Most financial institutions don’t fully understand the business of Hollywood. The terms of a revolver or borrowing base are set by a group of MDs that have never been practitioners at a studio and have limited optics on how a studio is run and where the industry is heading. However, this space isn’t without risk especially for studios that don’t have a distribution network. Most studios are simply looking to breakeven and make most of their money on the one or two movies that outperform. Unlike investments in more traditional industries, a $100MM investment in a film is a complete projection and combines art and science to come up with an investment rationale. When compared to making a $100MM investment in an existing widgets business with historical financials, investing in a film (outside of a presale) is incredibly risky. When you combine these factors the results are poor terms and many operational hurdles to stay compliant to a debt facility. 

An important note is that creatives most likely have no access to financial institutions as a source of capital. They are essentially required to have their projects funded by a studio or international distributor. The former can put creative guidelines to a project and the latter greatly reduces the chance of selling a project to a global distributor as territory rights have already been sold.

The film business is very akin to venture capital and the financing structures should match that. As noted above, the film business counts on “hits'' to drive overall profitability with most projects either breaking even or losing money. The same goes with VC. There is a reason VC companies (for the most part) don’t use debt to fund investments. This type of business model doesn’t align with debt being the primary way for studios to fund projects; however; this is the only option that exists in the market. It inherently doesn't make sense to overlay financial structures that are more appropriate for a widget maker than venture bets. Available financing models are not scalable or efficient for most players in Hollywood. 

A DAO can be a singular low touch financing source that can be accessible to creatives and studios alike. This structure, especially when run by former and current operators, can provide market appropriate financing (equity preference over debt) while truly understanding how this business operates. In a ideal world a DAO can:

• Be a truly novel and incremental source of financing

• Increase optionality and financial upside for studios and creatives

• Act as financing plus

  • Financing with added component of providing long term economic upside to DAO participants in the form of tokens and reducing CAC

To conclude the meeting, the head of film will note the following to set up the financial analysis of the film:

• Deal structures and terms being negotiated with potential distribution partners

• Budget

• Talent backend considerations

Coming from that meeting, content strategy or finance teams will start building a greenlight model to forecast the financial performance of the film for each respective case and deal structure. There are many different deal structures for theatrical film investments outside of a distributor directly producing a film and releasing it though its own distribution network. The following represents a high level overview of the different ways film deals are cut:

• 50/50 Cofi - partner with a distributor and share profits 50/50 after studio recoups P&A spend and distribution costs

• Co-Financing Agreement - invest in a film for a minority stake and a studio charges a distribution fee

• Worldwide Presale - sale of all territories and receive upfront MG that covers budget + premium and entitled to overages if profits are seen after a large distribution fee and interest on MG

• Domestic Co-Fi and Foreign Presale - 50/50 co-if on domestic profits and sell international territories for a MG and the opportunity to capture overages after a distribution fee and interest

• SVOD or Streaming Sale - Sell to a streamer for a MG; usually MG is derived by determining what it would have to be in order to achieve a similar level of profitability as a theatrical release when you factor in reduced costs by not having a theatrical release

The results of the greenlighting exercise are presented to the underwriting committee to determine whether or not to greenlight a film.

The likely outcome of the current market environment is the acceleration of the trend of larger studios with a sizable IP library making fewer bets on original content as internal operators will be financially incentivized to stick to known IP either through adaptation from other media or through construction of their own IP continuity (MCU). Content strategy decisions of well-capitalized studios will have trickle-down effects on small and independent studios who primarily develop and produce original content. Studios without output deals to streamers such as Netflix or Amazon, will probably face a liquidity crunch in the short to medium term. These studios most likely have an asset back facility, revolver, or a blanket corporate facility facilitated by a major bank to fund content investments. Each of these financing structures typically offer poor advance rates to collateralize future cash flows that a studio can borrow against. The terms of a borrowing base generally make studios operate with very little liquidity on a month to month basis and requires active management to make sure a company stays compliant. The current theatrical market makes using a facility to fund projects that aren’t simply cost plus deals incredibly risky, even if there is strong conviction on a project. This essentially forces these studios to become content arms dealers to larger distributors and handcuffs the creative decision making to only align to what a handful of buyers want. Additionally, decreased demand for original content reduces the probability studios with distribution arms will co finance films aimed for a theatrical release, which again only increases the risk profile of financing original content. All of these headwinds reduce the bargaining power for small and independent studios which lowers future liquidity projections and increases a company's overall risk. 

On the creative and production side of the business, independent financing of indie / small budget (sub $10MM) films based upon original IP has come back to life in 2022. However, financing has been incredibly conventional and comes with stipulations. Much of the current film financing has been originating in Europe and requires producers and studios to presale European distribution rights. De-risking a project through distribution rights sales before a film is made can be a good thing. Outside of the obvious financial considerations, having upfront funding allows for offers to be made immediately to talent which increases the negotiation power of creatives and producers with distributors. However, being forced to sell distribution rights to fund a project gives producers less options to monetize a film and reduces the financial upside for all parties (studios and creatives) as presale participation waterfalls usually don’t pay in excess of the upfront minimum guarantee unless there is major outperformance of a project. 

There is an immediate need in the market for novel financing models to address the pain points of small / independent studios and creatives. A DAO can be a source of financing that operates within the existing system yet alleviates many of the pain points that exist from traditional sources of capital within the Hollywood ecosystem.

For example, with a show like American Vandal, you often see the rationale that it was cancelled because “it was produced for Netflix by an outside studio. The streamer, like most in the TV space, is increasingly looking to produce things in-house in an effort to control the global rights to a project”. This implies that the issue with the content being produced by an outside studio was a worldwide rights issue. But that’s not the full picture.

For one, the large majority of deals Netflix cuts for originals are worldwide exclusive deals. Sometimes the producers of the show are able to keep international rights, but usually Netflix owns the 1st cycle worldwide rights for season 1 and 2. Third-party produced content is also significantly more expensive than in-house produced shows, and then on top of that Netflix might not control rights after the contractual 1st cycle window ends. That’s just one example but it’s representative of a pattern of coverage that fails to dig deeper into Netflix’s content strategy decisions.

Netflix like any subscription-based service wants to acquire new customers, cut costs, and reduce churn. Internal content strategy teams analyze new and existing content to determine how valuable a show or film would be to their service. The analysis of content and its impact on the core business drivers is a capital allocation exercise with the goal of finding the most efficient asset mix. The content strategy team calculates how efficient each film or television show will be on their platform and compares a program's efficiency score to similar titles. Inefficient titles will be canceled (with some exceptions) and efficient titles will be greenlit. 

Before we dive into some of the more complicated aspects of Netflix’s content strategy and why a show becoming too expensive really matters, let's first take a step back and discuss how Netflix acquires content for its service and how some deals are structured. 

Obviously, the content catalog on Netflix is composed of Netflix originals and non-original third party content like The Office. Most of the third party content has already been aired/distributed by another company or has been previously released in theaters. Once the rights for third party content becomes available, Netflix can purchase them from another studio or rights holder in return for that content to be hosted on their platform. These content deals are negotiated for exclusive/non exclusive rights, length of time, and the availability of the content in certain territories. In the last few years, Netflix has made a large effort to have Netflix originals make up more of the content on their service. The average viewer may not be aware but most Netflix originals are actually produced by third party studios and Netflix simply purchases the rights and labels the content as a Netflix original. This is true for both film and television content. As an example,  Stranger Things is a Netflix original and produced by Netflix and House of Cards is a Netflix original and produced by MRC. 

For television programming, Netflix buys the worldwide distribution rights of a show in return for 100% of the net budget + a premium (generally somewhere between 15 – 30% of the net budget). For television shows, on top of a premium, baked into the contract are premium / cost escalators that contractually increase the shows cost to Netflix for every new season that is greenlit. This is in addition to overages (non-budgeted costs) or concessions Netflix might pay to cover additional costs to make the show over the course of production. This is true of Netflix produced content as well.

For films, Netflix purchases third party properties by acquiring worldwide or territory rights for a minimum guarantee or “MG” that generally gets a studio to a similar level of profitability as if it was released theatrically under a sales case. The only caveat to this are movies that studios know are bad before they are released. In this situation a studio will try and dump the film to a streamer to get back to even or take a slight haircut. Content strategy teams at other studios have already modeled out profitability cases well before the release of a film. It is quite easy to restructure these models to show a streamer sales case and back into what the MG would have to be in order for a studio to be just as well off as a theatrical release. I will say this structure is definitely more reflective of a pre-COVID market unless the sale is for a tentpole property like Spongebob.

Simply put, 3rd party content can cost Netflix significantly more money than producing content themselves because of the paid premiums on production costs. Unfortunately for Netflix, third party originals have historically had more critical success in both reviews and award considerations. While Netflix produced content is on the rise, the company will still allocate a significant amount of money to third party content. 

Now that we established why third party content costs more than self produced programs, let's explain why this matters.

Netflix is a SVOD service and charges a fixed subscription fee. No customer can pay to watch only The Witcher. Under this business model, value isn't directly derived from one show or film. Saying a show is starting to cost too much money doesn’t mean much because there is no standard P&L directly attached to the programs they make. This is very different from a traditional media company. When Disney makes a film there is a P&L attached which is known as an Ultimate. The value of a specific film to Disney is clearly seen as the Ultimate outlines revenues and costs. In this economic model it’s easy to say something costs too much because costs are easily attributed to specific programming along with profits or losses. 

It’s important to note that COVID-19 and the rise of streaming platforms from established media companies has started to change the traditional film economic model for companies like Disney. COVID-19 has essentially paused the theatrical business with many studios pushing their films to 2021+. Now studios like Disney have to debate whether to push content to Disney+, release with PVOD, or push a film's release date to when the company believes consumers will return to theaters. It’s a tough decision especially for higher profile / budget films. Pushing theatrically will force a company to spend millions in additional P&A and release in a competitive window as most studios have already pushed their slate to next year. Releasing on PVOD is risky as this distribution strategy hasn't really been tested with a tentpole film and the results have been mixed for the films that have tried this strategy. If a studio also owns a SVOD like Disney with Disney+ they can add a film like “Mulan” to the service which may increase demand for the platform but the studio won’t receive cash that can be directly attributable to the film. A studio can also sell a film to a 3rd party SVOD and receive upfront cash but they lose out on any potential upside or a chance to increase the prestige of a owned SVOD. It will be tough for these companies to determine what is the best path as the economic model for each decision is clouded with uncertainty. For smaller production companies this decision becomes even more significant as revenue driven from Film and TV properties has likely dried up over the past few months and there is most likely a liquidity crunch that has to be proactively managed. The clear winner during this time are established SVODs like Netflix that will buy up distressed film assets from smaller cash strapped studios and larger companies that can’t stomach additional AD spend. 

No matter how successful any film or television show is, Netflix gets paid the same from subscribers. While bad programming can lead to an increase in churn and a reduction of new subscribers, no one can attribute a bad financial quarter from Netflix on a terrible film. 

While a program's specific costs doesn’t matter in the traditional sense to Netflix it matters a great deal when thinking about efficiency. As I noted above, Netflix is trying to find the most efficient way it can allocate its content budget. To calculate efficiency Netflix needs to take a deep dive into viewership data and content costs.

Netflix’s content strategy team will have to answer whether or not greenlighting a new season of a hit show like Stranger Things is an efficient use of capital. Do people like Stranger Things or just Sci-Fi TV, Teen TV, TV Thrillers, and TV Horror shows?  This is something Netflix has to figure out. If a show has a ton of viewership it's easy to just say this is a successful show and greenlight a new season. The show in actuality might just be successful because subscribers like the genre(s) and viewership has little to do with the shows IP. In order to answer this question, there are multiple considerations that are weighed together. Factors like award nominations (contributes to prestige and marketing capabilities), attributable new subscriber growth, and viewership from relatively inactive (likely to cancel) subscribers to the show will be looked at relative to comparable shows on the platform to see if Stranger Things outperforms its peers on those metrics. A nuanced view on viewership is another critical component to determining efficiency and how a show is performing relative to its peers inside and outside of the genre.   

While traditional viewership data like the amount of people watching a show and the number of hours people watch a program are important and can help distinguish a show's popularity from one comparative program to another, it doesn’t really answer how valuable the show is across the subscriber base. What’s worth more to Netflix: Show A that has 1MM cumulative hours of viewing across 10k subscribers or Show B that has 100k cumulative hours of viewing across 100k users? If the total subscriber base collectively  watches 500k hours of The Office and 100k hours of Stranger Things does that make The Office 5x more valuable of a show for Netflix? Seeing that every subscriber is worth the same to the company, i.e. the biggest user and smaller user pay the same amount, viewership data becomes a tricky data point to assign value to one show over another and can be full of noise that doesn’t provide much value for Netflix. How do you look at every user’s viewership data and assign value to content under the constraint that every subscriber is worth the same?

Netflix uses an adjusted view rate to try and answer this question. Each subscriber is allocated one vote that is divided and distributed across all the programing they watch. A subscribers point is divided proportionally to the amount of time they have watched each program relative to their total viewing time across all programs. For example, If Subscriber X watches 10 hours of content equally over 5 shows during their subscription, each show will receive 1/5th of a vote. If Subscriber Y watches 4k hours of Show A and 1k hours of Show B, Show A would receive 4/5ths of a vote and Show B would receive 1/5th of a vote. Subscriber Y watched significantly more hours of Show B than any one show Subscriber X watched. But because each subscriber is worth the same, Show B receives the same amount of votes of any show Subscriber X watched even though each show was watched for only 2 hours. An adjusted view rate can also be viewed as a proxy for revenue for a program. If we factor a subscriber’s revenue multiplied by the programs share of votes, we can impute a show specific revenue. This concept is vitally important when thinking about efficiency on Netflix’s platform. Again as noted above, special value cohorts like viewership for new subscribers (attributable customer acquisition) and viewership from subscribers likely to cancel (attributable churn reduction) will have additional weight relative to the standard user.

After calculating the adjusted view rate of a show we can now calculate efficiency as we know how much money it took to produce / acquire a piece of content. Efficiency is calculated by taking the adjusted view rate of a piece of content and dividing by the share of aggregate spend of that content. The efficiency of the entire platform is 1. (Adjusted Hours Viewed for All Content divided by Total Hours Viewed for All Content) divided by (Total Aggregate Spend divided by Total Cost of All Content) equals one. When Netflix is entering into price negotiations or deciding whether a show should get a renewal, the content strategy teams generally target for an efficiency greater than 1. There are exceptions such as a  film / television show that has a high profile artist attached that Netflix might want to develop a relationship with or if the company wants to try and launch a new tentpole. Seeing we established costs increase season over season, if a show doesn’t proportionally increase in adjusted viewership, a hit show will eventually become inefficient relative to comparative content and a bad investment to greenlight a new season. This is really why costs matter so much and why popular shows tend to get cancelled earlier than expected. 

The value of a hit is almost like a bell curve if the x-axis represents time / cost and the y-axis represents value / efficiency. 

By maximizing the efficiency of its platform, Netflix is able to address the core of its business model: acquire new customers, cut costs, and reduce churn. By knowing when to cancel a show it not only saves Netflix money but allows them to reallocate resources to acquire or produce content that is more in demand and possibly cheaper than an existing show. Canceling a show and creating a new one also immediately increases the variety of programming on the service. Netflix is solving the problem of "what is the minimum supply I can give subscribers for the cheapest amount of money to keep the both the most and least demanding consumers.” Maximizing efficiencies is also a business necessity because of the monetization strategy Netflix deploys and the competitors it goes up against.

Netflix unlike other streaming services like Disney+ or Amazon Prime is a pure play SVOD. This means the company’s revenue is generated solely from their subscription service and isn’t supplemented by the company's other revenue generating business. Let’s take a look at some of Netflix’s competitors and the safety net they are afforded:

It should be clear that Netflix’s competitors can afford to make a lot more mistakes. Not just with margin for error but a longer leash. There can be more qualitative / holistic assessments that can be made for content vs what a pure play SVOD can account for. They’re not just financially supported by the parent company’s business units but are supported by incredibly valuable and established IP that streamers can utilize without needing to make a huge acquisition. Gone are the days where Netflix can just leverage other companies IP for their own benefit (a COVID-19 world being the current exception) because slow moving conglomerates didn’t see where the market was moving and majorly undervalued their library content. How can Netflix compete when Disney can just decide to make a Marvel or Star Wars film / television show whenever they want to?  The answer is being smarter than everyone else and maximizing how efficient they can make their content strategy.  

By moving away from hits and poorly performing content sooner and reinvesting that money into other areas, Netflix can stay nimble and cater to current and prospective subscribers while actively managing costs. Netflix embraces making content decisions that will cannibalize viewership of hit programming. By doing this, consumers can expect a constant wave of mini hits that will keep subscribers engaged year round vs having the platform controlled by a small handful of mega hits which currently defines most legacy media streaming services. It should now be understood that content strategy decisions are way more complex than a simple understanding of content costs and viewership.  Understanding adjusted view rate and efficiency calculations are incredibly important when thinking about why Netflix is canceling or greenlighting a television show or film. This approach to content strategy is a business necessity and one of the only competitive advantages it has over established media companies. The next time your favorite show gets canceled hopefully you can reject simple analysis and embrace the idea that Netflix has already made your next favorite show.