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Harvard Business School





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 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.




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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.





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




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.




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






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.





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.





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



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 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





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




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.




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.



Arundel Partners: The Sequel Project






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




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





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




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.




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.






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




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.





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.



Arundel Partners: The Sequel Project






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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