auditions, are content to give away a substantial piece of their producer’s share of net profits to make the money-raising process smoother, quicker and easier.
CONCLUSION
Theater remains a high-risk investment. A motion picture, for example, at least results in a tangible product, allowing home video and television to serve as a safety net when all else has failed. When a Broadway show fails, that’s normally the end of the story. Propelled by negative, or even lukewarm reviews, an investment of $8 million can, quite literally, evaporate overnight.
However, when a Broadway show hits, the potential profits are phenomenal. In 1995, the New York Times reported that “Phantom of the Opera” had grossed $1.5 billion “out-earning even the most successful movie ever made, ‘Jurassic Park.'” At that point, according to the New York Times, “Cats” had made even more money than “Phantom of the Opera.” The potential for profit in shows with that degree of success is unlimited and, to an investor with interests beyond the investment in the show itself — such as a theater in which the show could play for ten or twelve years, or a local presenter with a list of subscribers across the United States who want the show to come to their city year after year — the reason for investing is clear.
But even the old-fashioned reason for investing — that an investor really loves a show and wants to be associated with it — cannot be totally discounted in the theater of today, nor should it be. Investing in a play or musical, after all, should be viewed as at least as praiseworthy as making donations to an art museum or symphony orchestra; investing in theater can carry the same amount of prestige, give the same amount of personal intellectual pleasure and, if the stars align properly, could result in a truly admirable return on investment.