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Harvard Business School

 


 

9-292-140

 

June 12, 1992

 


 

Arundel Partners: The Sequel Project

 

In April 1992 Mr. David A. Davis, a movie industry analyst at Paul Kagan Associates, Inc. in

 

Los Angeles, was asked to look at and comment on an unusual business idea. The idea was to create

 

an investment group, Arundel Partners, which would purchase the sequel rights associated with

 

films produced by one or more major U.S. movie studios. As owner of the rights, Arundel would

 

wait to see if a movie was successful, and then decide whether or not to produce a second film based

 

on the story or characters of the first.

 

The proposal was innovative in several respects. First, Arundel would purchase sequel

 

rights before the first films were even made, let alone released. Second, the investor group would not

 

make artistic judgments or attempt to select the rights for particular movies based on predictions of a

 

possible sequel?s success. Instead, Arundel would contract to purchase all the sequel rights for a

 

studio?s entire production during a specified period (one to two years), or alternatively, for a

 

specified number of major films (15 to 30). Third, Arundel?s advance cash payments for the rights, at

 

an agreed-upon price per film, would help finance production of the initial films.

 

The idea was intended to capitalize on a few specific characteristics of the movie industry.

 

Producing and distributing motion pictures was a risky business and predicting the success of any

 

one film was extremely difficult, if not altogether impossible. Moreover, studios? production

 

decisions were driven by both creative and business considerations, which often conflicted. The

 

combination of uncertainty and conflict sometimes strained the financial resources of even the largest

 

studios. Arundel could expect to avoid the conflict between art and commerce and, at the same time,

 

escape (for a price) much of the risk associated with the unpredictability of moviegoers? tastes. The

 

idea was expected to appeal to studios because Arundel would offer cash when it was needed most,

 

during an initial film?s production. Since Arundel would seek to purchase the rights to many films,

 

the total payments by Arundel could be substantial and would help reduce the studio?s borrowing.

 

Whether Arundel could expect to make money depended heavily on how much it had to pay

 

to purchase a portfolio of sequel rights. In 1992 the major studios did not usually sell sequel rights,

 

nor did they explicitly assign them a value when deciding to put a project into production. However,

 

casual inquiries suggested that studios would find the idea tempting at a price of $2 million or more

 

per movie. At prices below $1 million per movie they probably would not even discuss it. Paul

 

Kagan Associates, Inc. had expertise in analyzing the film business, and it had assembled certain

 

proprietary data on industry cash flows. Hence, Mr. Davis was asked how much the sequel rights

 

were worth.

 


 

William A. Teichner, Charles M. Williams Fellow, prepared this case under the supervision of Professor Timothy A.

 

Luehrman as the basis for class discussion rather than to illustrate either effective or ineffective handling of an

 

administrative situation.

 

Copyright ? 1992 by the President and Fellows of Harvard College. To order copies or request permission to

 

reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to

 

http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system,

 

used in a spreadsheet, or transmitted in any form or by any means?electronic, mechanical, photocopying,

 

recording, or otherwise?without the permission of Harvard Business School.

 

1

 

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292-140

 


 

Arundel Partners: The Sequel Project

 


 

The Movie Business

 

To reach the public, a movie went through three stages: production, distribution, and

 

exhibition. Production involved creating the film negative. Distribution consisted of advertising the

 

film, making prints, shipping prints to theaters, reproducing the film onto videocassettes, and

 

licensing it to pay and non-pay television and other outlets. Finally, exhibition traditionally consisted

 

of projecting films in theaters, but increasingly included other viewing media, such as home video.

 

In 1992, the major movie companies (and ultimate parent companies, if different) involved in

 

U.S. production and distribution were MCA Universal (Matsushita Electric Industrial Co., Ltd.);

 

Metro-Goldwyn-Mayer Inc. (Credit Lyonnais Bank Nederland N.V.); Orion Pictures Corp.;

 

Paramount Pictures Corp. (Paramount Communications, Inc.); Sony Pictures Entertainment, Inc.

 

(Sony Corp.);1 The Walt Disney Company;2 Twentieth Century Fox Film Corp. (The News

 

Corporation, Ltd.); and Warner Brothers, Inc. (Time Warner, Inc.).

 

These companies, or studios, were all engaged in both production and distribution, and in

 

some cases exhibition as well. Several of the parent companies or their subsidiaries owned movie

 

theater chains, pay TV channels, and/or TV stations.

 

In 1991 the major studios and smaller distributors released 150 and 274 films, respectively, in

 

the United States. While the major studios distributed just 35% of all films released in the United

 

States, they accounted for 93% of all revenues received from U.S. movie theaters. These revenues

 

were known as film rentals because the distributor essentially rented prints of the film to theaters for a

 

specified period of time. The top U.S. rental film of 1991, Tri-Star?s Terminator 2, represented

 

approximately 5% of total U.S. industry rentals. The top five films accounted for 16% of total rentals

 

and the top ten films accounted for 26%. The industry?s market share leader (in rentals) changed

 

from year to year according to which studio?s releases were most successful. Exhibit 1 presents

 

selected data from 1980-1991 for U.S. film distributors.

 


 

Production

 

Most movies were based on existing literary properties, and producers who planned to adapt

 

a property into a movie normally had to acquire its film rights.3 Sometimes literary agents

 

introduced properties to producers. Other times, large talent agencies presented producers with

 

packages consisting of a script, director, and principal actors. Sometimes producers discovered or

 

created properties on their own. Producers frequently purchased options on the film rights to literary

 

properties. However, most such options were never exercised?the likelihood that a movie would be

 

made from an optioned property was very small.

 

Production costs were incurred in each of three primary stages: pre-production, principal

 

photography, and post-production. Costs for pre-production included expenditures for script

 

development, set design, casting of actors, film crew selection, costume design, location scouting, and

 

budget planning. The costs associated with principal photography included fixed salaries of actors,

 


 

1Sony Pictures owned Columbia Pictures and Tri-Star Pictures.

 


 

Both were involved in production and

 

distribution.

 

2The Walt Disney Company owned three film studios: Walt Disney, Touchstone, and Hollywood Pictures, and

 

distributed their films through Buena Vista Pictures Distribution, Inc., a wholly-owned subsidiary.

 

3The term producer was used in a variety of ways in the motion picture industry. Here, it refers to the

 

individuals or companies that owned the rights to produce a film.

 

2

 

This document is authorized for use by David LaBarre, from 1/3/2016 to 5/31/2016, in the course:

 

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Arundel Partners: The Sequel Project

 


 

292-140

 


 

directors, writers, and other personnel.4 They also included rent, wages, and other expenses for

 

soundstages, set construction, lighting, transportation (for location shooting), costume making,

 

special effects, and miscellaneous items. Finally, post-production costs consisted of expenses for film

 

editing, the laying down of sound effects and music, and the addition of titles and credits. On

 

average, the entire production cycle required one year from the time a project was put into

 

production until the finished film was released to theaters.5

 

The total cost of production, including fixed expenses for story acquisition, was called the

 

negative cost, i.e. the cost to create the film?s completed negative, from which positive prints could be

 

made.6 The negative cost excluded advertising and other distribution expenses. While the negative

 

cost included fixed salaries to actors and others, it did not include future compensation that was

 

linked to either the film?s revenues or its earnings. Exhibit 2 presents a breakdown of items normally

 

included in a film?s negative cost.

 

In 1991 the average negative cost, excluding interest, for a major new movie was

 

approximately $20 million. This cost had to be financed somehow. Some producers (e.g., wealthy

 

individuals, producer partnerships, and movie studios) financed their own projects. Sometimes the

 

rights to certain revenues, such as from the home video or non-U.S. theater markets, were pre-sold to

 

raise cash for production. In other cases, independent producers obtained financing from major

 

studios. When a studio financed an independent production, it frequently supplied personnel,

 

facilities, supervision, and equipment.

 

It was very common for a project to be rejected by one or more studios before it finally

 

received financial support. Furthermore, studios often backed out of projects after investing initial

 

time or money, but before beginning principal photography.

 


 

Distribution

 

Typically, the studio that produced or financed a particular movie also distributed it. When

 

producers financed negative costs without help from studios, they often engaged studios to simply

 

pick up or distribute their films once they were completed. In their capacity as film distributors, the

 

studios managed the circulation of movies to theaters, the licensing of films to pay and non-pay TV,

 

and the duplication and distribution of videocassettes. They handled advertising, publicity, and

 

promotion for the films they distributed. They also collected proceeds from theaters and ancillary

 

revenue sources.

 

The traditional contract between the distributor and the producer allowed the distributor to

 

charge distribution expenses and distribution fees, which were deducted from the revenue the

 

distributor collected from theaters and ancillary markets. Distribution expenses included the direct

 

costs of distributing the film, while distribution fees were charged to cover the distributor?s overhead

 

and profit.

 


 

4It also included the costs of line producers who were hired by the financiers or producers of a movie. Line

 

producers managed the day-to-day physical production of the movie, from pre- to post-production. They also

 

oversaw production costs and hired and fired personnel. Their screen credits included executive producer,

 

producer, and associate producer.

 

5While it took about a year to complete most production, a script might hibernate in pre-production

 

development for several months or years before the beginning of principal photography if a producer could not

 

easily arrange financing or if a studio was not very interested in the project.

 

6Sometimes interest charges on loans to finance production were included in negative costs. Here, interest

 

charges are excluded from negative costs.

 


 

3

 

This document is authorized for use by David LaBarre, from 1/3/2016 to 5/31/2016, in the course:

 

CMBA 5715: Advanced Financial Management - Winton (Spring 2016), University of Minnesota.

 

Any unauthorized use or reproduction of this document is strictly prohibited.

 


 

292-140

 


 

Arundel Partners: The Sequel Project

 


 

Distribution expenses These expenses primarily represented the costs of advertising in

 

newspapers and on television, of making prints of the film for theaters, and of duplicating

 

videocassettes. Advertising costs were ordinarily the largest single distribution expense by a wide

 

margin, and occasionally exceeded a film?s negative cost. They varied with the length of time a

 

movie played in theaters. In 1991, the average U.S. advertising cost for a major film was $10 million.

 

The cost of prints and videocassette duplication varied with the number of theaters a movie played in

 

and the number of videocassettes sold, respectively. Other smaller distribution expenses were

 

shipping and insurance costs and miscellaneous fees, duties, and taxes.

 

Distribution fees Distributors traditionally charged a fixed percentage of the proceeds they

 

received from the various theatrical and ancillary markets to cover their overhead and profit.

 

Because distribution fees were often calculated as a fixed percentage, they could be more or less than

 

the overhead expenses actually incurred by the distributor.7 The studio in its role as a distributor

 

generally charged lower fees when an independent producer (rather than the studio) financed the

 

negative. In addition, fees varied by ancillary market and country. For example, fees were usually

 

higher on non-U.S. proceeds than on U.S. proceeds.

 

For independently-financed films distributed by a studio, a common distribution fee was

 

22.5% of U.S. rentals and 32.5% of most non-U.S. rentals. However, if the movie was studio-financed,

 

the fee was generally 30% of U.S. rentals and 40% of most non-U.S. rentals.8 Fees on home video and

 

pay television revenues were often the same as those on theater rentals. U.S. network TV fees were

 

sometimes several percentage points lower, while U.S. syndicated TV and non-U.S. TV fees were

 

several percentage points greater.

 


 

Exhibition

 

Exhibition usually referred to projection of movies in theaters, but, defined broadly,

 

encompassed ancillary markets as well. Films were released to the various markets in stages that

 

spanned seven or more years from the date of initial release. U.S. films were typically released first to

 

U.S. movie theaters, about one year after going into production. Revenues from ticket sales in movie

 

theaters were known as gross box office proceeds. During 1991, for each dollar of gross box office

 

proceeds, about 50 cents was remitted to the distributor as film rentals.9

 

About two months after their release in the United States, films were released to non-U.S.

 

theaters. About eight months after theatrical release, videocassettes were sold in the United States

 

and soon thereafter in non-U.S. markets. Movies normally appeared on pay TV in the beginning of

 

the second year after release and shortly afterwards on non-U.S. pay TV. In the third year, films aired

 

on U.S. network TV and non-U.S. TV. Finally, films might be licensed to independent television

 

stations around the world six to eight years after their theatrical release. Exhibit 3 illustrates the

 

sequence of releases to various markets.

 


 

7The distribution fee percentage was sometimes lowered once certain pre-determined dollar amounts were

 


 

reached.

 

8Under both scenarios, fees on U.K. and Canadian rentals were typically lower than for other countries. In

 


 

addition, distribution fees were generally lower when independent producers helped finance distribution

 

expenses.

 

9A common arrangement between the distributor and the theater exhibitor provided that the distributor would

 

receive the greater of: (a) 70% of the gross box office proceeds in the first two weeks (60% for the following two;

 

50% for the next two; 40% for the next two, and 35% for the remainder of the run) or (b) 90% of the gross box

 

office proceeds after subtracting out a reasonable, and pre-determined, amount of cash to cover the costs of

 

operating the theater.

 

4

 

This document is authorized for use by David LaBarre, from 1/3/2016 to 5/31/2016, in the course:

 

CMBA 5715: Advanced Financial Management - Winton (Spring 2016), University of Minnesota.

 

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Arundel Partners: The Sequel Project

 


 

292-140

 


 

Calculation of Net Profits

 

After distribution expenses, distribution fees, the negative cost, and any other expenses were

 

subtracted from all revenue, what remained were net profits.

 

For an independently-financed film distributed by a studio, the studio collected proceeds

 

from the various revenue sources, subtracted distribution expenses and fees, and remitted the

 

balance to the producer.10 After subtracting the cost of the film?s negative, the independent producer

 

was left with the film?s net profits.11 See Exhibit 2 for the calculation of net profits for a typical

 

movie.

 

For movies financed by a studio, the studio?rather than the producer?subtracted out the

 

negative cost. Again, what remained was the film?s net profits. For taking on the risk of financing

 

the film, the studio often kept 50% or more of the net profits and remitted what was left to the

 

producer. If there were zero or negative net profits, the studio remitted nothing and bore any loss

 

itself.

 


 

Sequels and Arundel Partners

 

More than 60 films produced since 1970 had one or more sequels made subsequently. Not all

 

commercially successful first films were followed by sequels, but practically all sequels followed

 

successful films. Many of the most profitable movies of the past 20 years spawned one or more

 

sequels. These included, for example, Airport, Back to the Future, Beverly Hills Cop, Friday the 13th,

 

Ghostbusters, The Godfather, Jaws, Police Academy, Raiders of the Lost Ark, Rocky, Star Trek, Star Wars,

 

Superman, Teenage Mutant Ninja Turtles, and Terminator. The long-running James Bond film series had

 

begun in 1962 with Dr. No, which was followed by 16 sequels.

 

Sequels were based on characters or situations portrayed in the initial movies. Scripts for

 

sequels were usually written after the first film?s release, and in some cases were worked on by

 

individuals other than those who had created the original. The median release date for a sequel was

 

three years after the first film?s release, and most were released within one to five years.

 

The average negative cost for a sequel was higher than for the first film. For sequels made

 

after 1970, the inflation-adjusted negative cost was about 120% of the first film?s negative cost,

 

according to one estimate. This was partly because the commercial success of the first film enhanced

 

the bargaining power of key creative talent, who demanded higher compensation for the sequel.

 

A similar analysis showed that the average sequel produced only 70% of the (real) rentals

 

that the initial film had earned. Exhibit 4 displays comparative, inflation-adjusted cost and revenue

 

data for a sample of first films and their sequels. Exhibit 5 shows rental data for a small number of

 


 

10Occasionally, a major actor?s contract specified that he or she would receive a percentage of the film?s

 


 

revenues. In that case, these gross participations were often paid out of the distributor?s proceeds before fees and

 

expenses.

 

11Sometimes creative talent received net profit participations, or percentages or any positive net profits the film

 

made. The arrangement described in the text, wherein fees were deducted by the distributor, was fairly standard

 

in the industry and was called a distribution fee deal or net deal. In the 1980s, two other kinds of deals became

 

common. These were the gross percentage deal and adjusted gross percentage deal. In the gross percentage deal, the

 

producer received a fixed percentage of the film's proceeds received by the distributor. In the adjusted gross

 

percentage deal, the producer received a fixed percentage of the distributor's proceeds after certain items were

 

first subtracted.

 

5

 

This document is authorized for use by David LaBarre, from 1/3/2016 to 5/31/2016, in the course:

 

CMBA 5715: Advanced Financial Management - Winton (Spring 2016), University of Minnesota.

 

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292-140

 


 

Arundel Partners: The Sequel Project

 


 

films that spawned more than one sequel. For most such film series, rentals declined with each

 

additional installment in the series.

 


 

The Sequel Project

 

Arundel Partners would be interested in purchasing the sequel rights for one or more

 

studios? entire production over an extended period of not less than a year. If a particular film was a

 

hit, and Arundel thought a sequel would be profitable, it would exercise its rights by producing the

 

sequel itself or hiring professionals to do so. Alternatively, it could sell the rights to the highest

 

bidder. Inevitably, most first films would not justify sequels, and for them the sequel rights would

 

simply not be exercised. As a practical matter, for most movies it would be very clear after their first

 

few weeks in U.S. theaters whether a sequel would be economical or not.

 

It would be critically important to Arundel that a number of films and a price per film be

 

agreed upon before either Arundel or the studio knew which films would be produced. Once

 

production started, the studio would gradually but inevitably form an opinion about the movie, and

 

Arundel would not want to have to bargain over individual projects about which it knew less than

 

the studio.

 

Otherwise, many details of a potential contract between Arundel and the prospective studio

 

still needed to be worked out. For example, in addition to the price of the rights, a satisfactory

 

method of payment had to be agreed upon. The simplest approach would be for Arundel to make

 

payments to an escrow account when a first film went into production. These payments could then

 

be disbursed to the studio as the movie progressed through production. Certain films might have to

 

be excluded from the arrangement if the studio itself did not already own their sequel rights. To

 

keep the studio committed to the success of possible sequels, it probably would be desirable to have

 

the studio retain an interest in the revenues or the net profits of the sequel, or to have rights for

 

subsequent sequels, i.e., third, fourth, and other future films, revert to the studio.

 

For tax purposes, it might be desirable to fix an expiration date for the sequel rights, perhaps

 

three years from the first film?s release, by which time Arundel would have to declare its intentions

 

or forfeit the rights. This would allow Arundel enough time to make a decision about making a

 

sequel, and enable it to more quickly write off its investment in rights it chose not to exercise. If the

 

studio were interested, Arundel could grant it a right of first refusal on any rights it planned to sell.

 

The contract also could provide that Arundel would use the original studio for distribution,

 

assuming its distribution fees and expenses were competitive.

 


 

Available Movie Data

 

The value of the sequel rights depended heavily on the statistical distribution that

 

characterized the returns earned by first films. Actual data on realized returns for a large sample of

 

first films were not publicly available, although rough estimates could be made for hundreds of films

 

based on public information. Further, Paul Kagan Associates, Inc. had assembled a proprietary

 

database on which even more reliable estimates could be based for an even larger sample of recent

 

movies.

 

Estimates of the financial performance of all first films released by six major studios during

 

1989 are presented in Exhibit 6.12 These estimates were used to compute the discounted cash flows

 

presented in Exhibit 7, under the assumptions described in the Appendix. The discounted costs and

 


 

12Exhibits 6-9 exclude releases from Orion and Metro-Goldwyn-Mayer, both of which were experiencing severe

 

financial problems in 1992. Orion was in Chapter 11 bankruptcy proceedings in April 1992.

 


 

6

 

This document is authorized for use by David LaBarre, from 1/3/2016 to 5/31/2016, in the course:

 

CMBA 5715: Advanced Financial Management - Winton (Spring 2016), University of Minnesota.

 

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Arundel Partners: The Sequel Project

 


 

292-140

 


 

revenues were used to compute simple one-year returns for each film. As Exhibit 7 shows, returns

 

were highly variable, ranging from 1,224% for Tri-Star?s Look Who?s Talking to -91% for Paramount?s

 

We?re No Angels.

 

Exhibits 6 and 7 also estimate costs, revenues and one-year returns for hypothetical sequels for

 

each first film, according to the assumptions outlined in the Appendix. Essentially, these figures are

 

projections of how a sequel would perform, assuming it was made, and assuming it was ?typical?.

 

For example, Warner Brothers? Batman was expected to result in a successful sequel, with a projected

 

return of 225%. Not surprisingly, however, most movies? hypothetical sequels performed...

 


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