Solution: Base residuals on budgets

By Schuyler Moore

Nov 8, 2007

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How to resolve the ruckus over residuals is the single biggest challenge facing the town in the wake of the standoff between producers and writers. Most of the disagreements between the studios and guilds center on how to calculate royalty payments and what to base them on, but I believe there is a simple, fair alternative method that eliminates all the contentious issues.

Why not calculate residuals right up front as a percentage of a film's budget? The amount of residuals thus calculated could then be paid in installments (one-fourth per year for four years, for example) to more or less track the result under the current approach for the payment of residuals (where residuals are due as revenue is received).

Alternatively, the residuals could be paid all upfront if the guilds would accept a reasonable discount for the time value of money and the elimination of the risk of nonpayment that is inherent in the installment approach.

There is tremendous logic for tying residuals to a film's budget: First, in the absence of knowing anything else, the best prediction of a film's gross receipts is based on its budget.

Almost all presales and output agreements provide for payments based on a film's budget, so there is a direct correlation between the budget and receipts. Secondly, residuals have been paid long enough that expected residuals can be calculated, on average, as a percentage of a film's budget.

In fact, this is exactly what SAG does when that guild demands an advance bond to secure residuals.

All I'm suggesting is that this should be the end of the process, rather than the beginning. Historical averages will not match any particular film's exact revenue, but this brings me to the third and final logical argument:

Why should residuals be tied to a film's revenue in the first place? The intent is just to provide extra compensation to the guild members, and it is just as logical to base this extra compensation on a film's budget as it is to base it on gross receipts.

So what percentage of the budget should residuals be? The starting point should simply be the historical average of residuals to film budgets, which will differ for each guild. From there, it is simply a matter of arm-wrestling as to whether the percentage should be higher or lower when the guild agreements come up for renewal.

This will at least be an honest negotiation, as opposed to the artificial debate about what income streams should or should not be included or whether a 20% DVD/VHS royalty is appropriate.

In other words, money is money, and the bottom line is how much money will residuals cost, not whether any particular income stream is or is not included.

(As for verifying the true cost of a film, it is a relatively simple matter since film companies have to certify the budget of each film for accounting and tax purposes. In addition, for films that are bonded, the bond company confirms the budget. The guilds in any new agreement will need to get the film companies to commit to deliver this information, failing which, the guilds' own determination would govern what the budgets are.)  Such a budget-based formula should benefit everyone.

It creates certainty as to how much residuals will be owed, and it eliminates all the current arguments over the calculation of residuals. Such a solution also eliminates the time-consuming and expensive accounting and auditing process.

It might also benefit everyone if the film company could elect to pay residuals right up front as part of a film's budget. For the guilds, that would mean certainty of payment and accelerated cash flow (albeit subject to a reasonable discount for the time value of money and elimination of risk).

Counter-intuitively, upfront payments might also benefit many film companies: A film's budget would thus increase by the amount of residuals, and because presales and output agreements almost always calculate the amount owed as a function of the budget, an increase to the budget will increase the amount the film is sold for.

By including residuals in the budget, it becomes possible to finance residuals using standard film financing techniques, such as bank financing, presales, etc.

It is typically far better to have this issue dealt with upfront than to be caught owing residuals at a time when the film company does not have the cash to pay them. (Residuals are now calculated on gross, not net, receipts, so they apply even if a film is running at a loss.)

As long as the upfront payment is discounted, the total amount of residuals owed is less than under the installment approach.  In all events, this suggested alternative is far better than the current lunacy. It would be a tragedy if the industry is shut down with prolonged strikes over issues as abstract as whether only 20% of Internet revenue should be included in gross receipts. This suggested alternative also eliminates for all time the endless arguments that will otherwise occur as future media are developed.

But if this suggestion doesn't work, then my back-up proposal is to include both video and Internet revenue at 100% (so the guilds can declare victory), but make the residual rate 20% of the current rate (so the studios can survive). Heck, if you can't fight the lunacy, you might as well join it.

Schuyler Moore is a lawyer at Stroock, the author of "The Biz," and an adjunct professor at the UCLA School of Law and UCLA Anderson Business School. He can be reached at smoore@stroock.com.