Contracts 101 - How to avoid worthless "net profits"

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Ciao everybody!


Today's discussion is about "net profits" as they exist in the world of indie film. Depending on your contract, net profits can be your best friend ... or your worst enemy, which will haunt you forever.

For our hypothetical discussion, let's assume you just graduated from film school. Congrats!

Then a month later, two producers offer you the opportunity to direct a feature. You read their script, and it's f***ing kooky -- a sci-fi sports flick about Mussolini traveling through time to lead the Detroit Lions into the NFL playoffs. Because you've never been hired to direct a feature before, you decide to take the gig if you can rewrite the script and if they will pay you DGA scale.

So, you meet in a Beverly Hills coffeeshop and tell the producers how you feel. "The project seems cool, but the story is totally unrealistic," you explain. Then you hand them 10 pages of notes and casting ideas.

Two hours of nodding later, the producers agree to change the Detroit Lions to the Cleveland Browns. Everything else will remain the same. Your fee will be $15,000 USD plus 5% net profits, and they tell you who the lead actor will be -- their friend Bob, who has never acted before.

You sign the deal. You didn't have the time or money to hire a lawyer to review the contract, but you don't care. It's your first feature, and besides--the producers agreed to give you 10% of the net profits from the movie, which they increased from 5% after you asked. If the film hits, you'll be rich.

Rock-n-Roll.

Then you pack your bags and fly to Toronto or wherever they got tax credits to work, you wake up early and shoot a lot of weird scenes of Bob pretending to be an Italian dictator peering through a fence at an NFL football team. Somehow, someway, you get the crazy movie done. In fact, you're a directing genius, and you knock their stupid script out of the park.

Post-production become a celebration of cinematic excellence. The film gets done, and everyone is hyping.

Then somehow, someway, that kooky film wins Sundance and Cannes. Sales agents buy the producers stupid-expensive bottles of champagne and fight over the right to sell the film. Next comes a new poster and a major league distributor. Everyone and their brother puts crazy money into P&A, and your formerly-little movie makes a huge splash in Hollywood, breaking box office records along the way.

You get lots and lots of press, the film makes lots and lots lots of money. People go nuts

Woah. Grab more champagne....

1 year later...

Your kooky movie is famous, Bob has a new career, and random nerds at college parties everywhere act out your scenes and quote dialogue.

Then suddenly, Variety reports the film made $250,000,000.

Wow!! That's a lot of zeros. Your friends congratulate you. Your alma mater brings you in to give a speech. People cheer and cheer.

You've made it.

But, where are you, really?

Well, you've already been paid $15,000. It was a pittance, true.

But legally speaking, you were paid an agreed-upon sum for agreed-upon services. You're not in a guild or union. Barring fraud, trying to invent a lawsuit that your fee was too low because the movie is famous will result in Hollywood ridicule and courtroom laughter.

But wait! You have 10% net profits!! Which is the reason you signed the deal. This is GENIUS. It has to be. You haven't seen money yet, but the producers just bought new homes in Malibu. Bob just bought a red Ferrari and crashed into a Jack in the Box on Santa Monica Blvd.

Then suddenly, in the midst of all of that craziness, your net profit statement arrives. Finally. And your statement does not say "zero."
It says less than zero. You are $300,000 in the red.

Technically speaking, you have a ham sandwich.

WTF is going on? How is this possible?

IMPORTANT CONCEPT - NET PROFITS

My friends, please understand one thing.

There are a million different ways to name and/or define contingent compensation on a movie. Your contingent compensation may be called "net profits" or "adjusted gross profits" or "gross profits" or "profits" or "distributable cash" or any number of other things.

The key to understand is that your net profits only mean what your contract says they mean.

Ponder this.

A good entertainment attorney can draft a contract that will give you 1% net profits and make you insanely rich if the film hits as described above.

On the other hand, that same entertainment attorney can also draft a contract that will give you 25% net profits from the film, but at the same time, ensure you will never see a dime, even if the film makes $100 million at the box office.

The point is not to suggest renegade contract drafting by evil lawyers (which happens), but rather that you cannot know what ANY profit numbers mean until an attorney or very experienced "somebody" takes a good long look at your contract.

Don’t get fooled by contractual smoke and mirrors. There is no standard or universal definition of net profits in Hollywood. There are some basic principles that most producers uphold, but there is no guarantee that your definitions will not differ wildly from your expectations. The only way to know what your "net profits" mean, is to read and understand the definition in your contract. Otherwise, you have no idea what that 10% means. Zero.

Furthermore, a "net profits" definition can be one sentence, or 10 pages or more, depending on the studio. There might even be multiple levels and multiple definitions. If you're on a film with Spielberg, your net profits definition will probably differ from his, no? Point of fact, everyone on a movie may have a different definition of contingent compensation, especially on a studio film.

Accordingly, it is possible in the kooky hypothetical described above, that your movie could bring in $250 million and you may still have no net profits. And you might have to pay your own way to the premiere and buy your own ham sandwich.

And even if your kooky film wins an Oscar, you will still have zero. You will likely have an opportunity to direct a movie again, yes. But what about the net profits from the movie, which might be the most valuable project of your entire life?

Forget it. Game over.

OK, enough about the problem. Now, let's chat about solutions.

HOW TO AVOID A NET PROFITS NIGHTMARE

First and foremost, Rule 1 - get a good entertainment lawyer to review your contract. Enough said.

Now, let's look past the lawyer-answer.

Generally, here are a few big-picture issues to look out for in a contract, in terms of net profits. This is general info to help you in the initial stages of looking at your contract, not legal advice, nor a substitute for good counsel. But this will get you started.

A. MOST FAVORED NATIONS.

As stated above, you have no idea what your 10% net profits means unless and until you read the definition in your contract. But if the movie is big enough and/or counsel it is crazy enough, your profit definition could be about as easy to decipher as unlocking an iPhone with psychic powers.

What do you do?

You can hire counsel and he or she can negotiate the net profit definitions. And/or -- you can use a trick of the trade called a "most-favored-nations" reference. "MFN" for short.

Most-favored-nations is a term of art from the days of people trading spices on big ships, fighting pirates and all that. Basically, the concept is to tie your profit definition to another party on the movie. And if you're smart, one of the VIPs.

There are many ways to word this, but here is a basic example of this concept in a contract provision:

.... the Producer shall pay to the you TWO POINT FIVE PERCENT (2.5%) of the “Net Profits” of the Picture. Statements of account and the associated Net Profits, if any, shall be paid at the same time and calculated and defined in the same manner as for the lead producer of the Picture.

See what just happened?

There are 100 different ways to word it, but suffice it to say, I just tied your profits definition to the lead producer -- who will have the best definition on the film, because he or she (or their lawyer) came up with it. So, instead of negotiating a definition, jump on the bus with a VIP such as the lead producer, an executive producer, the director etc.

When that VIP receives any profit from the movie, so will you. Genius, no?

You can also add language that ensures there will be no more favorable contingent compensation on the film, regardless of what that term is actually called in anyone's contract. Producers won't agree to add this unless: (i) you're an A-list star; or (ii) they only have one definition of net profits; or (iii) they know with 100% certainty no one will have a better profit definition than you.

B. FINANCIAL STATEMENTS.

Beyond your profits definition, you need a provision that addresses financial statements. Because if you don't have this, you're at the mercy of the producer as to when and you ever get any type of written "anything" concerning your net profits. Which may be never (it happens).

There are many ways to word this, but here's a basic excerpt:

Within ninety (90) days after the last days of March and September of each year, the Producer will prepare and furnish semi-annual statements to the Director hereunder, and each Statement shall be accompanied by payment of all royalties due thereby.

C. AUDIT RIGHTS

OK, cats, here is a mission critical concept when it comes to contingent compensation. Pay attention.

If you don't have audit rights in your contract, you will have no legal right to look at the financial records.

Read that 2x. In that case, if the producer will not cooperate, the only way to look at the financial records from the film will be through filing a lawsuit.
Which will suck, one way or another.

There are many ways to word this, but here is a basic excerpt:

Accounting records relating to Net Profits shall be available for audit on thirty (30) days notice, at reasonable times during business hours at the Producer’s principal place of business, to a duly authorized person or firm acting on behalf of the Performer. Said audit rights shall not be exercised more than once in any twelve (12) month period, and only with respect to new activity reflected in statements received by the Performer within one (1) year prior to the commencement of the audit.

D. PAYING FOR THE AUDIT?

And finally, if you audit someone who should be paying you royalties or net profits, and the books are way off, you shouldn't have to pay for the audit.

There are many ways to word this, but here is a basic excerpt:

If an audit reveals that the Producer underreported any item bearing upon the computation of amounts payable to the Contractor by five percent (5%) or more, the Producer shall, in addition to re-calculating and making payment of the amounts due based on the actual and true items, pay the Contractor's actual out-of-pocket audit costs.

CONCLUSION

You cannot know anything about your "net profits" (whatever they are called) on a movie -- unless and until you read and understand the definition that is in your contract. Tying your definition to that of other VIPs on the movie is one way to mitigate the risk.

For more information about film finance, check out my article - A Simple Guide to Financing an Independent Film with Private Equity.

I enjoy helping filmmakers. If you need counsel, give me shout.

Thanks for reading

Lee

 
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Everything's good but I disagree about associating any payments with net profits. The reason is as a lead producer on a feature where I've raised the money, I'm having the payments made to an SPV and my friends who are producers and shooting a movie in January are doing the same thing. Therefore, the net profits calculation is still zero.

Instead, it's better for directors to demand tranches of gross revenue. E.g. $0k - $50k USD, zero gross profit. If the movie makes $50k - $100k, 1% of gross. $100k - $250k, 2% of gross in this tranche. $250k USD+ means 3% of everything. It's fairer and if it works, makes you a ton of money.
 
Everything's good but I disagree about associating any payments with net profits. The reason is as a lead producer on a feature where I've raised the money, I'm having the payments made to an SPV and my friends who are producers and shooting a movie in January are doing the same thing. Therefore, the net profits calculation is still zero.

Instead, it's better for directors to demand tranches of gross revenue. E.g. $0k - $50k USD, zero gross profit. If the movie makes $50k - $100k, 1% of gross. $100k - $250k, 2% of gross in this tranche. $250k USD+ means 3% of everything. It's fairer and if it works, makes you a ton of money.

Great input! Hollywood would certainly be a better place with this type of arrangement, I've done a few deals like this, more or less.

The problem is that most of the time, if not 99% of the time - professional financiers will not agree to provide gross profits to anyone, they want to recoup their investment (plus a premium) before anyone else gets paid anything (excluding residuals or a bank that provided gap finance). That's the only part of the waterfall that is very difficult to change, barring A-list talent etc.

If/when you can get an investor to agree to this arrangement, or if you are the investor and are willing to provide it - GENIUS!
Sign me up. That's certainly better and fair, which we could use more of in the business.

CAVEAT - if any other party on the film has MFN treatment on their contingent compensation -- then you will have to pay gross to them as well, and the percentage of gross will double, triple etc, at a certain point, it will get tough for the investors to accept.

But again, this is a great idea if you can make it happen! Thanks for commenting, I appreciate it.
 
Great input! Hollywood would certainly be a better place with this type of arrangement, I've done a few deals like this, more or less.

The problem is that most of the time, if not 99% of the time - professional financiers will not agree to provide gross profits to anyone, they want to recoup their investment (plus a premium) before anyone else gets paid anything (excluding residuals or a bank that provided gap finance). That's the only part of the waterfall that is very difficult to change, barring A-list talent etc.

If/when you can get an investor to agree to this arrangement, or if you are the investor and are willing to provide it - GENIUS!
Sign me up. That's certainly better and fair, which we could use more of in the business.

CAVEAT - if any other party on the film has MFN treatment on their contingent compensation -- then you will have to pay gross to them as well, and the percentage of gross will double, triple etc, at a certain point, it will get tough for the investors to accept.

But again, this is a great idea if you can make it happen! Thanks for commenting, I appreciate it.

Hence tranches. Tranches can be moved up and down and mimic profitability without getting into the issues around profitability calculations.
 
Hence tranches. Tranches can be moved up and down and mimic profitability without getting into the issues around profitability calculations.
I understand. If you can get investors to agree to this, that's fantastic, good for you. Hollywood would be a better place if all deals were like this. You also have to account for SAG residuals etc, but keeping it simple -- instead of the investor getting $100K, they get $99K, the director gets $1,000 right off the bat. I get it. That deal makes sense, and it is fair.

But at the end of the day ... tranches that mimic profitability, or sliding scale gross points, or contingent deferments, or whatever other term is used to describe it, you are simply taking some money out of what is typically and exclusively the investor's initial pool of revenue from which they recoup their investment, and handing it to the director.

If I can get that type of deal for a director client, we are hyping!

But in my experience, it's not practical to expect professional investors to sign off on this, absent circumstances such as an A-list star, or a super low budget project that cannot pay much (or any) fees -- investors tend to get stuck in "how it's supposed to be." They will not agree to pay out anything until they fully recoup and then some, the only exceptions being residuals or a bank that puts itself in front of all else in the waterfall. Unfortunately.
 
I understand. If you can get investors to agree to this, that's fantastic, good for you. Hollywood would be a better place if all deals were like this. You also have to account for SAG residuals etc, but keeping it simple -- instead of the investor getting $100K, they get $99K, the director gets $1,000 right off the bat. I get it. That deal makes sense, and it is fair.

But at the end of the day ... tranches that mimic profitability, or sliding scale gross points, or contingent deferments, or whatever other term is used to describe it, you are simply taking some money out of what is typically and exclusively the investor's initial pool of revenue from which they recoup their investment, and handing it to the director.

If I can get that type of deal for a director client, we are hyping!

But in my experience, it's not practical to expect professional investors to sign off on this, absent circumstances such as an A-list star, or a super low budget project that cannot pay much (or any) fees -- investors tend to get stuck in "how it's supposed to be." They will not agree to pay out anything until they fully recoup and then some, the only exceptions being residuals or a bank that puts itself in front of all else in the waterfall. Unfortunately.

It's interesting because the investors we dealt with for the feature we sold are really cool about this stuff. Their attitude is if they can get a winning team together and keep it together, we can keep making money for them.

But then again, we're super low budget so I guess it's easier for us and the UK's very different from Hollywood. Plus the proposed structure was that costs are covered first. i.e. The director takes a lower fee but if it makes money, then they get more. A lot more. And everyone's happy.

So it's interesting for me that your investors would balk at that kind of thing. But then again, I guess if you're going higher budget plus your investors are Hollywood, then things are different.
 
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It's interesting because the investors we dealt with for the feature we sold are really cool about this stuff. Their attitude is if they can get a winning team together and keep it together, we can keep making money for them.

But then again, we're super low budget so I guess it's easier for us and the UK's very different from Hollywood. Plus the proposed structure was that costs are covered first. i.e. The director takes a lower fee but if it makes money, then they get more. A lot more. And everyone's happy.

So it's interesting for me that your investors would balk at that kind of thing. But then again, I guess if you're going higher budget plus your investors are Hollywood, then things are different.

Ahhhh.... I didn't realize you were from the UK. I have a few UK clients, and interestingly enough -- that is one of the few places I have seen deals like the one you describe. USA investors are greedier. :)
 
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