Profit participation

Profit participation is a very complex topic that is the subject of a great many accounting disputes, legal claims, and general ill-will between companies and the people to whom they’re supposed to be paying participations.

This post is an attempt to give as simple a picture as possible. Even so, this is your fair warning that this is going to be a very long post, and I will be generalizing or simplifying a lot of really complex concepts for the sake of providing a clearer, broader overview.

Also, please keep my disclaimer in mind. I am by no means an undisputed authority on this topic and in trying to distill a complex process down, there will likely be some details that you’ll want to consult an attorney and/or accountant about before diving into profit participation on your own deals.

For everyone else, I hope this overview helps to demystify this complicated concept a bit.

First, we need to define some terms (see basic definitions for more info):

Profit participation (sometimes called backend)is when you get a percentage, however small, of the film’s revenue.

Gross profits are a total amount of revenue earned by the film.

Net profits are what’s left over from gross profits after deductions have been made.

Second, it needs to be said that these are malleable concepts.

While gross profits can refer to the total amount of money the film makes (a box office return of $50 million is often expressed by saying the film grossed $50 million), it can also refer to the total amount of money an entity takes in. Since exhibitors take a chunk of the film’s box office haul (let’s just say it’s 10%), gross can also refer to the $45 million ($50 million less 10%) that the distributor actually pulls in even though it’s not the full box office return of the film. In situations like that, those gross amounts are sometimes qualified as distributor’s gross, company’s gross, etc.

Similarly, net profits can mean a whole lot of different things. Depending on how they are defined in the agreement, net profits can mean anything from “what the distributor earned less their fee” to “what’s left over after the distributor gets paid, all actual costs are recouped, money is set aside for future costs, and everyone else gets paid.” Since there are different levels of net profits, they are sometimes referred to with qualifiers like company’s net, producer’s net, etc.

Because of this malleability, it’s important to understand that being entitled to net profits isn’t necessarily always bad, and being entitled to gross profits isn’t necessarily always a major windfall. That’s because…

Third, you have to pay very close attention to how things are defined in the agreement. There are a lot of defined terms (concepts that are capitalized in an agreement and have a very specific meaning: Writer, Producer, Fixed Compensation, Property, Sole Credit Bonus, Net Profits, etc.) and each of them needs to be clearly explained.

Depending on the company, you might see terms like Adjusted Defined Receipts (ADR), Adjusted Gross Receipts (AGR), Modified Adjusted Gross Receipts (MAGR), and so on.

There are also a ton of other terms that need to be defined when you’re talking about profit participation:

What constitutes Theatrical Exhibition? Does that mean only multiplex theaters, or does it also include ancillary markets like viewings that take place on airlines, military bases, and schools?

How do I know what Home Video means? Does that include the rental and sale of just VHS, DVD, and Blu-ray, or does that also include additional formats like the different forms of streaming (VOD, SVOD, etc.)?

What is the Territory this agreement covers? Do you participate in the worldwide profits of the film, or only those profits earned in the theatrical territories of North America and Europe, and the home video territories of English-speaking Africa and the Middle East?

Each of these defined terms means something very specific, and it’s important to clearly understand what each defined term in your agreement means.

If you don’t understand the terms being defined in your agreement, you won’t be able to have an educated understanding of how your deal works.

And if you don’t understand the mechanics of how your deal works, you won’t know when you’re getting screwed.

Now that we’ve gone over the basics, let’s talk about structure.

EXHIBITS

When attorneys draft talent and production agreements, they typically use templates so they don’t have to start from scratch each time. These templates agreements have consistent form language (also called “boilerplate”), which the attorney can then modify as necessary.

For example, boilerplate travel language might begin as follows:

If Company requires Artist to travel more than fifty (50) miles from Artist’s then principal place of residence (currently Los Angeles, CA) (a “Distant Location”) for the purposes of rendering services hereunder, then Artist shall be entitled to one (1) business class, if available, roundtrip air transportation, hotel accommodations, one (1) rental car during the period that Artist is required by Company to render services at a Distant Location, and a reasonable per diem to be negotiated in good faith.

This way, the attorney has language to use as a foundation and can modify accordingly. They can change out the current place of residence, change “hotel accommodations” to “first-class hotel accommodations” if they negotiate for it, and swap out the per diem language to read, “and a $75 per diem” once the good faith negotiations have taken place.

In some cases where there’s a complex concept at issue (like profit participation, dispute resolution, etc.), attorneys will draft standalone legal documents called Exhibits, which can be appended to a contract as needed. So any time an attorney is negotiating a talent deal that includes a profit participation, they can just tack on “Exhibit AGR/NP” and reference the exhibit (and definitions therein) in the agreement itself rather than worrying about haggling over each defined term every time.

What’s especially important to note is that exhibits rarely change, if ever. They’ll get updated periodically (probably every few years) to incorporate clarifications and adjustments that may result from changes in labor law, guild rules, etc. But, for the most part, these complicated exhibits aren’t typically negotiated. They’ve been around a long time, the companies can justifiably cite them as longstanding precedent.

Plus, it’s against their interests to negotiate against their own carefully crafted language, so chances of getting them to change their profit participation formula are really small.

What companies have started doing is having different versions of those exhibits for different levels of talent. These are called Riders, which will amend the language of an exhibit. For example, an exhibit might say things like, “We’ll deduct a 15% distribution fee off the top and set aside $1 million for potential claims against the film.” A rider then might say, “All the stuff in the exhibit still stands, but we’ll make it a 10% distribution fee instead and we’ll only count $500,000 against potential claims.”

With this model, the studio has a very easy system for negotiating deals. If they get talent high level enough to warrant participating in the profits of the film, they can just attach the exhibit and not haggle over every nuance of how those profits are calculated. And if the talent is really in demand, they can agree to include the rider that gives the talent more favorable terms.

THE WATERFALL

Let’s look at how money comes back to the profit participants on a film.

We’ll start with the price of a movie ticket (we’ll call it $10 to make it a nice round number), and work our way backwards:

The exhibitor makes money by taking a percentage of that profit off the top. Let’s say 10%. So on that theatrical run, the exhibitor made $1 and the remaining $9 is headed back to the distributor.

The distributor probably has a profit participation definition that sets aside a fee for themselves, and then lays out a very long list of things they have to recoup. Let’s say they also have a 10% distribution fee. The distributor gets to keep $0.90 of that ticket and there’s now $8.10 left for everything else.

Maybe the production company has a fee too. Maybe they get 10% after the exhibitor and distributor take their off-the-top fees. $0.81 to the company, and the amount of the ticket leftover is now $7.29.

And so on and so forth. There are deductions for all kinds of expenses and potential expenses, which we’ll get into below.

This cashflow is called the waterfall because the money starts at the top and cascades down and through a great many tiers, paying out a fraction of the earnings at each step.

RECOUPING AND HOLDBACKS

The distributor (and often the production company) often build several tiers into their waterfall to account for their costs, both existing and assumed. After all, you can’t call a movie profitable until you’ve paid off the expenses it’s incurred! Some of these expenses include:

  • The actual cost of producing the film
  • The amount of money spent on prints and advertising (P&A)
  • Fees to sales agents and amounts due to collection accounts
  • Residuals they’ll eventually have to pay
  • Taxes, potential claims, transportation charges, filing costs for patents, trademarks, and copyrights… and so on and so forth.

So while it may be true that you’re entitled to 2.5% of the net profits of every ticket sold, that’s only after the film’s budget (let’s call it $10 million), P&A spend (let’s call it another $10 million), and various other sunk costs (let’s call those $5 million) are recouped.

Therefore, you won’t get your first 2.5% on a ticket sold until the company has made its $25 million back from the film’s performance.

But wait, it gets worse.

SLIDING SCALE

If all of that isn’t complicated enough, some of these waterfall tiers operate on a sliding scale. P&A costs, for example, aren’t a fixed amount that never changes. There’s the spend for the initial release, the home video release, the pay and free TV windows, the super special deluxe 10th anniversary re-release, etc.

On a smaller movie with a $10 million budget, a studio might spend $10 million on the advertising and marketing campaign for the initial domestic release… then another $5 million to roll it out in foreign territories… then another $2.5 million for its debut on home video and/or streaming… and so on.

Since these kinds of costs are ongoing, it means that even when a film is bringing in money, it’s also adding money to the incurred costs. It’s effectively extending and recalculating the point at which a film becomes profitable, even as profits are coming in.

So whereas you needed $25 million in box office revenue to break even before, now you need $37.5 million to cover the ongoing P&A spend. Or $40 million if you factor in the ongoing costs of paying continuing residuals. Or $45 million if you include all the people who get more favorably-defined participations ahead of you (the producers, director, top acting talent, etc.).

CREATIVE ACCOUNTING

The term “creative accounting” is often used to describe accounting practices where a company claims that a seemingly successful film is not profitable.

Creative accounting happens as a result of all of the above factors. Money traveling through a multi-tiered waterfall that considers recouped costs, plus holdbacks, plus increasing amounts calculated on an ongoing sliding scale makes for some pretty complex and ever-changing math.

Let’s take a look at an example of how that works with a theoretical movie that made $100 million on a $25M budget. In most cases, that would be considered a big success because it, in theory, made four times what it costs to produce. But let’s strap ourselves into a barrel and take a trip down the waterfall:

  1. Start with $100 million box office revenue
  2. Less 10% off the top to the exhibitor = $90 million
  3. Less 20% off the top distribution fee = $72 million
  4. Less 10% off the top production company fee = $64.8 million
  5. Recoup $25 million budget = $39.8 million
  6. Recoup $25 million initial P&A spend = $14.8 million
  7. Set aside $10 million for residuals, bonuses, and other expenses = $4.8 million
  8. Pay out $4 million in participations to people higher in the waterfall = $0.8 million
  9. Recoup or set aside $5 million for future P&A = -$4.2 million

Oh dear, we seem to have lost money on this movie! Sad face.

This is a dramatically oversimplified version of the accounting that goes into a film across multiple account expenses and streams of revenue, but the bottom line is that, through all the costs, amounts set aside in anticipation of future costs, and revenue splits between the different entities involved in the producing, distribution, and exhibiting of a movie, revenue goes quick and it’s not difficult to get to a point where you’ve spent (or anticipate on paper maybe having to spend) more than the film brought in.

HOW TO GET PAID

So how does someone get paid who has a profit participation in a film?

Maybe you’ve lucked into a situation where you have a demonstrably successful film with a company who gave you a fair backend definition and performs a common-sense accounting of the film’s performance (hey, it could happen!).

In that case, congratulations! Enjoy the checks when they arrive.

For everyone else, chances are you’re going to have to pursue the company and argue over how the accounting has been done. That usually means auditing a company’s records, usually at your own expense (which is not cheap, by the way).

Here’s how it usually goes:

  1. Your reps call the company and say, “Hey, this movie was made for $25 million and it just crossed $100 million at the box office. That sure sounds like a hit to me. Where’s my client’s profit participation?”
  2. Company: “Nah, we ran the numbers and we’re still in the red, man. Didn’t you see the participation statement we sent last quarter that showed how much debt this film is still carrying? We stand by those numbers.”
  3. You hire an auditor to come in. This auditor will look at all the information. The box office revenues, the company’s agreements with exhibitors and distributors and sales agents and collection accounts and other profit participants. He or she will actually do the math and follow the money through its various channels.
  4. After weeks, maybe months, the auditor will complete the audit and render an opinion. Probably something along the lines of, “Well, I think you’ve calculated this wrong… and that’s an exorbitant amount to withhold for that one little thing… and c’mon, you should have already paid most of the residuals at this point so you don’t need to hold on to all of that money anymore… so by my calculations, the film isn’t $2 million in debt, it’s actually $10 million in the black! And since my client has a 2.5% participation, that’s $250,000 you owe my client!”
  5. The company will refute the findings and claim that the auditor is being overly optimistic in his calculations. Of course they need to hold back that much money for that one thing, etc. Basically, “Thanks for playing, but we don’t agree.”
  6. Rinse and repeat a few times until your reps threaten to actually sue over withheld profits, the company being in breach of their agreement, etc.
  7. The company will probably then say, “Look, let’s not drag this out in court. It’s a losing proposition for everyone. So let’s just agree to disagree and split the difference. You think your client should get $250K and we say nothing is payable at this time. Let’s settle this for $125K right now and call it a day.”
  8. You and your reps do the math and realize if you go to court, you’re probably looking at another several months or even years of fighting, and tens, maybe hundreds of thousands of dollars in expenses. You paid $25K for the audit, so settling now and paying for the audit still nets you $100K and you accept and call it a win.

A note on #8. If you wrote on a billion-dollar juggernaut of a hit movie and you’re talking about potentially millions of participation dollars, maybe it’s worth fighting in court. But it is a slog, so you need to make sure you have the time, energy, and money to fight a protracted legal battle with a company that is, in all likelihood, better positioned to make this difficult on you than you are to make it difficult on them.

ALTERNATIVES

Based on all the above, profit participation may not seem like a great idea. And, to be honest, unless you’ve got a great participation definition and/or the film is hugely successful, it’s probably not the ideal structure for getting paid in success.

The upside of profit participation is that there’s an unlimited profit potential. If the movie keeps raking in cash, you keep getting cash. The downside of profit participation is that you often have to prove the film is profitable, which is a time-consuming and often personally costly endeavor.

The alternative is to create fixed payments that are due at fixed thresholds. For the purposes of this discussion, I’m not going to include production bonuses, credit bonuses or other money that’s attached to the making of the movie; this is purely about how you can craft additional compensation based on a finished film’s path to success.

Box office bonuses are one of the best ways to accomplish this. Maybe you get $50,000 when the film hits $100 million at the box office, and another $50,000 at $125 million, and $150 million, and $175 million, and $200 million. Box office bonuses can also be calibrated in other ways, such as a multiple of the budget (e.g., $50K when the box office reaches 2x, 2.5x, 3x,, 3.5x, and 4x the Negative Cost of the film), or even as a hybrid (e.g., $50K at the earlier of $100 million or 2x Negative Cost).

Performance at the box office is easy to verify from a number of sources, and there’s no room for interpretation here; the bonus is either payable or it’s not. So if you write a movie that ends up being a $100 million solid performer, you get $50,000. If you write a movie that ends up being a $200 million hit, you’ve got a $250,000 windfall in your bank account. If the film’s Negative Cost is established as $25 million and the film makes $50 million, that bonus payable at 2x Negative Cost is now due.

Awards bonuses are a similar performance-based bonus that you can opt for if you’re writing the kind of movie that might be more likely to get nominated for an award than, say, be the highest-grossing hit film of the summer.

The success of a film during awards season is similarly easy to verify; it’s pretty hard to refute that a film was nominated for or won an award! So maybe you have a bonus structure where a Golden Globe is worth $50,000 for a nomination or $100,000 for a win, and an Oscar is worth $75,000 for a nomination and $150,000 for a win. If you write a movie that gets honored with a golden statue, you also get a check to go with it.

Set up bonuses and other milestones are triggered when a movie gets a larger push to audiences than expected. These come in a lot of flavors; payable upon securing of a distribution deal, payable depending on the number of screens the film is released on or caps out at, etc.

For example, if you’re making a small independent film, maybe you have a $25,000 bonus if the film wins a prestigious festival prize. Or maybe it’s $50,000 upon securing a deal with a major distributor. Or maybe it’s initially intended for a limited initial theatrical release of 500 screens and you get $10,000 for every additional 500 screens that the film expands to during the release window.

There are a lot of options here and they can be customized and negotiated into your contract so that you feel some degree of confidence that you’ll be rewarded for the success of the film.

IN CONCLUSION

To wrap things up, keep in mind that profit participation is really complicated. This blog post you’ve just read is over 3,500 words on the subject and it’s only scratching the surface and providing simplified, broad generalizations.

If there are a handful of takeaways I can offer, it would be this:

  • If you are considering a profit participation component to your deal, you absolutely need an attorney, and probably an accountant, to help you navigate the language of the definition. You should understand in detail how the participation is paid so you can adjust your expectations accordingly.
  • Don’t get suckered in by generalizations like, “gross points are good and net points are bad,” or by pie-in-the-sky projections. It can potentially cost you a lot of money if you’re relying on generic assumptions and fantasies of best case scenarios.
  • If you find the whole idea of profit participation unnecessarily complicated and just want to feel like you’re getting something extra if the movie exceeds expectations, consider a series of box office bonus or another objectively-attainable payment structure. Bonuses are clearer, easier, and quicker… and can often be just as financially rewarding (if not more so) for all but the biggest of big hit movies.

Thanks for bearing with me during this dry, longwinded dive into profit participation! And, as always, please make sure you speak with an actual attorney and/or an accountant before signing any agreement with a profit participation component. It’s way too complicated and important a topic to just take my word for it!

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