MAY 1997





Gap Financing

Friend or Foe?


In his article for The Business of Film, Special Cannes Edition, Greg Bernstein discusses how producers have come to him having raised equity, subsidies, grants or other forms of cash infusions, for a third to half of the budget, but cannot figure out how to raise the remaining necessary capital. The key to this quandary is "gap financing." So what is this mysterious pot of gold? The article explains this, plus a prelude to insurance backed financing.

Greg S. Bernstein

Lew Horwitz runs an ad for his company every now and then that reads: "If' you think gap financing is to fix your kid's teeth, think again."

Surprisingly, many producers do not understand what gap financing is, how it works, when it's appropriate and what it truly costs, despite the fact that a significant number of independent films produced last year could not have been produced but for gap financing.

Recently, I have had a number of producers come to me and explain that they cannot get their films financed the way they used to because of a lack of a number of territories pre-buying films and the U.S. market being extraordinarily tight for most independent productions. Others have come to me having raised equity, subsidies, grants or other forms of cash infusions, for a third to half of the budget, but cannot figure out how to raise the remaining necessary capital. The key to both of these quandaries is "gap financing." So what is this mysterious pot of gold?

Gap financing refers to financing the difference between the production budget for the film (inclusive of bank fees, completion bond, contingency, etc.) and the amount of presales or other funding that a bank would traditionally use as collateral for "production loans" by using an estimate of the value of the unsold rights to the film. For example, if the production budget is $2.5 million and $ 1 million of the budget is already covered by presales, investor funds or other collateral, the remaining $1.5 million that is not covered by any collateral, other than the future potential sales on the film, is considered the "gap."

Traditionally, banks and other lenders would not lend against the speculative nature of "projected sales" on unsold territories. Lenders wanted to know exactly how and when they were to be paid. No guessing. No acting like an investor waiting to see what sales can be made once the film is finished. No, banks wanted the full cost of production to be covered by presales.

Unfortunately, that is not possible today. Today, presales in Germany, South Korea, Italy and Latin America (and sometimes even Japan) are still available. U.S. presales for lower budgeted independent productions are few and far between, and then only a fraction of the amount the used to be. Sales in other territories, particularly the U.K. and France, are unlikely until the film is complete. Of course, this does not mean that these territories have no value, only that their value cannot be fixed before the film is made.

A few years ago, when domestic pre-buys either dried up or became relatively insignificant, most Indies turned to financing films almost entirely through international presales. Then, many international territories stopped pre-buying films. A crisis developed. How would the Indie producer get his film made if he could not make enough presales that would satisfy the bank in order to cover the budget? Fortunately, this potential crisis would also hit the bankers who had previously provided Indie production financing. The bankers started to realize that if they did not find alternate ways to finance films, they would be out of business as well.

Since the bankers had spent 15 years or more banking presales and getting to know the market fairly well, and since they also got to know many of the international sales agents very well, the bankers started to feel comfortable relying on certain sales agents' estimates of what the unsold territories on a film might bring when the film was finished. The bankers did not see this as a change in "lending" funds vs. "investing" in films (banks never invest, only lend). There was just a little less certainty regarding a portion of their collateral. As a matter of fact, when the bankers' first started providing gap financing, they usually only "gapped" 20% to 25% of the budget, which was not much more than their interest and fees. As the bankers got more comfortable with gap financing, they expanded the amount they would gap finance and the sales agents they would accept for gap financing.

Bankers providing gap financing today are a small club. The members include Imperial Bank. The Lewis Horwitz Organization, Bank Paribas, F.I.L.M.S. and Newmarket Capital Group. One should be cognizant of the fact that each of these bankers have different lending requirements, terms, minimums and limits. Some of the hankers will not take on projects that involve lending of less than several million dollars (which may be composed of a combination of gap and non-gap financing). Others will, in certain circumstances, provide loans where only a few hundred thousand dollars are needed. Some of the bankers take larger risks than others, while some might gap a bigger portion of the budget. Some charge lower fees and some charge higher fees. Some take ongoing interests in the profits of the film and others do not.

In order to approve a gap financing deal, a bank generally looks at: (a) who the sales agent is, how long have they been in business, has the bank approved the agent before, etc.; (b) the predictions of the sales agent as to the minimum amounts that can be obtained from the unsold major territories; (c) the banker's own analysis, based on experience, as to how much a film of the particular genre, budget and lead actor will typically do in the unsold territories (in other words, do they "buy" the estimates of the agent); and (d) whether the predictions for the major territories are at least two times the amount of the gap. If all of the criteria are met, the bank will usually provide the necessary financing.

Banks typically provide gap financing of somewhere between 25% to 60% of a film's budget. It is unusual for a bank to provide 100% gap financing or, even if cash or other funds secure part of the budget, provide any amount of gap financing without some presales in place. Having presales in place are an indication to the bank that the sales agent is actually able to sell the film at prices commensurate with what the agent has predicted. In other words, the marketplace has reviewed the film project and determined that it is viable and worth paying a certain sum of money for territorial distribution rights. For example, if the sales agent has predicted a sale to France of $100,000 once the film is finished but, has only been able to obtain a presales in Italy for $25,000, the banker might consider it less likely that the sales agent will, in fact, achieve the numbers he or she is anticipating for France, and maybe many other estimates may be off too. On the other hand, if a presales for $100,000 has been achieved in Italy, the bank can be fairly comfortable that a sale around the $100,000 mark for France is viable and that the agent is correct on other estimates. So what does gap financing cost? Most banks charge 5% to 10% of the amount of the gap being financed, plus interest charges. Although, some banks "lake a piece of the action," most do not. Many banks prefer to finance the entire production, making both traditional banking fees, plus interest, on the pre-sold portion and "risk adjusted" fees on the gap portion. Take a $2 million film, for example, that has bankable presales of $1.25 million and, therefore, needs gap financing of $750,000. Assuming for the moment that the bank has agreed to provide the gap financing, the pricing would go as follows:

1. With respect to the portion of the budget covered by presales, the bank would likely charge 2.5 points, plus interest at prime plus 2.5%.

2. On the $750,000 gap portion, the bank would charge a loan fee of 10% ($75,000), plus interest at prime plus 2.5%.

One should note that gap financing requires a larger interest reserve than traditional production financing since there is an ongoing interest charge associated with sales being consummated after the film is finished. In the case of presale financing, the presale usually pays off at the time of delivery. When the contract pays off, the bank is paid and the interest charges stop accruing. However, with gap financing, some sales may not have been made by the lime the film is completed and delivered. Accordingly, interest charges will continue to accrue until additional sales occur, delivery is made and the loan is fully paid.

So what does gap financing cost? Most banks charge 5% to 10% of the amount of the gap being financed, plus interest charges. Although, some hanks "take a piece of the action" most do not. Many banks prefer to finance the entire production, making both traditional banking fees, plus interest, on the pre-sold portion, and "risk adjusted" fees on the gap portion

Usually, the bank is looking to the sales agent to be making sufficient additional presales during the film's production such that by the time of completion, enough sales have been achieved to actually pay off the loan. Nevertheless, the bank hedges its bet by reserving interest charges out of the budget to cover a period beyond completion of the film (By the way, the banks do not give the producer and sales agent an infinite amount of lime to make the sales necessary to pay off the loan. It is unlikely that the bank will permit the loan to continue beyond six months from delivery of the film.)

The best time to see a bank about gap financing is after the producer has secured the lead actor and sales agent and the sales agent has put together reliable projections. One caveat is to make sure that the sales agent is one acceptable to the bank. After all, the banker is relying on the reputation of the sales agent as to the reliability of the estimates, ability to turn the estimates into reality, deliver the picture and collect on the sales. More importantly, ongoing relations drive the relationship between the sales agent and banker. If the sales agent fails to achieve the projected sales such that the bank is not fully repaid (so far, this has never happened), banks providing gap financing will not longer accept that sales agent for gap financing, and, maybe, even for regular presale financing. Thus, the sales agent may be out of business. That's a lot of pressure to make sure the bank does not lose. Therefore, the banker is probably more concerned about who the agent is more than any other fact.

Some producers and distributors consider gap financing to be too expensive. But is it really? In the above example, the financing cost on the gap portion of the loan was $75,000, plus interest, vs. only $18,000, plus interest, on the same portion if it had been covered by presales. I do not consider a $58,000 spread that expensive in the scheme of things on a $2,000,000 film, especially when considering the fact that presales were likely unattainable. (Of course, there are those who argue that preselling gives away the store and should be avoided, while others argue that presales are probably the best deal you are ever going to get. Unfortunately, in today's market, there is no way to tell since you will not get a presale in many territories.) Therefore, the only current alternative to gap financing is to locate equity investments.

Equity investments usually carry higher rates of return and ongoing profit interests. Typically, an investor putting up the $750,000 gap out of a $2 million budget is going to seek a 20% return and require an ongoing profits interest of about 30%. Looking only at the profits interest, if a $2 million film is anticipated to generate profits of at least $200,000, the gap financing would have been cheaper in the long run (i.e., 30% of the $200.000 profit is already $60,000). Recently there has been a lot of talk about another form of gap financing called insurance guarantees. Just as the bankers have analyzed the industry and decided that there is relatively modest risk in providing gap financing; so, too, have insurance companies.

Unlike banks, insurance companies have done an "actuarial" analysts of the industry. The insurance companies looked at studio films and determined that given a group of films (usually somewhere between four and eight films) released by a studio, over a period of time, the films returned enough revenues to recoup their investment. (Obviously, if this was not the case, the studios would have been out of business long ago.) Clearly, one single film may be a real loser and another film may be a hit. The key is to spread the risk over a number of films, just as insurance companies spread out car insurance risks over a number of drivers. As the insurance companies see it, they have a relatively small real risk given the studio's history of net profit over a large group of films as opposed to net loss. So what do the insurance companies insure and how do these policies help get films financed?

The insurance company issues a policy for a fixed dollar limit that guarantees that the beneficiary of the policy will, over a period of time (usually 30-36 months) recoup the investment in the film from the film's revenues or the policy will pay off the deficit (up to the limit of the policy). Usually, the policy is issued in an amount necessary to cover the "gap". For example, if a $5 million budget film has international presales of $3 million and has a gap of $2 million, the producer needs a policy for $2 million. Like bank gap financing, the unsold territories must have sufficient realistic projected revenue. Up to now, the insurance companies have looked to the unsold domestic market.

Since the policy, like presales, is not cash, the policy must be taken to a bank and borrowed against. Using the above example, the bank would loan the full $5 million budget using the $3 million in presales and $2 million insurance guarantee as collateral. Because the bank is lending money, it charges interest and loan lees against the entire loan, not just the presale portion, albeit it charges a lower fee and interest rate on the portion guaranteed by the insurance than it would if the bank had provided gap financing (in this case the bank is looking to the insurance company to make good on its promise [usually a safe bet| rather than the sales agent to make good on his or her projections [not quite as sure a thing]). In any event, the hank charges (as much as a one point fee and interest at prime plus one) are on top of the insurance company's premium (fee) of around 10% of the policy (gap). Moreover, since the policy will not pay off for many months (or even years) following completion of the film, the bank must once again hedge its bets and increase the interest reserve.

Because the guarantees are based on studio averages, so far, the insurance guarantees have been limited to large independents who make a number of large budget films distributed through the studios. These include Mike Medavoy's Phoenix Pictures (TriStar) and Peter Hoffman's CineVisions (Paramount). The insurance companies have not yet ventured into independent production, except for those typically distributed through major studios.

Some insurance companies have looked at independent films but have not been able (o figure out how they would make them fit within their actuarial analyses that a "group of films" will recoup the investment since most Indies only make one or two films a year and may not have them released by a studio. Speculation is that the insurance companies may be able to satisfy their actuarial issues by looking at a group of films handled by a particular sales agent. Just as the banks have looked at a sales agent's history and reliability in making reliable projections, so too can the insurance company count on the sales agent making the necessary sales so that the policy is not called.

This would make the insurance guarantees essentially identical lo bank gap financing. Given the relative cost of the insurance policies, is it a viable alternative to bank gap financing? Probably not. Not only do the policies cost more, when interest and other factors are considered, they are not as easy to consummate as a bank gap financing deal. Moreover, once the insurance companies do move into the independent production arena, the effect may be to drive prices down on bank gap financing and/or to increase the amount of the gap risk that banks are willing to take in order to be more competitive with these insurance guarantees.

Insurance guarantees still have a place with larger independent production companies that have studio output deals. The insurance guarantees eliminates the need for advances from the studios (although they still require the studio's theatrical release commitment). This makes the cost of the insurance policy rather insignificant next to the potentially higher distribution fees, studio profit participation and control issues.

In summary, the advantages of gap financing to the independent producer are enormous. It provides lower cost in the long term compared to equity investment or insurance guarantees and, more importantly, are easier and, relatively, quicker to "close" on a picture that's "almost there". Given recent changes in the marketplace, I predict that 1997 might find gap financing supporting between 30% to 50% of independent film productions.





Reprinted with permission by The Business of Film

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