Making of a movie: VC v/s Slate financing
Christopher Nolan has always been known as someone going for extremes. For his upcoming movie ‘Tenet’, he has crashed a real Boeing 747 into a real building. Tenet star, Robert Pattinson called his move ridiculously bold. It indeed is bold when you are going to blow up millions of dollars and have literally got one shot to get everything right. He did this because crashing a real plane was easier to do as compared to using miniatures for cinematic effects and also because apparently it was cheaper than CGI effects. Cheaper!
So how much money goes into production and who funds it? What is the business case here? This piece talks about film financing, particularly about an SPV called slate financing. I have compared it to VC financing in tech start-up ecosystem and covered few other nuances.
To begin with, how does VC financing in start-up ecosystem work?
VCs first create an idea or a vision for the fund and choose their investment space. Sectors/industries in which they plan to invest and where they see the opportunity. For instance: Healthcare, AI, E-commerce, etc. Stage of the company in which they want to invest, i.e. early stage, series A/B or late stage or an angel investor on the other hand. Post that, they too create a sales pitch for the fund and start looking for the investors called Limited Partners (LPs). LPs are HNIs, pension funds, insurance funds, etc.
LPs too diversify their investment portfolio. Given that VC business is high risk and high return business, so LPs generally allocate a small proportion from their investment kitty for VCs. Later on, VCs too diversify their investment funds by betting on various companies aligned with the vision of the fund.
Now, VCs know that most of the start-ups would eventually fail. This happens when they are not able to offer a much needed exit to the VC firm in form of acquisition, exit through next funding round or much touted IPOs. So VCs have to take an informed bet (if there is any such thing) or rather take a calculated risk on those 40x or 50x return start-ups. Let’s do some maths now:
Let’s assume a newly formed VC fund has raised $500 Mn from various LPs and has started investment in early stage companies in essential services. Let’s say they find 50 promising start-ups or ventures in this space and invest $10 Mn in each (not being pro- equitable distribution, this is just for simplicity).
Given that, most of the ventures fail, let’s allocate some return numbers over a time span of 8 years (Actual timeline for a startup to deliver return is generally more than 8 years):
A- 40% ventures would fail i.e. generate negative return to the tune of 50%
B- 30% ventures would generate no return or just break even
C- 25% ventures would generate 4x or 5x return
D- 4 or 5% would generate 50x return — success rate in reality is less than 5%, return could be more than 50x but let’s just assume for simplicity
After discounting recoupment value at 10% cost of capital, we get an IRR of 15.2%. VCs charge management fee on annual basis apart from claiming a share on the profit of the fund. Don’t forget, VCs are supposed to pay back to LPs. VCs can get actively involved in the portfolio companies and try to steer the ship tightly. They do act as mentors also and help founders succeed by leveraging their network and industry knowledge. The business is of course far more complex and harder than this basic calculation but the point that I want to drive home is that the overall wealth generation depends largely on those one or two ventures which become highly successful, the kind of return that Softbank made on Alibaba.
Now, let’s compare VC business to film financing from the lens of a special purpose vehicle called slate financing. (Thanks to 5th term course at IIMA called financing of firms for teaching basics of slate financing).
Film production is also like building a start-up. A team comes together to execute an idea for screen. Better the team (read: cast, cinematographer, script writer, etc.), higher are the chances of success. Each film poses the potential for a great windfall or incredible loss. Also, most of the films fail, just like start-ups. (Strictly speaking in financial terms, may be not so much from some abstract artistic point of view, but need to call that out, before some ships of theseus fan stands up with firearm).
Studios are just companies delivering products (read: completed films) and these companies too need funding. Enters Slate financing, which essentially stands for investment in a specific number of films ranging from couple to dozens of films with a partner studio. While the studio owns the right for production and distribution with fixed fee, investors are in only for money. Larger the no of films in the slate, bigger is the financing deal, higher are the chances of success.
So, who puts money in slate financing deal? Hedge funds, Private equity firms. What if a production house or a studio doesn’t want to do slate financing, how do they raise funds for movie production? Using personal equity, bank loans and borrowing or maybe by striking some shady deal if you are in Bollywood, I’m not getting into those details.
Coming back to Slate financing, it is far more popular and widely used in west than in India. Slate is popular primarily because it offers risk diversification to the investors but also because studios and production houses love this model. This is due to minimum interference from their investors in movie production, casting, shooting, finalizing location and that’s a huge relief. So, if Karan Johar’s Dharma production has raised money through slate financing, KJo can take a call on casting SRK again and again with no pressure from investors on casting real actors like Ayushman Khurana or at least having a real movie script. Additionally, slate financing deals are often created in a manner that keep investors out of key franchises. So, if an investor was able to become part of the slate which produced LOTR 1 but that might not happen for LOTR 2 and 3. Studio can deliberately create a separate slate for the franchises and mint all the money.
So, why would investors invest in a slate to begin with?
Consider those old VCs who earlier raised $500 Mn from LPs have again raised same amount of money through slate financing. The Slate is having 50 projects, each now invested with $10 Mn. Again, let us evaluate the slate over a time span of 3 years, assuming most of the slate would have almost the same fate as VC’s portfolio, i.e. :
A- 40% projects would fail i.e. generate negative return to the tune of 50%
B- 30% projects would generate no return or just break even
C- 25% projects would generate 2x or 3x return
D- 4 or 5% projects would generate 20x return — these are films like Avengers but even they don’t generate returns comparable to a tech unicorn.
After discounting recoupment value at 10% cost of capital, we get an IRR of 11.3%. This is quite low as compared to VCs investment in tech fund, hence VCs generally don’t invest in slates. However, It may become sensible for investors to put money in slate if they allocate higher weight-age to time value of money. Because unlike traditional companies or even tech start-ups, movie projects are shipped in less than one year.
In recent times, this cycle of producing, marketing, distributing and recoupment is getting shorter and shorter. So, in max one year or so, you are able to go through the complete product life cycle. At any point of time, a slate comprises of multiple projects under various life cycle stages. Whole slate can deliver under a period of 3 years or so. Unlike VC funds, where success depends on one big spike, slate can make sense due to faster turnaround. But still, VCs just don’t invest in slates and that’s a problem for the ecosystem.
Indian film industry is valued at around Rs.200 Bn. Films that we watch on screen is just the frontend, the UI/UX but how much have you heard or read about the backend. How many tech startups are entering or operating in this space, trying to disrupt or build the next unicorn. None, whatsoever. This is primarily because of the knowledge gap or information asymmetry, whatever you call it. Traditional tech VCs don’t understand the KPIs or metrics of film making. Film industry doesn’t allow outsiders to participate, maybe because they have insecurities or maybe because they don’t understand how to leverage the thriving tech ecosystem for better. Hence, entire ecosystem suffers.
Whatever innovation that has happened in film industry happened in the post production/distribution component of the supply chain in form of streaming through OTTs (Netflix/Prime video) or booking through digital platforms (Book my show/Paytm). But by that time your product is already shipped. All the production cost has become sunk cost. What if, studios collaborate with mainstream tech ecosystem to cut down production cost and build efficiencies by leveraging technology.
Studios can try to improve chances of a slate’s success by banking on predictive analytics or running some simulation model. It can use parameters like past films, cast, director, cinematographer, etc. as input to create reliable models and simulate multiple outcomes. How about replicating stage financing in film industry, I guess it’s something that has never been tested before. Individual projects of a slate can have minimum guarantees (MGs) to start recoupment as soon as distribution of the project begins, thereby shortening the recoupment cycle even further. Overall, slate financing can make sense and a lot more can be done in the film industry. What we need is transparency in the film industry, far better collaboration and interaction among various constituents to unleash growth. So that new innovation in tech can cut down cost of CGIs by a huge factor and Nolan doesn’t have to crash a real plane in a real building again.