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STRATEGY

So You Wanna Be in Pictures

An independent entrepreneur creates an inexpensive alternative to the large Hollywood movie studios.
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Filmstar Inc. is out to free Hollywood producers from the studios' stranglehold. But will producers take the risk?

Getting into the movie business is easy. Really. All you need is a lot of money. If you have that, then you can find a script, producer, director, and some stars; make the movie; and advertise and promote it. If lots of people like your movie, you make a bundle. If nobody likes it, you lose your shirt.

You might make the bundle, but the odds are better you'll lose your shirt.

Harlan Kleiman, a veteran of the theater and television businesses, wanted to get into the movies, but a couple of things about the conventional strategy troubled him. First, he did not have a lot of money -- some, but even a well-rewarded corporate executive like Kleiman can't finance a movie out of his take-home pay. Also, the prospect of losing a bundle didn't appeal to him much. So over several years he sought an alternative strategy for entering the business, one that did not take a lot of money and that improved the odds of keeping his clothes. Eventually he worked out his concept and launched his company, Filmstar Inc. Now, he has to execute the plan.

Which doesn't mean Kleiman has donned a beret to shoot pictures -- though at one time he wanted to. That he now does not makes him a bit of a maverick in an already idiosyncratic industry. To appreciate how Kleiman is different, you have to know what is normal, if normal is a word that applies anywhere in the fantasy business of Hollywood.

Producers are close to normal. These hardworking people actually make movies. They pull together the story, the actors, the director, and the technical crew. They're re-sponsible for all the arrangements -- for equipment, locations, transportation, and so on, everything including lunch. They get the film shot and then edited. In theory, producers also own the movies they make, but in actuality, they usually do not own them for long. That's where studios come in.

Studios solve problems for producers, beginning with the biggest one: money. Producers usually do not have money; studios do. So to finance their movies, producers often try to sell the project to a studio. If it buys the producer's proposal, the studio owns all the distribution rights to the movie. In effect, the producer has become an employee of the studio while producing the film. He or she gets a negotiated fee and -- if the picture is a hit -- maybe profit participation. Studios solve other problems, too. They provide producers with everything from accounting and payroll services to advertising and promotion services -- even lunch. They just bill all of that, along with a healthy chunk of their overhead, to the producer's film. The charges quickly accumulate. Typically, a studio-made film must generate in sales more than four times its negative cost -- the cost to film the movie before distribution prints are made and before advertising charges -- before it breaks even and before the producer who originated the whole thing sees a nickel of profit.

That's what Kleiman faced when he decided he wanted to make movies a few years ago. No tenderfoot in the entertainment industry, Kleiman had specialized in pay TV and home video. He had been head of programming for Home Box Office and senior vice-president of the cable di-vision of Warner Communications Inc. Years earlier he had cofounded the Long Wharf Theatre in New Haven and lectured on theater at Harvard, Yale, and New York Universities. Now, armed with a script, he went to a studio. The people there told him the deal, and he didn't like it. "The odds," he says between courses at a Hollywood sushi restaurant where he is well known, "were with the house. 'OK,' I said, 'I'll be an independent producer.' But then I learned that there is no such thing. An independent producer is just dependent on more people."

What he means is that every service a studio provides a producer can also be found outside a studio. Producers can hire an independent payroll service or an independent accounting service; they can hire writers, film editors, and publicists. They can raise their own money, too, by preselling the distribution rights to their movies to theatrical distributors, video distributors, and cable and broadcast TV outlets. Then they can do the same thing in the foreign markets. They are, it is true, independent of the studio, but you can see the problem with this independence. "How was I going to make a movie," Kleiman recalls asking himself, "if I had to do all this other stuff?" Kleiman could not understand how he was supposed to be a full-time artist and a full-time businessman at the same time. "So I said to myself, 'If I'm an intelligent producer with this problem, there must be others with the same problem.' "

Where there is a problem, every entrepreneur knows, there is an opportunity. Kleiman talked to independent producers. It wasn't fair, they told him, that studios grabbed practically all the profits from a film just for fronting the money. Sure, it was their money, but there are two kinds of equity, and the studio system took no account of the sweat that producers invested in their films. What if he could devise a plan that would allow producers to retain more of the upside potential and not burden them with all the managerial minutiae that filmmaking entails? They would like that, they said. So, rather than make movies himself, Kleiman decided he would see if he could devise a better way of helping producers make movies.

Here was his idea: he would put together a one-stop service supermarket for indies. They could come to this company and arrange for whatever they needed: financing, distribution, payroll, marketing, merchandising, and so on. They could buy single services or all of them -- whatever the situation demanded. But this company would be different from a studio in two fundamental ways.

First, it would be cheaper to use than a studio. Studios are vertically integrated movie manufacturers with everything under one figurative roof. Their overhead costs are inevitably high because of hard-to-detect inefficiencies, cross-subsidies, and the price of corporate management. Instead, Kleiman imagined a synergistic collection of profitable, autonomous businesses that he could acquire and operate under a holding-company umbrella, each business providing one of the services that producers were looking for. The Filmstar synergy, he says, will come from one subsidiary company feeding business to another.

Second, studios take risks that Filmstar would not. Studios finance movies. They can claim most of the profit when a film does well, but they take the bath when a film flops. Kleiman's companies would not invest their own money in a producer's idea. They would, for the most part, operate on a fee-for-service basis. That means that Filmstar's income from a picture would be largely insensitive to the film's box-office, TV, or home-video sales.

Of course, Kleiman would rather be associated with profitable films than with losers. Filmstar's biggest challenge as a foreign distributor, for example, is to acquire the rights to films that will make lots of money for the overseas subdistributors that are Filmstar's customers. But under Kleiman's plan, one or two over-budget disasters would not bring his business to its knees as they might if he were relying on box-office sales to recoup his expenses.

The idea seemed appealing. Where most people with a similar idea had gone wrong in the past, Kleiman says, was in not being able to resist the camera's lure -- that is, getting into the filmmaking business themselves. Making movies is seductive and sexy and can be terribly profitable. However, it is awfully risky, especially for a start-up with no inventory of films to provide continuing revenues. Also, when a company like Filmstar makes its own films, it becomes a competitor to the independent producers who are the market for the services it offers. Eschewing its own productions may mean that Filmstar will never pocket huge profits from an E.T.-like success, but its standard fees will keep rolling in. Each portfolio company would have its own market, its own management, and its own projectable income. That -- projectable income -- is what Kleiman keeps stressing as the characteristic distinguishing Filmstar from other industry start-ups.

Furthermore, Filmstar wasn't just a plan to make money. Kleiman hoped it might change Hollywood, allowing some producers to make films they could not make under the studio-dominated system. He points out that the so-called 20-80 rule is applicable in the movie business: even though studios make only 20% of the pictures, they pocket 80% of the industry's revenues. "This was a way for me to be part of the system while having an opportunity to build something that might affect the system," he says.

Kleiman spent most of 1986 and '87 and some $600,000 of his own money trying to figure out how to raise more cash and turn his concept into a business. Without adequate capital, he couldn't acquire a going concern, and without a going concern, he couldn't raise capital -- until he hit on the notion of making Filmstar's first business the business of sales. Specifically, Kleiman thought he could raise money to capitalize a company that specialized in foreign distribution of U.S. films. Why that?

To start, being a foreign distributor would require relatively little capital. Filmstar would just be the sales representative between the film producer and the foreign subdistributors who actually place films in movie houses. Foreign sales of U.S.-made films were growing faster than domestic sales. In fact, the eight major overseas markets together -- Japan, Germany, France, the United Kingdom, Italy, Spain, Scandinavia, and Australia/New Zealand -- were nearly as big as the U.S. market. In 1988, for instance, the film industry generated $8.6 billion in domestic sales -- about 30% of that from box office, 40% from home-video sales, 10% from pay TV, and the rest from broadcast TV and other sources. Sales to those same outlets overseas came to $7.1 billion. For 1989 foreign sales will probably fall just short of $9 billion, better than a 25% increase over last year.

Foreign distribution, Kleiman thought, would be cheap to get into and could be lucrative if done well. This could launch his company. The business plan he prepared to attract investors stressed the foreign-distribution business and barely mentioned the larger concept -- blue sky, the lawyers feared -- at all.

Other people bought his idea. A group of friends invested $900,000, which, at his own insistence, Kleiman tucked into escrow until Filmstar could raise public equity as well.

What Kleiman had not figured on was the effect of Black Monday on his progress. The Wall Street underwriter that was to take Filmstar public went under a few days after the crash and before the offering. Kleiman found another underwriter, off-off-Wall Street, and despite the dismal market conditions, went ahead with his company's initial public offering. By February 1988 he and the underwriter had managed to sell units of stock and warrants worth $1.3 million, not the $5 million he had originally wanted. However, added to what was in escrow, that came to $2.2 million, enough to get him started.

If it's done right, foreign distribution can be a cash-positive business almost from day one. You get money before you deliver the product, and you do not have to pay your supplier until well after the product is delivered. Also, there is little risk that you cannot control -- if, again, it's done right. Foreign-distribution deals can take countless forms, but here is how a typical one might work.

A producer brings a film to Filmstar for foreign distribution. (Domestic rights have probably already been sold to one of the major studios, which control most domestic distribution.) Filmstar's vice-president of worldwide sales, Sudy Coy, a 16-year veteran in the business, looks at the movie and, based on her knowledge of the foreign markets, estimates the minimum guarantee she thinks she can get for the movie from the international subdistributors she'll license to. Then Filmstar will propose a deal to a producer. It might, for instance, offer to split the foreign income 75-25, keeping the smaller share for itself. And it will usually offer to guarantee the producer some minimum payment -- usually 60% of the minimum guarantee Coy expects to command from the foreign subdistributors. If she estimates a $1-million guaranteed minimum, Filmstar will offer to guarantee the producer $600,000. If Coy's estimate is right and she actually gets a $1-million guaranteed minimum in the foreign market, the producer will end up with $750,000 -- minus Filmstar's out-of-pocket selling expenses for that film and commissions. In her smoke-husky voice, Coy will tell you that her record for being on the money is very good. If it stays that way, these deals hold hardly any other risk for Filmstar.

If the film does better than everyone expects, Filmstar and the foreign subdistributor will split the overage, with Filmstar's share declining as the gross rises. Filmstar in turn passes this revenue back to the producer after taking out its sales fee -- 25% in this case.

The nice thing is that Filmstar has not put a single dollar at risk in the deal. The subdistributor could be buying a pig in a poke. The kicker is that the payouts are often structured so that Filmstar gets its cash from the subdistributor months before its payouts to the producer are due.

In the 12 months ending last May 31, its first full year in the business, Kleiman's foreign-distribution arm handled rights for 11 films -- 7 completed and 4 in preproduction. That makes Filmstar a significant but not major player in an industry that produced more than 500 feature films in 1988.

The company is building its relationships with foreign subdistributors and with producers -- the suppliers of films. The subdistributors, Coy says, will do business with anyone who can supply them with a continuous flow of the pictures their audiences want to see. Right now, the taste of fans overseas as well as here is running to high-budget productions -- so-called A films as opposed to cheaper B and cheapest C movies -- in the action-adventure genre. That means, she and Kleiman both acknowledge, that Filmstar has to hustle to continue upgrading the movies it can procure for foreign distribution.

Here, again, is where Kleiman's synergistic concept comes in. Theoretically, the company's foreign-distribution arm will gain an advantage in attracting makers of quality films, because Filmstar will also offer producers services such as:

* Financing. Whatever else they might need, producers always need money. Filmstar plans to be able to help producers raise it in several ways. For instance, it might issue a producer a letter of credit, which the producer could use as loan collateral in exchange for future distribution rights. Filmstar could make loans directly to producers -- both pay-or-play and bridge loans. The first helps producers get a commitment from their talent, who will not sign without a promise of pay whether or not they are "played." The loan lets a producer make that promise and get on with fund-raising. Bridge loans help producers finish films when other cash has run out. With either type of loan, Filmstar will negotiate not only repayment but future rights and, if it can, some equity in the picture. It still won't be taking much of a risk, though. Any loans or letters of credit will be backed by distribution rights to the film. Filmstar could also act as a producer's agent or broker, arranging for a bank or other lender to discount the producer's receivables (presold distribution rights, for instance) for production financing.

* Payroll. A Filmstar subsidiary can handle a production's payroll accounting and disbursements -- such as employee paychecks, workers' compensation insurance, and tax withholding.

* Marketing, advertising, and media buying. One or more subsidiary companies could provide the creative as well as production services required to market and promote a producer's film.

* Product licensing. Want to buy a Batman T-shirt or an E.T. doll?

* Product merchandising. Actors do not drink Coke on camera because they necessarily prefer it to Pepsi. Coca-Cola has paid for that tacit endorsement.

* Production services. Someone has to run the budget and manage the staff while a movie is being made. A Filmstar company, for a fee, could do that.

* Financial management. With all the money producers are going to make working with Filmstar, they are going to need help managing their personal finances. Another Filmstar company could do that.

Filmstar could do most of these things, but so far it does not. The company lacks the capital required to acquire the operating subsidiaries and provide financial services to independent producers.

So far, Filmstar has acquired a small payroll company that services television awards specials and is expanding into television series and films. It has issued one letter of credit to the producer of Bethune, which stars Donald Sutherland as a Canadian doctor working in Mao's China.

The trial partnership Filmstar had with a company to provide film marketing services didn't work out -- a personality conflict, Filmstar's Peter Kares says.

Kares, 46, is the president of the company and owned Producers Funding Corp., which Filmstar acquired in early 1988. But the company's arrangement with an East Coast merchant bank for production loans to producers that Filmstar brought to the bank didn't pan out. Kares's role now is to scout out the films whose foreign-distribution rights Filmstar would like to acquire and to strike deals with these producers.

Kleiman has hired 31-year-old Robert Wolpert, a product of Harvard Business School whose last activity was training for triathlons, to help him structure his holding company and act as its chief of operations. "My personal interest," Wolpert says, "is making the acquisitions work." However, managing acquisitions is not an acute issue just now with only a single portfolio company showing on the organization chart. As yet, Kleiman and Wolpert have not articulated how the organization will be structured and managed when there are more.

Kleiman spends most of his time these days in meetings, on the phone, and booking flights -- all in a search for companies to acquire and for new capital to help him acquire them. Though he has a preferred order of acquisitions in mind, he recognizes the necessity of responding to opportunities as they arise, he says. He'll take them in the order in which he can get them -- assuming he can afford them. He would also like to expand the distribution business to television and video.

Filmstar has to raise more capital if Kleiman's ambitions are not to be frustrated. Its only significant equity infusion was the $2.2 million that came in the original private placement and IPO. There are some warrants outstanding, but they are not likely to be exercised unless the price of Filmstar's stock picks up. It has traded at slightly less than $2 a share, more than $2 off its post-IPO high of 4. With an investor loan of $350,000, the company bought a certificate of deposit that it used to collateralize part of the bank letter of credit it gave to the producer of Bethune. It sold part of the rights to pay for the rest. Recently, an investor group signed a letter of intent to drop $1.25 million into the company.

Currently, Kleiman is circulating a business plan in hopes of finding an underwriter to help him sell several million dollars in debt or convertible debt. Debt at this point would be preferable to equity, Kleiman says, in order to minimize equity dilution. The largest chunk of the money, if he can get it, will back the financing arm of the business. The ability to issue bankable paper to producers will make Filmstar a stronger player in the competition to acquire foreign rights to the big-budget, potential blockbusters that overseas moviegoers increasingly prefer.

The company's batting average to date isn't bad, apparent testimony to Kares's eye and Coy's sense of what the market will pay. "Every film we have acquired to date," Kleiman claims, "has been or will be profitable." Nonetheless, Filmstar's May 31 year-end audited financials show a heavy loss. While the company has written contracts worth, it says, $9.5 million, its auditors won't permit the company to claim these revenues until they are received. Sales for 1989 were $3 million with a loss of $961,000.

Almost everyone who moves to Hollywood gets star struck. Who doesn't want to be in the movies, given the chance?

Not he, Kleiman insists, in his fifth-floor Wilshire Boulevard office in West L.A., a few blocks short of Beverly Hills. Filmstar will not make movies. "I want a business that's very simple. I want one level of business we can control and predict and one level with upside potential that we don't have to put a lot of money into. I'm not afraid to deal with the mundane and make it exciting. I get thrilled with the opportunity to drive just a part of this industry."

For an update on this company, see Anatomy of a Start-Up Revisited: Try Harder, Part II

Research assistance was provided by Leslie Brokaw.


EXECUTIVE SUMMARY

THE COMPANY

Filmstar Inc., Los Angeles

Concept: One-stop supermarket of financial and marketing services for independent film producers, which would provide them an alternative to turning their movies over to studios

Projections: Expected May 31, 1989, year-end loss of $961,000 on revenues of $3 million; projected 1990 profit of $520,000 on revenues of $9.7 million

Hurdles: Getting the capital required to (1) acquire the operating subsidiaries the concept calls for and (2) back the loans and letters of credit it must extend in order to attract independent producers, especially those making the A movies sought in foreign markets

PROJECTED SALES AND PROFITS
($ thousands) 1989 1990 1991
Fiscal year Projected Projected

Revenues* $2,976 $9,703 $17,186

Net income (loss) (961) 520 1,545

Cash, year end 581 2,680** 1,356

* In 1989, 82% from distribution services; in 1990, 95% from distribution services; remainder from payroll services

** Assumes $5 million private debt offering, FY 1990

THE FOUNDER

Harlan Kleiman

Chairman and CEO, Filmstar Inc.

Age: 49

Source of idea: Attempted to produce a movie in Hollywood and was disgusted by the terms the studios tried to exact

Personal funds invested: $650,000

Equity held: Nearly 30%

Other businesses started: Long Wharf Theatre, regional professional theater in New Haven; Caravatt-Kleiman Inc., video software; Leslie Kleiman Inc., pay-TV video production

Typical workweek: 65 hours

Outside board of directors: Yes

What I lose sleep over: Running a publicly traded company


PRODUCER'S CHOICE

Why movies make money (or don't)

An independent producer can get a movie financed in one of two ways: (1) sell the movie to a studio, which pays the producer a flat fee, typically 5% of the negative cost and a percentage of the profits, and assumes liability for all costs; or (2) use services such as those offered by Filmstar to make and market the movie, retaining ownership, eventual profits, and also liability for losses, if any. Here's how a ledger might look for making the same film under each scenario:

COSTS ($ thousands) Filmstar Studio

Negative cost 1 $8,000 $10,000

Prints and advertising 4,000 4,000

Finance charges 2

Two-year production loan at 11% 1,760 2,200

3% bank-commitment fee 240 --

One-year loan for prints 560 440

and advertising 3

15% commitment fee 600 --

SUBTOTAL 15,160 16,640
15% studio overhead charge -- 2,496

Miscellaneous 4 1,200 1,200

TOTAL COST BEFOREDISTRIBUTION 16,360 20,336
SALES
(minus cost of sales)
Domestic theater film rental 5 15,000 15,000

(Studio distribution fee) 6 (2,250) (5,250)

(Filmstar fee) 7 (1,275) --

Video Filmstar Studio

Producer's royalty 8 -- 3,600

Sale of video rights 4,400 --

(Filmstar 10% sales fee) (440) --

Pay TV, cable (minus distribution fee) 2,400 2,400

Foreign distribution -- 11,200

Presale of rights 3,200 --

(Filmstar 25% sales fee) (800) --

(40% studio distribution fee) -- (4,480)

(Dubbing, subtitles, etc.) -- (2,400)

NET SALES 20,235 20,070

SUMMARY

Total picture sales 25,000 32,200

(Studio distribution fees) (2,250) (12,130)

(Filmstar commissions) 9 (2,515) --

Total picture cost before distribution (16,360) (20,336)

NET PROFIT (LOSS) 3,875 (266)
Net to producer 3,875 500 10

NOTES:

1. Actual cost of making film (payroll, equipment, location expenses, meals, and so on) before interest and charges, expected to be lower with Filmstar

2. Independent producer borrows from commercial bank; studio film is financed internally with imputed interest assigned

3. Unsecured loan from commercial bank for independent producer, estimated rate 5% over prime; 2% over prime imputed for studio loan

4. Guild fees, residuals paid to artists

5. Film's share of box-office receipts

6. Studio typically charges 15% to distribute independently produced films for which the producer provides for print and advertising costs, 35% for in-house films

7. Negotiated distribution fee: 7.5% to 10% net rental income

8. Studios manufacture and sell videocassettes, paying straight 20% royalty to producer; assumes video sales of $18 million

9. Does not include payments for production-related services covered in negative-cost line item, so does not represent total of Filmstar revenue on project

10. Producer's only income is the predetermined flat fee, which was part of the film's negative cost


WHAT THE EXPERTS SAY

FINANCIER
CAROL WAKEFIELD

Vice-president of entertainment division, Tokai Bank, Los Angeles; frequent lender to film projects

The one-stop shopping idea has merit. Most of the independents I deal with don't know how to put the whole project together and get their film done. They need somebody in the early stages who can do it for them -- so a company like Filmstar should have a lot of business.

What's keeping it from being hugely successful is money. It's at the point in its corporate life when an equity investment might be more appropriate than debt financing. I don't know whether I'd lend to it now, given how undercapitalized it is. I'd never lend to it unsecured.

Maybe Filmstar should try a public offering again or bring in an investor with big bucks. Some kind of subordinated debt offering might be interesting, but it's not ripe for bank financing.

OBSERVER
PAUL KAGAN

President, Paul Kagan Associates, Carmel, Calif., which publishes "Motion Picture Investor" and 29 other media-industry newsletters

Conceptually, it's the right idea at the right time. The movie business probably has more need for a company like this than most because the creative people -- the producers, writers, directors, and actors -- don't have financial expertise.

Filmstar has to pick the right films. It has to finance them carefully; it can't overextend its credit resources. It also must watch its corporate overhead. And it must be sure it gets into the right distribution networks and theaters.

Filmstar has to focus on wooing the best of the independent producers. If it does that, it can create a much-needed niche business.

RETAIL BROKER
DAVID ALMQUIST

Associate vice-president, Prudential-Bache Securities Inc., Laguna Hills, Calif., specializing in investment opportunities

This concept is overdue in Hollywood. Put yourself in an independent producer's shoes. Would you go to work and sell your soul to a studio, knowing that really you had a very limited upside? I don't think I would.

So Filmstar may open a new segment, though it'll take time for producers to become aware of the possibility of getting paid what they're worth. It makes sense from an incentive standpoint; we'll probably see lots of little companies jumping in and operating similarly.

Any good company is sometimes too aggressive and can run short of capital. But I think these are capable, experienced people who are going to know when to stop and say, "We've got to regroup and get additional capital; we can't stretch ourselves too thin."

Harlan is smart to try to maintain as much equity in the company as possible. But I certainly wouldn't see it as a negative if he came out with a debt offering.

For Filmstar, credibility is the foremost issue. Producers want to be associated with credible names. Filmstar needs to establish credibility.

COMPETITOR
RICKI AMES

Vice-president of international sales, Enoki Films USA Inc., a worldwide distributor and producer of children's programming and feature films

Until independent producers have the necessary clout or money, Filmstar could be valuable to them -- if it gets its act together and offers one-stop service. But its concept has to be complete.

The only things it is offering are payroll and foreign distribution. And foreign distribution is not something that independent producers want to give up if they don't have to. Most are also distributors, and foreign distribution is the way you make your money. We'd rather distribute on our own than pay Filmstar a percentage to do it.




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