Digital Cinema Finance 101
by Michael Karagosian
©2009 MKPE Consulting LLC All rights reserved worldwide
originally published in the 15 November 2009 issue of Digital Cinema Report
Exhibitors today are faced with several options for acquiring digital cinema equipment. If seeking a financing plan in which studios provide financial assistance through the virtual print fee mechanism, it is worth taking time to understand the hurdles to financing such deals.
To a bank, virtual print fee (VPF) financing is anything but straight-forward. A deployment entity holds title to the equipment, but the equipment is in the possession of an exhibitor. The exhibitor uses the equipment to generate revenue, but the revenue that pays off the equipment debt comes from the studios, paid out incrementally. The deployment entity invoices the studios for the VPF, not the exhibitor. A complicating twist is that there are contractual issues that must be met by the exhibitor, with failure to do so resulting in non-payment of a VPF to the deployment entity. There are risks with any deal, but while this is not your typical equipment loan, the mechanisms behind these deals are solid and are worth gaining comfort with.
In a so-called virtual print fee deal, the deployment entity signs a deployment agreement with each of the major studios. The primary purpose of this agreement is to provide a fundable instrument describing the flow of payments used to recoup equipment costs. To simplify the administration of such agreements, steps are taken by the deployment entity to equalize the core terms. With the benefit of multiple players engaging in such negotiations, the trend over time has been for the agreements to be "rounded," lessening the equalization effort needed.
The virtual print fee provides the revenue used to retire equipment debt. The VPF is a fee paid per booking, as opposed to a fee paid per distribution, or a fee paid per play. It should be well known that the VPF is not an arbitrary figure. Ideally, the combined cost of the VPF plus the cost to generate and ship a digital print costs no more than that to generate and ship a film print.
There are several ways in which the equipment can be financed. If the deployment entity has substantial assets, it can issue debt. Alternatively, the deployment entity can borrow against the digital cinema equipment itself. Or it might collect some of all of the money from the exhibitor. Of course, the deployment entity may have cash available to invest. A combination of these methods may also be used.
When VPF financing was first conceived, it was expected that large companies with significant assets would back these deals. But of the four deployment entities in the US with the potential to self-finance or issue debt, Dolby, Kodak, and Technicolor have either reduced their presence or completely pulled out of the deployment business. Sony today is the only deployment entity that remains in this class. Cinedigm, as with several peer deployment entities around the world, has financial commitments that allow it to borrow against the equipment. In such deals, the bank expects a certain amount of equity in the equipment to be contributed by either the deployment entity or the exhibitor. But the main challenge with commercial financing of equipment is that the loan, termed senior debt, will typically have a 5 year term. Unless there is a substantial equipment equity contribution, the monthly revenue from VPFs will not be sufficient to meet the monthly obligations of the senior debt. Additional funds are required. This results in junior debt, which is likely burdened with a high interest rate. The junior debt can have a significant impact on the overall deal.
In a recoupment scenario, the studio agrees to pay a certain percentage of the purchase and financing costs. Generally, there is a requirement for the exhibitor to also contribute towards a minimum percentage of these costs. When a commercial equipment loan is the principal finance mechanism, someone has to pick up the unresolved costs not met by VPF revenue. Depending on the way the deal is constructed, that someone could be either the exhibitor or the deployment entity. The unresolved costs may also be financed through junior debt. Fortunately, studios are willing to pay VPFs over a term longer than 5 years, providing an opportunity to recoup the unresolved costs associated with the senior debt after the senior debt is retired. The balancing act, of course, is to do so within the term of the deployment agreements.
Exhibitor financing is a popular option now available through deployment entities in Europe and the US. When deployment entities talk about exhibitor financing, they are referring to the case where the exhibitor, and not the deployment entity, is responsible for 100% of equipment costs. Typically, the exhibitor's bank is paid from the deployment entity's VPF revenue pool, which may not directly correspond to the VPFs earned at the exhibitor's sites. If the exhibitor funds the purchase of equipment through a commercial loan, it is the exhibitor who picks up the unresolved loan costs not met by the VPF payments to the bank. Depending on how the deal is constructed, there may be an opportunity to recoup these costs over time.
The wonderful thing about VPF deals is that everyone gets to pay. Once content exceeds a certain length, the content supplier is expected to contribute to the recoupment pool. If that supplier is you, you may have to dip into your pocket. For many exhibitors, this is not a popular feature. Dependent on the deal, on-screen advertising and special screenings can generate fees. In addition, risk may be shared. Exhibitors and/or maintenance entities may be financially responsible for missed shows. Deployment entities may impose their own restrictions that affect content bookings. While much effort went into the technology of digital cinema so that business could continue in the same manner as with film, the exhibitor may find that digital cinema financing has a lot more impact than expected on how business is conducted.
Digital cinema financing may not be simple, but it is understandable. By digging into the details, you can learn if the deal on the table is for you.