Size Really Does Matter

By Loren Sklar

As I begin to talk to clients about film investing, I have discovered that the people interested in funding movies and the producers interested in making movies disagree about the level of funding necessary to proceed with a film. Investors, as you might expect, want to make the movie for as little as possible and typically quote a figure of $100k as reasonable. Experienced producers, however, insist that no project budgeted at less than $1M is worth pursuing. Who is right?

To answer this question, I sorted all of the films in my database by budget size and divided the list into various buckets from films made for less than $50k to those with budgets greater than $128M. [The database, btw, now includes 6600 titles. I only used the 5500 films with complete revenue and budget data and released between 1998 and 2007 inclusive. ROI was calculated using a proprietary formula designed to model standard industry contracts.] Next, I plotted what percent of each bucket managed to break even. As you can see in the chart below, a clear trend emerges. A higher percentage of films in the larger budget categories earned a positive return.

Chart 1: Percentage of Films That Break Even at Various Budget Levels

This result is not surprising. The studios discovered in the late 80s and early 90s that event films such as Batman and T2 generated coverage from the entertainment press. This free marketing -- or buzz -- helped drive revenues. This rationale was used to justify larger and larger budgets for tentpole films. [A tentpole film is a large, blockbuster movie that supports the studio's entire annual slate with the revenue it is expected to generate.] The phenomenon became self-reinforcing as top talent, whose gross point deals encouraged the selection of projects with the highest box office, gravitated to movies with bigger budgets, and the studios threw the financial muscle of their marketing divisions behind these blockbusters, spending enormous sums on marketing in order to protect the large upfront costs associated with producing such films.

Is the best strategy, then, to invest only in those films that cost more that $128M? The answer is no and for two reasons.

One, the established players, the studios, have a competitive advantage in this space. They are already producing big, expensive movies and doing it well. With the cost of production facilities amortized over many films and many years, the studios have achieved economies of scale that first-time entrants are not likely to match. It is necessary to find another category of film in which to compete.

Two, it requires an enormous capital investment to diversify a portfolio of big budget films. Remember that while big budget movies are less risky than low budget projects, even blockbusters fail. These failures are extraordinarily expensive. Speed Racer and The Invasion, each of which lost more than $70M after marketing costs are included, are just two examples from the past year. To protect one’s investment from the occasional failure, an investor would have to build a portfolio of films rather than invest in a single project, and to do so at this elevated budget level would require an outlay on the order of $500M to $1B.

Chart 2: Risk Profiles at Various Budget Levels

The chart above shows risk profiles for films of various budget size. This chart is similar to a topographical map, but the contour lines indicate levels of constant risk rather than constant elevation. Along any given line, the investor assumes an equal amount of risk to achieve the ROI shown for a particular budget level. For example, the risk associated with the 75th-percentile line is greater than that for the 25th-percentile line because the film must outperform 75% of all other films in a budget category rather than outperforming only 25% in order to reach the ROI indicated. Even along the high risk 95th-percentile line, films made for less than $1M do not earn a positive return. While a high level of risk is not inherently bad, you do want to be compensated for the risk that you take. Films made for less than $1M are characterized by both a high level of risk and a low rate of return. The savvy investor will shift to the right along a suitable risk contour, capturing a higher rate of return for the same level of risk.

Thank you to Kylee Heap for editing this article and for helping to clarify the concept of risk contour lines.

Monster in a [New] Box

I haven't posted to the blog this week because I have been busy migrating all of my accumulated data to a single, custom-designed database. In addition to creating a unified system for managing the data, I have expanded the number of titles from 2000 to 6600. The more extensive list of titles is an effort to reduce survivor bias by including those films that received only minimal theatrical release or no theatrical release at all. The majority of analysis overstates film's profitability because it fails to account for the cost of those films that earn no return whatsoever. The migration process should be complete by next Wednesday, and I am looking forward to resuming my research with this new, more powerful tool. Thank you to Arthur Vincie for his invaluable assistance programming the database.

Batting .300

By Loren Sklar

Michael Lewis’s books seem to play a recurring role in my life. I first encountered his writing when I worked at Goldman Sachs on the Equity Derivatives trading floor. For those of you unfamiliar with a trading floor, it consists of a long, continuous desk crammed every four feet with two computer screens, a phone, and an angry trader. Over six hundred phone lines can ring at any time, and if any one of the lines isn’t answered before the third ring, one of the head traders will scream, “Pick up the f***ing lights!” The phone lines are called lights because, in addition to ringing, a light will flash on the console indicating which line it is.

In my first month on the trading floor, I dreaded picking up the lights, not because I couldn’t help the customer on the other end of the line, which I couldn’t. I feared answering the phone because all of Wall Street is on a first name basis, and I didn’t know which Andy, Mike, or Tom the person wanted to talk to. I was scared of the phone, but I was more scared of disappointing my bosses so, after two rings, I would cautiously hit the blinking light and say, ”Hello, Goldman Sachs.”

Some time during that first month, I picked up the phone to hear a voice asking to speak to Dave. Luckily, only one Dave worked in Equity Derivatives so, brimming with confidence, I called over to David Rogers, one of the partners, and asked if he would take a call from a John Meriwether. I heard several chuckles from the people around me. I asked my deskmates what was so funny, but no one would explain the joke. The next day, a copy of Lewis’s Liar's Poker, in which John Meriwether plays a prominent role, appeared on my desk. Meriwether had been calling to discuss the final details of unwinding Long Term Capital Management’s $3.6B bailout, an obviously important phone call that no one clued in to the goings on of the trading floor would want to screen.

Another of Lewis’s books, Moneyball, helped inspire my current analytical curiosity regarding film financing. The book focuses on the general manager of the Oakland Athletics, Billy Beane, and his statistical analyst and sabermetrics guru, Paul DePodesta. The Oakland As are a small market team and, due to limited financial resources, are forced to use statistical information to identify and hire undervalued players. Beane asks the questions, “How do you evaluate an individual’s contribution to a group effort? How do you value talent? And can incorrect assumptions about the value of talent be exploited to overcome financial disadvantage?” By using information better than anyone else, Beane is able to assemble a perennially competitive baseball team at a small fraction of the price.

My area of expertise is film, and I started to ask the same questions about film production. Is an above-the-line star primarily responsible for box office results, as is commonly assumed, or do other of a film’s collaborators contribute just as much to a film’s financial success. If so, which ones? What metrics are used to price talent, acting and otherwise? Is it possible to develop a more insightful set of statistics? And, most important, can an under-funded independent film producer exploit a deeper understanding of statistics to compete with $100M Hollywood tentpoles?

In baseball, a player who is able to maintain a .300 batting average is considered successful. In Hollywood, only three in ten films must break even in order for the slate to be profitable overall. Lewis's Moneyball shows us that a baseball manager can employ statistical analysis to assist in picking those players capable of achieving this benchmark. My goal is to demonstrate how a similar approach might prove fruitful in selecting which film projects to finance.

The Blair Witch Doesn't Exist

By Loren Sklar

Today, I started writing a business plan for a new film project, and it occurs to me that first-time filmmakers could use some pointers on the dos and don'ts of crafting a business plan.

The biggest mistake I see in business plans for low-budget projects is the inclusion of wildly inappropriate "comps", the list of films used to show income potential. The most frequently abused titles are The Blair Witch Project, My Big Fat Greek Wedding and Pi. My response to reading such fantastical claims is to mumble quietly to myself, "Witches and Weddings and Pi, Oh My!"

Incidentally, the box office success of The Blair Witch Project is not a story of brilliant low-budget filmmaking. Rather, it is a story about the power of internet-based marketing. This success has been difficult to replicate despite attempts by the studios to do so. See Plane, Snakes on.

Why is it a bad idea to include these titles? By presenting such films as examples, you imply that your project could match this rate of return for your investors. IMDB lists 18,695 movies filmed in the United States in the 20 years since Steven Soderbergh's Sex, Lies, and Videotape sparked the current renaissance in independent film production. To place in the top ten by ROI requires that you outperform 99.95% of all films made in this period. In statistical jargon, that is called a three-sigma event.

TOP TEN FILMS BY RETURN-ON-INVESTMENT

 Title ... ROI*

 The Blair Witch Project ... 50181%

 Super Size Me ... 35320%

 Napoleon Dynamite ... 13784%

 Open Water ... 9303%

 Saw ... 6535%

 My Big Fat Greek Wedding ... 5432%

 Pi ... 5186%

 Fahrenheit 9/11 ... 2473%

 Saw II ... 2420%

 Lost in Translation ... 2177%

 *ROI is my own calculation based on data provided by Baseline Research, Variety and The-Numbers.com

If you tell investors that your project is in this category, one of two things will happen, neither one good. One, the investor will reject your proposal -- and is right to do so -- for relying on the unreasonable assumption that your film will perform in the top .05%, or two, the investor will develop impossibly high expectations about the money that he can earn on your film and will be disappointed when these expectations are not met. Can you say lawsuit?

So, when writing your business plan, resist the temptation to include these spectacular, and atypical, examples of film's return potential. Remember, The Blair Witch doesn't exist, slim down before the Wedding and keep your arguments rational.